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Advance Financial Accounting (FIN-611)

LESSON # 29

IAS 8

ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND

ERRORS

This standard shall be applied in selecting and applying accounting policies, and

accounting for changes in accounting policies, changes in accounting estimates and

corrections of prior period errors.

DEFINITIONS:

The following terms are used in this standard with the meanings specified:

Accounting policies:

These are the specific principles, bases, conventions, rules and practices applied by an

entity in preparing and presenting financial statements.

Change in accounting estimate:

It 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. Changes in accounting estimates result from new information or new

developments and, accordingly, are not corrections of errors.

Example-1:

English Limited acquired an asset. The company estimates its useful life 5 years i.e.

future economic benefits shall be drawn from the asset in next 5 years.

This is an accounting estimate.

After 2 years, the company estimates its remaining useful life 4 years. There is a

change in total useful life of the asset in third year.

This change is a change in accounting estimate.

Material:

a) Omissions or misstatements of items are material if they could, individually or

collectively; influence the economic decisions of users taken on the basis of the

financial statements.

b) Materiality depends on the size and nature of the omission or misstatement

judged in the surroundings circumstances.

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c) The size or nature of the item, or a combination of both, could be the

determining factor.

Example-2:

Ihsan Sports Private Limited is in the course of finalizing its financial statement for the

year ended 30th June. 2004.

The following information is available from draft financial statements: -

Sales Rs. 200,000,000

Gross profit Rs. 50,000,000

Net profit

Rs. 20,000,000

a) Sales made during the month of June are omitted from above records

amounting to Rs. 10,000,000.

b) Purchase of stationery on 30th June amounting to Rs. 5,000 is also omitted from

above records.

Required: Which items are materials with respect to the above drafts of financial

statements?

Solution:

Sale omitted are 5% of total sales recorded, while stationery purchased is

0.0025%

Sales omitted are 50% of net profit while stationery purchased is 0.025%.

So, sales omitted are material, which could influence the economic decisions of users.

But stationery is not a material because the amount is immaterial with respect to sales

and net profit.

Prior period errors:

These are omissions from, and misstatements in, the entity's financial statements for

one or more prior periods arising from a failure to use, or misuse of, reliable

information that was available when financial statements for those periods were

authorized for issue; and could reasonably be expected to have been obtained and

taken into account in the preparation and presentation of those financial statements.

Such errors include the effects of:-

Mathematical mistakes;

Mistakes in applying accounting policies;

Oversights; or

Misinterpretations of facts; and

Fraud

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Retrospective application:

This application is applying a new accounting policy to transactions, other events and

conditions as if that policy had always been applied i.e. effect of change in accounting

policy regarding previous period is to be calculated.

Retrospective restatements:

Retrospective restatements is correcting the recognitions, measurement and disclosure

of amounts of elements of financial statements as if a prior period error had never

occurred i.e. correction of error is to be made by restating the previous income

statement and opening balance of previous periods' retained earnings.

Prospective application:

It is change in accounting policy and of recognizing the effect of a change in an

accounting estimate, respectively, is:

a) Applying the new accounting policy to transactions, other events and

conditions occurring after the date as at which the policy is changed; and

b) Recognizing the effect of change in the accounting estimates in the current and

future periods affected by the change.

ACCOUNTING POLICIES:

Selection and Application of Accounting Policies:

When a Standard or an Interpretation specifically applies to a transaction, other event

or condition, the accounting policy or policies applied to that item shall be determined

by applying the Standard or Interpretation and considering any relevant

Implementation Guidance issued by the IASB for the standard or interpretation.

In the absence of a Standard or an Interpretation that specifically applies to a

transaction, other event or condition, management shall use its judgment in

developing and applying an accounting policy that results in information that is:

a) Relevant to the economic decision-making needs of users; and

b) Reliable i.e. the financial statements:

Represent faithfully the financial position, financial performance and

cash flows of the entity. Reflect the economic substance of transactions,

other events and conditions, and not merely the legal form;

ii.

Are neutral, i.e. free from bias;

iii.

Are prudent; and

iv.

Are complete in all material respect.

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Accounting policies are selected and applied in accordance with a particular standard

e.g. FIFO or Weighted Average for inventory measurement. If there is no specific

policy in the standard, interpretation or any guidance issue by IASB, the policy

selected should fulfill the requirements given in the above paragraph.

In making the judgment described in above paragraph, the management shall refer to,

and consider the applicability of, the following sources in descending order:

a) The requirements and guidance in Standards and Interpretations dealing with

similar and related issues; and

b) The definitions, recognition criteria and measurement concepts for assets;

liabilities, income and expenses in the Framework.

Consistency of Accounting Policies:

a) An entity shall select and apply its accounting policies consistently for similar

transactions, other events and conditions, unless a Standard or an Interpretation

specifically requires or permits categorization of items for which different

policies may be appropriate.

b) If a Standard or an Interpretation requires or permits such categorization, an

appropriate accounting policy shall be selected and applied consistently to each

category.

CHANGES IN ACCOUNTING POLICIES:

An entity shall change an accounting policy only if the change:

a) Is required by Standard or an Interpretation; or

b) Result in the financial statements providing reliable and more relevant

information.

Example-4:

Lasani Private Limited have been following LIFO (an allowed alternative

treatment of previous IAS-2) for Inventory measurement. Now the entity is

required to adopt FIFO or weighed Average method for Inventory

measurement (as per the revised IAS-2).

This is a change in accounting policy required by standard.

ii.

Pak Limited has been recognizing revenue on dispatch of goods to customers.

The company has now decided to recognize revenue on approval of goods by

the customer. This change was due to unreliable courier service. The products

delivered were not received in good condition by the customers and the

company used to take back these damaged goods.

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This is a change in accounting policy, which provides more reliable and relevant information

about the effects of the transactions.

The following are not considered as changes in accounting policies:-

a) The application of an accounting policy for transactions, other events or

conditions that differ in substance from those previously occurring; e.g. loans

were used for qualifying assets first time in current year. Previously loans were

used for purchase of vehicles and furniture etc.

b) The application of a new accounting policy for transactions; other events or

conditions that did not occur previously or were immaterial e.g. policy for

borrowing costs, loan taken in current year first time.

The initial application of a policy to revalue assets in accordance with IAS 16 Property,

Plant and Equipment or IAS 38 Intangible Assets is a change in an accounting policy

to be dealt with as a revaluation in accordance with IAS 16 or IAS 38, rather than in

accordance with this Standard.

APPLYING CHANGES IN ACCOUNTING POLICES:

a) An entity shall account for a change in accounting policy, if the change is

required by a standard, as per transitional provision, if any, given in the

Standard.

b) An entity shall account for a change in accounting policy retrospectively if:

The change is required by a Standard and where no specific transitional

provision given in Standard, or

ii.

Change in accounting policy is voluntary.

Retrospective application:

When a change in accounting policy is applied retrospectively, the entity shall adjust.

a) The opening balance of each affected component of equity for the earliest prior

period presented; and

b) The other comparative amounts disclosed for each prior period presented as if

the new accounting policy had always been applied.

Example-5:

During 2004, Aslam Engineering Ltd changed its accounting policy for the treatment

of borrowing costs that are directly attributable to the construction of commercial

building to serve as their head office power station. In previous periods, Aslam

Engineering Ltd had capitalized such costs. Aslam Engineering Ltd has now decided

to treat these costs as an expense, rather than capitalize them. Management judges that

the new policy is preferable because it results in a more transparent treatment of

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finance costs and is consistent with local industry practice, making Aslam Engineering

Ltd financial statements more comparable.

Aslam Engineering Ltd capitalized borrowing costs incurred of Rs. 2,600 during 2003

and Rs. 5,200 in periods before 2003. All borrowing costs incurred in previous years in

respect of the building under construction were capitalized.

Aslam Engineering Ltd accounting records for 2004 show profit before interest and

income taxes of Rs. 30,000, interest expense of Rs. 3,000 (which relates only to 2004);

and income taxes of Rs. 8,100.

Aslam Engineering Ltd has not yet recognized any depreciation on the building under

construction because it is not yet in use. In 2003, Aslam Engineering Ltd reported:

Rs.

Profit before interest and income taxes

18,000

Interest expense

Profit before income taxes

18,000

Income taxes

(5,400)

Profit

12,600

2003 opening retained earnings was Rs. 20,000.and closing retained earnings was

Rs.32, 600

Aslam Engineering Ltd tax rate was 30 percent for 2004, 2003 and prior periods.

Aslam Engineering Ltd had Rs. 10,000 of share capital throughout, and no other

components of equity except for retained earnings.

Solution:

Aslam Engineering Ltd

Extract from the Income Statement

(Restated)

2004

2003

Rs.

Profit before interest and income taxes

30,000

18,000

Interest expense

(3,000)

(2,600)

Profit before income tax

27,000

15,400

Income tax

(8,100)

(4,620)

Profit

18,900

10,780

Aslam Engineering Limited

Statement of Retained Earnings

(Restated)

Retained

Earnings

Rs.

Balance at 31 December 2002

20,000

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Effect of change in accounting policy (Note)

(3,640)

Balance at 31 December 2002 (restated)

16,360

Profit for the year ended 31 December 2003 (restated)

10,780

Balance at 31 December 2003

27,140

Profit for the year ended 31 December 2004

18,900

Balance at 31 December 2004

46,040

Note:

Effect of change in accounting policy is the de-capitalization of interest (net of income

taxes of Rs. 1,560).

Example-6:

Servis Shoes Limited has prepared the following information for the year ended 31

March 2005.

Profit & Loss Account

2005

2004

Rs.

Sales

75,000

72,750

Cost of sales

(50,000)

(48,500)

Gross profit (1/3 of sales)

25,000

24,250

Operating expenses

(7,500)

(7,750)

17,500

16,500

(4,950)

Income tax @ 30%

(5,250)

Net Profit

12,250

11,550

Statement of Retained Earnings

2005

2004

Rs.

Balance as at opening date

11,000

7,500

Profit for the year

12,250

11,550

23,250

19,050

Dividend

10,250

(8,050)

11,000

Balance as at closing date

13,000

The company used to account for revenue on dispatch of goods. The company

observes that the sales returns are increasing year by year. Due to a dishonest

employee, quantity received by customers was often less than quantity dispatched.

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Along-with administrative action the company also changed its policy for recognition

of revenue and decided to account for revenue after receiving acknowledgment from

customer.

Relevant amounts for the previous years; since the changed policy was adopted is Rs.

9,000 decrease in sales, resulting in a decrease of Rs. 3,000 in profit before tax.

For the current year 2005, goods dispatched by the company amounted to Rs. 1,500

which were acknowledged in next period, are included in profit & loss account

already prepared. For previous year 2004, this amount was Rs. 1,000.

Required: Account for the above change in Accounting policy.

Solution:

Service Shoes Limited

Profit & Loss Account

For the year ended 31 March 2005

(Restated)

2005

2004

Rs.

Sales (W-1)

74,500

71,750

Cost of sales - Balancing figure

(49,667)

(47,833)

Gross profit (1/3 of sales)

24,833

23,917

Operating expenses

(7,500)

(7,750)

17,333

16,167

Income Tax @ 30%

(5,200)

(4,850)

Net profit

12,133

11,317

Service Shoes Limited

Statement of Retained Earnings (Extract)

For the year ended 31 March

(Restated)

Rs.

Balance as at 31.3.2003 (W-2)

5,400

Profit for the year 2004 (restated)

11,317

16,717

Dividend

(8,050)

Balance as at 31.3.2004

8,667

Profit for the year 2005

12,133

20,800

Dividend

(10,250)

Balance as at 31.3.2005

10,550

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Workings:

(W-1) Adjusted sales for:

2005

2004

Rs.

Sales before change in Accounting policy

75,000

72,750

(Decrease) in sales

(1,500)

(1,000)

Increase in sales

1,000

Adjusted sales

74,500

71,750

(W-2) Adjustment in opening retained profits as on 31.3.2003

7,500

Profit before tax

3,000

Income Tax effect 30%

(900)

(2,100)

5,400

If retrospective application is impracticable then change in accounting policy will be

applied prospectively from the year when it is practicable to change.

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