This article was first published in the September 2012 UK edition of Accounting and Business magazine.
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The International Accounting Standards Board (IASB) Framework indicates that the objective of financial statements is the provision of information that is useful to a wide range of users. Readers of the accounts may be interested in using financial information for making political decisions as well as economic ones. Different entities may have a range of readers and thus the assessment of the common needs of users should be informed by the entity's experience of their readership. On this basis, the entity should select accounting policies and estimation techniques that disclose and present financial information that best assists effective decision-making, without reducing the usefulness of the financial statements for other readers. The question arises as to how these policies should be selected when moving to IFRS and what happens if the estimation techniques used are proven to be invalid.
Entities should follow the requirements of IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, when selecting or changing accounting policies, changing estimation techniques and correcting errors. An entity should determine the accounting policy to be applied to an item with direct reference to IFRS but accounting policies need not be applied if the effect of applying them would be immaterial. Users of the financial statements are assumed to have a reasonable knowledge of accounting and will use reasonable diligence in reading the financial statements. Considerations of materiality will need to reflect this assumed knowledge.
IAS 1, Presentation of Financial Statements, requires that an entity whose financial statements comply with IFRS should make an explicit and unreserved statement of such compliance in the notes. Inappropriate accounting policies are not rectified either by disclosure of the accounting policies used, or by notes or explanatory material. IAS 1 acknowledges that, in extremely rare circumstances, management may conclude that compliance with an IFRS requirement would be so misleading that it would conflict with the objective of financial statements set out in the Framework. In such a case, the entity is required to depart from the IFRS requirement, with detailed disclosure of the nature, reasons and impact of the departure.
IAS 8 also notes that it is inappropriate to make or leave uncorrected immaterial departures from IFRS to achieve a particular position. For example, where the revaluation model is used in IAS 16, Property, Plant and Equipment, it might be immaterial to revalue plant and equipment. However, the understatement of depreciation that may result might allow an entity to break even when full compliance with IAS 16 would have resulted in a loss being recognised.
Where IFRS does not specifically apply to a transaction, judgment should be used in developing or applying an accounting policy, which results in financial information that is relevant to the decision-making and assessment needs of users. IFRS also requires that policies are reliable and is prudent. In making that judgment, entities must refer to guidance in IFRS which deals with similar issues and then subsequently to definitions and criteria in the Framework.
Additionally, entities can refer to recent pronouncements of other standard setters that use similar conceptual frameworks. Entities should select and apply their accounting policies consistently for similar transactions. If IFRS specifically permits different accounting policies for categories of similar items, an entity should apply an appropriate policy for each of the categories in question and apply these consistently for each category. A change in accounting policy should only be made if the change is required by IFRS, or it will result in the financial statements providing reliable and more relevant financial information. Significant changes in policy other than those specified by IFRS should be relatively rare. IFRS specifies the accounting policies for a high percentage of the typical transactions that are faced by entities. There are therefore limited opportunities for an entity to choose an accounting policy, as opposed to a basis for estimating figures that will satisfy such a policy.
IAS 8 states that the introduction of an accounting policy to account for transactions where circumstances have changed are not a change in accounting policy. Similarly, a policy for transactions that did not occur previously or that were immaterial is not a change in policy and therefore would be applied prospectively.
A change in accounting policy is applied retrospectively unless there are transitional arrangements in place. Transitional provisions are often included in new or revised standards and may not require full retrospective application. Sometimes it is difficult to achieve comparability of prior periods with the current period where, for example, data might not have been collected in the prior periods to allow retrospective application. Restating comparative information for prior periods often requires complex and detailed estimation. This, in itself, does not prevent reliable adjustments.
When making estimates for prior periods, the basis of estimation should reflect the circumstances that existed at the time and it becomes increasingly difficult to define those circumstances with the passage of time. Estimates and circumstances might be influenced by knowledge of events and circumstances that have arisen since the prior period.
IAS 8 does not permit the use of hindsight when applying a new accounting policy, either in making assumptions about what management's intentions would have been in a prior period or in estimating amounts to be recognised, measured or disclosed in a prior period. When it is impracticable to determine the effect of a change in accounting policy on comparative information, the entity is required to apply the new policy to the carrying amounts of the assets and liabilities as at the beginning of the earliest period for which retrospective application is practicable. This could actually be the current period but the entity should attempt to apply the policy from the earliest date possible.
Where the basis of measurement for the amount to be recognised is uncertain, an entity will use an estimation technique, which is a normal part of the preparation of the financial statements without undermining their reliability.
Estimates involve judgments based on the latest available, reliable information and are applied in determining the useful lives of property, plant and equipment, provisions, fair values of financial assets and liabilities and actuarial assumptions relating to defined benefit pension schemes.
Accounting estimates need to be distinguished from accounting policies as the effect of a change in an estimate is reflected in the Statement of Comprehensive Income, whereas a change in accounting policy will generally require a prior period adjustment. If there is a change in the circumstances on which the estimate was based or new information has arisen or more experience relating to the estimation process has occurred, then the estimate may need to be changed. A change in the measurement basis is not a change in an accounting estimate, but is a change in accounting policy. For example, if there is a move from historical cost to fair value, this is a change in accounting policy but a change in the method of depreciation is a change in accounting estimate.
A change in accounting estimates should be recognised from the date of change, which may only impact on the current period or may impact the current and future periods. IAS 8 states that financial statements do not comply with IFRS if they contain material errors or immaterial errors that have been made intentionally to achieve a particular presentation. Material prior period errors must be corrected by retrospective restatement, in the first financial statements issued following their discovery unless it is impracticable to determine either the period or the specific effects of the error. As with retrospective application of an accounting policy, when an entity makes a retrospective restatement, or when it reclassifies items, it should present an additional balance sheet at the beginning of the earliest comparative period. However, it is thought that entities may choose to omit the additional balance sheet (and related notes) if there is no impact on that balance sheet and this fact is disclosed.
Amendment to IAS 1
The IASB has amended the requirements in IAS 1 relating to the additional balance sheet. Where an entity has applied an accounting policy retrospectively and this has a material effect on the information in the balance sheet at the beginning of the preceding period, it is required to present that balance sheet. However, under the amended standard, which applies for annual periods beginning on or after 1 January 2013, the entity need not present the related notes to the additional balance sheet. The amendment clarifies that the additional balance sheet is given as at the beginning of the preceding period regardless of whether an entity's financial statements present comparative information for earlier periods.
As previously mentioned, the use of hindsight is not permitted in correcting material errors. For example, if there were a prior period error relating to a provision calculated for decontamination costs in a building, information relating to the subsequent discovery of subsidence on the same site would be disregarded in calculating that particular provision.
IAS 8 states that the correction of a prior period error is excluded from the Statement of Comprehensive Income for the current period in which the error is discovered. However, if there is a correction to the extent that the amount attributable to a prior period cannot be determined, it is included in the current period Comprehensive Income Statement which means that prior periods may be partially adjusted but fully adjusted by the end of the current period. The correction of errors is different from changes in accounting estimates. Due to the complexity of IFRS, there is a high likelihood that the judgments used at the time of transition may result in prior period adjustments and changes in estimates. As can be seen from the above, the solution to these corrective actions is not always straightforward.
Graham Holt is an examiner for ACCA, and associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School