by Paul Robins
16 Oct 2001
FRS 18, Accounting policies sets out the principles to be followed in selecting accounting policies and the disclosures needed to help users to understand the accounting policies adopted and how they have been implemented.
Accounting policies contrasted with estimation techniques
The distinction between accounting policies and estimation techniques is an important one in practice, because changes in accounting policies are dealt with as prior-year adjustments, whereas changes in estimation techniques are completely reflected in the profit and loss account for the year of change.
Accounting policies are defined in FRS 18 as 'those principles, bases, conventions, rules and practices applied by an entity that specify how the effects of transactions and other events are to be reflected in its financial statements'. The accounting policy that is adopted for a particular type of transaction involves making a selection of three factors:
- Whether or not to recognise elements (assets, liabilities, gains or losses) as a result of the transaction - recognition criteria.
- How to attribute a monetary amount to the elements that are recognised - measurement bases.
- Where to present the elements in the financial statements.
Estimation techniques are the methods adopted by an entity to arrive at the estimated monetary amounts (corresponding to the measurement bases selected) for elements of the financial statements. As stated in the previous section, the distinction between accounting policies and estimation techniques is important. FRS 18 says that a change of accounting policy has occurred where there has been a change to any one of the components of the definition:
- Recognition criteria
- Measurement basis
- Method of presentation
Conversely a change that does not affect any of the above is a change in estimation technique. The FRS provides a number of examples and it will be useful to review some of them.
Example 1: capitalised finance costs
An entity has previously written all finance costs off to the profit and loss account as incurred. The entity now wishes to capitalise interest on borrowing incurred to finance the construction of fixed assets. This decision involves a change in:
- Recognition - the costs are now included as part of an asset
- Presentation - the costs are now presented in the balance sheet rather than the profit and loss account
Therefore the decision represents a change in accounting policy.
Example 2: depreciation of vehicles
An entity has previously depreciated vehicles using the reducing balance method at 40% per year. It now proposes to depreciate vehicles using the straight-line method over five years. This decision does not involve a change in any of the three key criteria:
- The fixed assets are still carried at cost less accumulated depreciation.
- The depreciation is still allocated to individual accounting periods so as to reflect the consumption of economic benefits.
- In the absence of information to the contrary fixed assets and depreciation are presented in the same way in the balance sheet and the profit and loss account respectively.
Therefore this is a change in estimate and not a change in accounting policy.
Example 3: accounting for fungible stocks
Fungible stocks are stocks that are indistinguishable from one another, for example identical nuts and bolts. The current policy is to consider such stocks in aggregate and measure them at their weighted average historical cost. However the entity decides to measure such stocks at historical cost on a FIFO basis. This decision involves a change in the basis used to measure stocks and as such represents a change in accounting policy.
Selection of accounting policies
Not surprisingly FRS 18 states that entities should adopt accounting policies that enable the financial statements to give a true and fair view. Just as predictable is the statement in FRS 18 that accounting policies should normally be consistent with the requirements of accounting standards and companies legislation. If, in exceptional circumstances, compliance with a particular accounting standard is inconsistent with the requirement to give a true and fair view then entities are permitted to depart from the requirements of that standard. Such instances are likely to be rare and the author would be reluctant to give a specific example!
FRS 18 states that two concepts, the going concern concept and the accruals concept play a pervasive role in the selection of accounting policies.
Financial statements are usually prepared under the assumption that the entity is a going concern. This is because measures based on break-up values tend not to be relevant to user seeking to assess the entity's ability to generate cash and be financially adaptable. When preparing financial statements directors should assess whether there are significant doubts about an entity's ability to continue as a going concern.
Other than in the cash flow statement the accruals basis of accounting requires the non-cash effects of transactions to be reflected in the financial statements for the period in which they occur. FRS 18 states that the accruals concept lies at the heart of the definitions of assets and liabilities that are set out in FRS 5 'Reporting the Substance of Transactions'.
The concept of accruals is closely related to the concept of realisation. Companies legislation only allows profits that are realised by the balance sheet date to be included in the profit and loss account. Unfortunately such legislation fails to give an adequate definition of 'realised'. FRS 18 does not seek to define the term 'realised' in its definitions section but does link realisation with the creation of new assets and liabilities and therefore with the concept of accruals.
Objectives against which accounting policy selection should be judged
These are those outlined in Chapter 3 of the Statement of Principles as being desirable characteristics of useful financial information:
Relevant financial information has the ability to influence the economic decisions of users and is provided in time to influence those decisions. Relevant information possesses either predictive or confirmatory value or both.
Reliable financial information must:
- Faithfully represent the transactions of the entity and therefore reflect their substance.
- Be neutral (free from bias).
- Be free from material error.
- Be complete within the bounds of materiality.
- Be prudently prepared under conditions of uncertainty. However, where no uncertainty exists prudence need not be exercised.
Useful financial information should be comparable with financial information of the entity that relates to a different period and with financial information relating to other entities. In practice comparability is achieved by a combination of consistency and disclosure.
Useful financial information should be capable of being understood by users with a reasonable knowledge of business and accounting and who are willing to study the information provided with reasonable diligence. Here the ASB is clearly trying to maintain a balance between providing financial information that is easy to understand but very incomplete and providing very comprehensive financial information that most users cannot understand. Constraints that affect the judgement of the entity regarding the appropriateness of accounting policies in particular circumstances.
There can be tension between the different objectives outlined in FRS 18 - particularly between relevance and reliability. In such circumstances FRS 18 requires that an entity selects the most relevant of the accounting policies that are reliable. There can also be a tension between two aspects of reliability - neutrality and prudence. Prudence clearly introduces a potential bias into the selection of accounting policies and directors need to find a balance that ensures that the deliberate and systematic understatement of assets and gains and overstatement of liabilities and losses do not occur.
In selecting accounting policies, entities need to balance the costs of following a particular policy against the benefits that are likely to flow to the user. However FRS 18 makes it clear that cost/benefits considerations do not on their own justify the selection of an accounting policy that is at odds with that laid down in accounting standards.
Reviewing and changing accounting policies
FRS 18 requires entities to review their accounting policies on a regular basis and change them where appropriate. However, any decision to change a particular accounting policy must be taken in the light of the key object of comparability that was discussed earlier. Frequent changes to accounting policies are not desirable because they make comparison more difficult. However, consistency is not an end in itself and it does not impede the introduction of improved accounting practices that result in improved information for users.
The issue of a new financial reporting standard often causes an entity to review its accounting policies even before the standard takes effect. Whilst FRS 18 does not require the early adoption of a newly issued FRS it appears to allow entities to do this.
It was stated earlier that an estimation technique is used to arrive at the monetary amount that is appropriate to a particular measurement basis. Not surprisingly FRS 18 requires entities to select techniques that enable the financial statements to give a true and fair view.
Estimations are by definition somewhat subjective. FRS 18 requires the estimations to be as accurate as possible but recognises that in deciding on the sophistication of the estimation technique used, cost/benefit considerations clearly come into force.
A change in estimation technique should not be accounted for as a prior year adjustment unless:
It represents the correction of a fundamental error.
Another accounting standard or companies legislation requires the change to be accounted for as a prior year adjustment - unlikely in practice.
FRS18 - Key disclosures
ACCA examinations are a lot more than just memory tests and so rote learning of the disclosure requirements of specific standards is not normally necessary. However, it is useful in the context of FRS 18 to note that the financial statements require entities to identify:
- The accounting policies selected.
- The key estimation techniques used (for example depreciation methods).
- Details of any changes to accounting policies.
- Information relevant to the assessment of an organisation as a going concern, if the going concern basis is under question.
- Details of any departure from the requirements of any accounting standard or companies legislation in the interest of showing a true and fair view.
FRS 18 is an important standard. It represents the bridge between the standard setting process and the Statement of Principles. It is to the credit of the standard setters in the UK that we now have a credible conceptual framework, which provides a sound basis for the future setting of accounting standards.
Paul Robins BSc MBA ARCS FCA is a freelance lecturer and consultant