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In the preparation of the financial statements, entities apply various judgements in the area of accounting estimates and accounting policies to account for the effect of transactions, conditions and events in the financial statements. Financial statements prepared must also faithfully represent the effects of transactions, conditions and events. When errors are identified in the financial statements for the previous reporting year/period, entities must make the necessary correction to the numbers. IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors governs the accounting requirements in these three areas.
In this edition of the factsheet series, we have prepared for you 9 quick facts relating to accounting policies, accounting estimates and errors based on the requirements of IAS 8.
In this section, we will first look at accounting policies and what are the requirements relating to it.
#1: What is accounting policy?
IAS 8 defines accounting policies as the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements. IAS 1 Presentation of Financial Statements requires entities to disclose material accounting policies information in the notes to the financial statements. Where the accounting policies relate to immaterial transactions, conditions or events, the accounting policies do not need to be disclosed in the financial statements.
The IFRS standards generally specify the accounting policy to be applied by entities to account for transactions, conditions or events. There are also certain transactions, conditions or events where the IFRS standards allow for entities to select/choose their accounting policy to account for them. For example, IAS 16 Property, Plant and Equipment allows entities to choose, as their accounting policy, to account for a class of property, plant and equipment using either the cost model or the revaluation model for subsequent measurement.
#2: What if the IFRS standard does not govern the transaction, condition or event?
It is possible for a transaction, condition or event not specifically governed by any IFRS standard. In the absence of an IFRS that specifically governs or applies to a transaction, condition or event, IAS 8 requires the management to use its judgements in developing and applying appropriate accounting policy. In doing this, the accounting policy chosen must result in information that is relevant and reliable in the financial statements.
IAS 8 further states that in developing and applying appropriate accounting policy for a transaction, condition or event, entities must observe the following hierarchy for the source of guidance:
- The requirements in IFRS dealing with similar and related issues – for instance, using the guidance in IFRS as an analogy; and
- The definitions, recognition criteria and measurement concepts in the Conceptual Framework for Financial Reporting.
IAS 8 also does not prohibit entities to consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop (i) accounting standards; (ii) other accounting literature; and (iii) accepted industry practice, so long the guidance is not in conflict with the source of guidance stated above.
#3: How do we determine whether accounting policy information is material?
As per the IAS 1, information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial statements make on the basis of those financial statements. Entities are required to apply judgement to determine whether a piece of information is material or not to the users of the financial statements. The IASB has also issued Practice Statement 2, Making Materiality Judgement to assist entities in this area. We have covered the discussion on this topic in 10 key takeaways on the Practice Statement 2, Making Materiality Judgements.
#4: Can entities change their accounting policies?
In general, entities are expected to apply accounting policies consistently for similar transactions, conditions and events from one period to another. This allows users of the financial statements to compare the financial position, financial performance and cash flows of an entity over time. However, entities may change their accounting policy for a transaction, condition or event only if: (i) the change is required by an IFRS, or (ii) change in accounting policy results in the financial statements providing reliable and more relevant information.
#5: What is the accounting implication when an entity changes its accounting policy?
The accounting implication from a change in accounting policy depends on the reason for such change. If the change is arising from the initial application of an IFRS, and such IFRS provides specific transitional provisions, then the accounting implication is very much dependent on the specific transitional provisions. For example, when IFRS 16 Leases was initially applied, entities are required by the transitional provisions to account for a change in their accounting policies for leases retrospectively (either full retrospective or modified retrospective). If the change in accounting policy is undertaken voluntarily or because of the initial application of an IFRS that does not include specific transitional provisions, entities shall account for such change retrospectively.
Retrospective application of a change in accounting policy requires an entity to adjust the opening balance of each affected component of equity for the earliest period presented and the other comparative amounts disclosed unless it is impracticable to do so. This is to reflect as if the new accounting policy had always been applied.
Change in accounting estimates
Now, let’s us look at the requirements for change in accounting estimates.
#6: What is a change in accounting estimates?
Currently, the technical term for a change in accounting estimate under IAS is an adjustment of the carrying amount of an asset, or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. A change in accounting estimate is made as a result of new information or new developments of the transaction, condition or event.
The IASB has, however, recently issued an amendment to the definition of accounting estimate where accounting estimates are defined as monetary amounts in financial statements that are subject to measurement uncertainty. This is due to the challenge that entities have in differentiating between accounting policy and accounting estimates. We have covered the amendments project in The upcoming amendments to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. The amendment is effective for the financial period beginning on or after 1 January 2023.
#7: How do we account for the change in accounting estimates?
Unlike the change in accounting policies which usually requires a retrospective adjustment, entities will account for the change in accounting estimates prospectively. Prospective adjustment requires entities to account for the effect of such change in profit or loss in the period of change or period and future period of change if it affects both. Where such change affects the assets and liabilities or relates to an item of equity, such change will be recognised by adjusting the carrying amount of the related asset, liability or equity item in the period when the change occurs.
The final 2 facts below discuss and explain the requirements when an error is identified.
#8: What is an error?
IAS 8 defines prior period errors as omissions from and misstatements in the entity’s financial statements for one or more prior periods. The prior period(s) errors arise from the entity’s failure to use or misuse of reliable information that (i) was available when financial statements were authorised for issue; and (ii) could reasonably be expected to have been obtained and taken into account in the preparation of financial statements. Errors can arise either from the recognition, measurement or presentation or disclosure in the financial statements.
#9: What is the accounting implication when an error is identified?
As explained above, entities must make corrections to the financial statements when errors are identified. In the financial period when errors are identified, entities must make a retrospective restatement, where practicable, by:
- Restating the comparative amounts in which the errors are identified; or
- Restating the opening balances of assets, liabilities and equity for the earlier presented when errors occurred before the earliest prior period presented.
The 9 quick facts above summarise the principles included in IAS 8. Stay tuned for our upcoming factsheet series for other standards. In the meantime, you can read various articles published in the Financial Accounting section.