IAS 8 Accounting Policies, Changes in Accounting Estimates
EZIKAN ACADEMY・43 minutes read
Accounting policies, which must be consistently applied according to IFRS standards, can only be changed retrospectively for better financial presentation, while accounting estimates are adjusted prospectively and do not require prior period corrections. Additionally, prior period errors necessitate retrospective adjustments, affecting reported earnings and retained earnings, as illustrated by specific financial figures and adjustments from previous years.
Insights
- Accounting policies are the specific guidelines that organizations follow when preparing their financial statements, which include methods for valuing assets like inventories and property. Once a policy is established, it must remain consistent over time unless changes are permitted by IFRS standards, highlighting the importance of stability in financial reporting.
- Changes in accounting policies can enhance the clarity and accuracy of financial statements, occurring either due to requirements set by IFRS or to improve presentation. Such changes must be applied retrospectively, meaning previous financial statements are adjusted to reflect the new policy, ensuring transparency and consistency in reporting.
- Distinguishing between changes in accounting policies and changes in accounting estimates is crucial; the former involves adjustments to recognition, measurement, or presentation, while the latter pertains to updates in estimated amounts without altering the underlying policy. This distinction impacts how adjustments are recorded and reported in financial statements, affecting stakeholders' understanding of a company's financial health.
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Recent questions
What are accounting policies?
Accounting policies are the specific principles, bases, conventions, rules, and practices that an entity applies in preparing and presenting its financial statements. These policies guide how various elements, such as inventories and property, plant, and equipment, are valued and reported. For instance, an entity may choose to value its inventory using the FIFO (First In, First Out) method or the weighted average method. The selection of these policies is crucial as they ensure consistency and reliability in financial reporting, allowing stakeholders to understand the financial position and performance of the entity accurately.
How do changes in accounting policies occur?
Changes in accounting policies can occur when required by International Financial Reporting Standards (IFRS) or when such changes lead to a better presentation of financial statements. Once an accounting policy is established, it must be applied consistently across reporting periods, with changes permitted only under specific circumstances. For example, if a new IFRS standard is introduced that necessitates a different approach to asset valuation, an entity must adopt this new policy. Additionally, if a change enhances the clarity or relevance of financial statements, it may also be justified. However, any change must be applied retrospectively, meaning prior periods' financial statements may need to be adjusted to reflect the new policy.
What is the difference between accounting policies and estimates?
Accounting policies and accounting estimates serve different purposes in financial reporting. Accounting policies are the principles and rules that dictate how financial transactions are recorded and reported, such as the methods used for inventory valuation or asset depreciation. In contrast, accounting estimates involve approximations made by management to determine the monetary amounts in financial statements, such as estimating the useful life of an asset or the allowance for doubtful accounts. While policies provide a framework for reporting, estimates are necessary for making informed judgments about uncertain future events. Understanding this distinction is essential for accurate financial reporting and compliance with accounting standards.
How are prior period errors corrected?
Prior period errors, which are mistakes or omissions in financial statements from previous periods, must be corrected retrospectively. This means that the financial statements for the affected periods are adjusted to reflect the correct information. For instance, if an error in inventory valuation from the previous year is discovered, the cost of sales and retained earnings for that year must be adjusted accordingly. The adjustments ensure that the financial statements present a true and fair view of the entity's financial position. This retrospective application is crucial for maintaining the integrity of financial reporting and ensuring that stakeholders have access to accurate historical data.
What is the impact of changes in accounting estimates?
Changes in accounting estimates affect the financial statements prospectively, meaning that the new estimates are applied to transactions and events occurring from the period the change is made, rather than adjusting prior periods. For example, if a company revises the useful life of its machinery, the new depreciation expense will be calculated based on this updated estimate going forward. Unlike changes in accounting policies, which require retrospective adjustments, changes in estimates do not necessitate restating previous financial statements. This approach allows entities to adapt to new information and circumstances while maintaining the continuity of their financial reporting.
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Summary
00:00
Understanding Accounting Policies and Changes
- Accounting policies are defined as the specific principles, bases, conventions, rules, and practices that an entity applies in preparing and presenting its financial statements, including methods for valuing inventories (FIFO or weighted average) and property, plant, and equipment (cost model or revaluation model).
- Once an accounting policy is chosen, it must be applied consistently from period to period, as frequent changes are not permitted unless allowed by IFRS standards.
- Changes in accounting policies can occur when required by IFRS standards or when such changes result in better presentation of financial statements.
- When selecting accounting policies, entities should adhere to accounting standards and use the most relevant and reliable policies, especially when no guidance is provided in the standards.
- Changes in accounting policies are identified through alterations in recognition, measurement, or presentation; if any of these three aspects change, it indicates a change in accounting policy.
- Recognition involves incorporating items into financial statements that meet the definition of an element; for example, if an expense is reclassified as an asset, this signifies a change in policy.
- Measurement refers to the monetary amount at which an element is recognized; a change from valuing non-current assets at fair value to cost indicates a change in policy.
- Presentation changes occur when the classification of expenses changes, such as charging depreciation to cost of sales instead of administrative expenses, which reflects a change in accounting policy.
- According to IAS 8, changes in accounting policies should be applied retrospectively, meaning adjustments must be made to the opening balance of retained earnings in the statement of changes in equity.
- Accounting estimates differ from accounting policies and involve methods adopted by an entity to arrive at estimated amounts for financial statements, such as allowances for receivables and changes in the useful economic life of property, plant, and equipment.
29:09
Understanding Changes in Accounting Estimates and Policies
- Changes in accounting estimates, as per IES 37, include adjustments such as altering the useful life of property, plant, and equipment (PPE), changing the residual value of PPE, and modifying the method of depreciation, which are all considered estimation techniques.
- Warranty provisions can also be adjusted based on updated information regarding claims frequency, which constitutes a change in accounting estimates under IES 37.
- According to IES 8, changes in accounting estimates should be applied prospectively, meaning the new accounting policy is applied to transactions and events occurring from the period the policy was established, rather than retrospectively.
- For example, if a company changes its depreciation method from straight-line to reducing balance, the new method affects future depreciation amounts but does not require adjustments to prior years' financial statements.
- Prior period errors, which are omissions or mistakes in financial statements from previous periods, must be corrected retrospectively, similar to changes in accounting policies.
- To determine whether a change is an accounting policy or an estimation technique, assess recognition, measurement, and presentation; changes in any of these criteria indicate a change in accounting policy.
- An example of a change in accounting policy is when an entity shifts from charging interest on construction costs to capitalizing it as an asset, which alters both recognition and presentation.
- Conversely, if a company changes its method of depreciation without altering recognition or presentation, it is classified as a change in estimation technique.
- Another example of a change in accounting policy is when overheads previously included in cost of sales are reclassified as administrative expenses, indicating a change in presentation.
- In a scenario where a company adjusts its provision for receivables from six months to three months due to economic conditions, this is classified as a change in accounting estimates, as it reflects a change in estimation technique rather than policy.
55:00
Correction of Cost of Sales Error
- The cost of sales for the year 20x1 has been overstated due to a prior year error, necessitating an adjustment to correct this by deducting the error amount from the cost of sales.
- The reported cost of sales in the statement of profit or loss for 20x1 is $33,500, while for 20x0 it was $30,230, indicating a need for adjustment due to an error of $2.5 million included in the opening inventory for 20x1.
- The adjustment for the prior year error results in a revised cost of sales for 20x1 of $31,000, calculated by subtracting the $2,500 error from the original $33,500.
- For 20x0, the closing inventory adjustment leads to a revised cost of sales of $32,700, which is necessary to correct the overstatement from the previous year.
- The revised income statement for 20x1 shows sales of $52,120 and $48,300 for 20x0, with the gross profit calculated as $21,100 for 20x1 and $15,600 for 20x0 after deducting the adjusted cost of sales.
- The tax charge for the current year is $4,600, and it is noted that the adjustments for prior year errors do not affect the tax calculation.
- The net profit after tax for 20x1 is adjusted to $16,500, calculated by subtracting the tax from the gross profit, while the net profit for 20x0 is $11,300.
- The opening balance of retained earnings for January 1, 20x0, is $11.2 million, and after adding the net profit of $13.8 million for 20x1, the retained earnings for 20x1 total $25 million.
- The prior year error adjustment of $2.5 million is deducted from the retained earnings, resulting in a restated balance of $22.5 million for 20x1.
- The closing balance of retained earnings for 20x1 is calculated as $39 million, which includes the adjusted retained earnings of $22.5 million plus the net profit of $16.5 million for the year.
01:17:53
Annual Profit and Retained Earnings Summary
- The profit for the year is calculated as $6,010, derived from the initial amount of $8,630 minus tax and terms totaling $2,620. The retained earnings as of January 1, 20X6 were $13 million, and after adding the profit of $8,950 for the year, the retained earnings for 20X7 amount to $21,950,000.
- A prior year adjustment for an inventory error of $4.2 million results in a tax consequence of $1,260,000 (30% of $4.2 million), leading to a restated balance of $19,010,000 after deducting $2,940,000 from the previous retained earnings. The adjusted profit for the year is $10,940,000, with no dividends declared, resulting in a total of $29,950,000 when combined with the restated balance.
