9.5 IAS 8 Accounting Policies, Estimates and Errors, and Disclosing Material Items

9.5 IAS 8 Accounting Policies, Estimates and Errors, and Disclosing Material Items

A standard that changed its name. Until the consequential amendments made by IFRS 18, this standard was called IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. It is now IAS 8 Basis of Preparation of Financial Statements, because IFRS 18 moved into it the requirements previously in IAS 1 on fair presentation and compliance with IFRS Accounting Standards, going concern, the accrual basis of accounting, and the disclosure of an entity's selection and application of accounting policies. The substance of the policies, estimates and errors material is unchanged; the title and the scope are wider. Use the current name in the exam.

---

1. Selecting an Accounting Policy

Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements. They are not optional preferences: where an IFRS Accounting Standard applies to a transaction, that standard determines the policy.

Where no standard specifically applies, management must use judgement to develop a policy that results in information that is relevant to users' economic decision-making needs and reliable — faithfully representative, reflecting economic substance, neutral, prudent and complete. In doing so it refers, in descending order, to:

  1. The requirements in IFRS Accounting Standards dealing with SIMILAR and
     RELATED issues;
  2. The definitions, recognition criteria and measurement concepts in the
     CONCEPTUAL FRAMEWORK for Financial Reporting;
  3. (May also consider) the most recent pronouncements of OTHER STANDARD-
     SETTING BODIES that use a similar conceptual framework, other
     accounting literature and accepted industry practices, to the extent
     these do not conflict with 1 and 2.

Policies are applied consistently for similar transactions unless a standard specifically requires or permits categorisation with different policies.

---

2. The Three Mechanisms, Side by Side

This table is the whole section in miniature. Learn it.

[!CAUTION] Where a change is difficult to distinguish, IAS 8 requires it to be treated as a change in ACCOUNTING ESTIMATE. This default is examined regularly, and it matters, because the prospective treatment is far less disruptive than a retrospective restatement.

The practical distinction that catches candidates

Changing the depreciation method — say from reducing balance to straight line — is a change in accounting estimate, not a change in accounting policy, because the method is the estimation technique used to consume the asset's economic benefits. The policy is the decision to depreciate the asset over its useful life; the method is an estimation input. The effect goes through the current and future periods and the comparative is untouched.

Impracticability

Retrospective application or restatement is required except to the extent that it is impracticable to determine either the period-specific effects or the cumulative effect. Impracticable means the entity cannot apply the requirement after making every reasonable effort — a genuinely high hurdle, not an inconvenience.

---

3. How Each One Lands in the Financial Statements

  CHANGE IN POLICY / PRIOR PERIOD ERROR (retrospective)
  +------------------------------------------------------------------+
  | STATEMENT OF CHANGES IN EQUITY                                    |
  |   Balance at 1 January 20X5 as previously reported          X     |
  |   Prior period adjustment                                  (X)    |
  |   Balance at 1 January 20X5 as RESTATED                     X     |
  +------------------------------------------------------------------+
  | COMPARATIVE STATEMENT OF PROFIT OR LOSS -- every affected line    |
  | is restated                                                       |
  +------------------------------------------------------------------+
  | CURRENT YEAR PROFIT OR LOSS -- contains NOTHING in respect of     |
  | the prior period                                                  |
  +------------------------------------------------------------------+

  CHANGE IN ESTIMATE (prospective)
  +------------------------------------------------------------------+
  | COMPARATIVES -- untouched                                         |
  | OPENING EQUITY -- untouched                                       |
  | CURRENT YEAR PROFIT OR LOSS -- absorbs the entire effect, in the  |
  | same line item the original estimate affected                     |
  +------------------------------------------------------------------+

---

4. Disclosing Material Items of Income and Expense

The FR syllabus asks you to indicate the circumstances where separate disclosure of material items of income and expense is required. Under IFRS 18 this is handled through the aggregation and disaggregation principles introduced in section 2.2 rather than by a list of named categories.

The rule is one of shared characteristics: items are aggregated only where they share characteristics, and are disaggregated where they do not. An item that is material by size or by nature and that does not share characteristics with the line it would otherwise sit in must be shown separately, either on the face of the primary statement or in the notes.

Items that commonly require separate disclosure in an FR scenario:

Two rules that sit alongside this:

• There is no "extraordinary items" caption. IFRS Accounting Standards do not permit items of income or expense to be presented as extraordinary, in the primary statements or in the notes. An item can be material, non-recurring and separately disclosed, but never "extraordinary".
• Where operating expenses are presented by function, IFRS 18 requires a note disaggregating specified expenses by nature — including depreciation, amortisation, employee benefits, impairment losses and reversals, and write-downs of inventories and reversals.

[!TIP] In the exam, the scenario usually tells you. The FR examining team's guidance is explicit that where an operating expense is to be disaggregated, the scenario will say so, and credit is awarded for following that instruction. Failing to present the named item separately loses the mark even where the arithmetic is perfect.

---

5. Worked Example: Three Adjustments, Three Different Treatments

Scenario — Ravensworth plc, year ended 31 December 20X6

Draft profit for the year ended 31 December 20X6 is $2,400,000; the reported profit for 20X5 was $1,900,000; retained earnings at 1 January 20X5 as previously reported were $6,300,000. The tax rate throughout is 20%. Three matters are outstanding.

(a) Ravensworth has decided to change its measurement of its head office from the cost model to the revaluation model under IAS 16, because directors believe current values give more relevant information. The revaluation is effected at 31 December 20X6.

(b) A delivery fleet acquired on 1 January 20X3 for $1,800,000 was being depreciated over nine years to a nil residual value. On 1 January 20X6 the fleet manager's review concluded that the remaining useful life from that date is four years and the residual value is $200,000.

(c) Closing inventory at 31 December 20X5 was overstated by $150,000 because a stock sheet was added up incorrectly. The error is material.

Analysis

(a) Change in accounting policy — but a special one. A move from the cost model to the revaluation model is a change in accounting policy. However, IAS 16 and IAS 38 contain a specific exception: a change to a revaluation model is dealt with in accordance with those standards, that is, prospectively as a revaluation, and not by retrospective restatement under IAS 8. The revaluation surplus is recognised in other comprehensive income at 31 December 20X6 and comparatives are untouched.

This is the exception that examiners most enjoy setting, because candidates who have learned "policy change equals retrospective restatement" apply the general rule and restate three years of depreciation for nothing.

(b) Change in accounting estimate — prospective.

Original annual charge:   $1,800,000 / 9 years                     = $200,000
Accumulated depreciation to 31 December 20X5 (3 years)             = $600,000
Carrying amount at 1 January 20X6                                  = $1,200,000
Revised charge from 20X6: ($1,200,000 - $200,000) / 4 years        = $250,000

Effect: an ADDITIONAL $50,000 charged in 20X6 and in each of 20X7-20X9.
Comparatives: UNCHANGED. Opening equity: UNCHANGED.
Draft profit falls by $50,000.

(c) Prior period error — retrospective restatement. Closing inventory in 20X5 was overstated, so 20X5 cost of sales was understated and 20X5 profit was overstated. The opening inventory of 20X6 was correspondingly overstated, so 20X6 cost of sales is overstated and 20X6 profit is understated by the same amount — the error reverses.

Gross error                                                   $150,000
Tax effect at 20%                                             ($30,000)
Net-of-tax restatement                                        $120,000

20X5 comparative profit:      $1,900,000 - $120,000  =  $1,780,000 (restated)
20X6 draft profit:            increased by $120,000, because the overstated opening
                              inventory has depressed the current year's figure
Current year profit or loss:  contains NO prior period adjustment

Revised figures

20X6 profit:   $2,400,000 - $50,000 (estimate change) + $120,000 (error reversal)  = $2,470,000
20X5 profit:   $1,900,000 - $120,000                                               = $1,780,000 (restated)

Presentation in the statement of changes in equity

RAVENSWORTH PLC -- STATEMENT OF CHANGES IN EQUITY (retained earnings column, extract)
                                                                          $
  Balance at 1 January 20X5, as previously reported                6,300,000
  Prior period adjustment (correction of inventory error)                 --
  Balance at 1 January 20X5, as restated                           6,300,000
  Profit for the year ended 31 December 20X5, as restated          1,780,000
  Balance at 31 December 20X5, as restated                         8,080,000
  Profit for the year ended 31 December 20X6                       2,470,000
  Balance at 31 December 20X6                                     10,550,000

The 1 January 20X5 opening balance requires no adjustment because the error arose in the year ended 31 December 20X5, which is within the comparative period presented. Had the error originated in 20X4 or earlier, the opening balance at 1 January 20X5 would have been restated instead.

---

6. Common Exam Traps

[!WARNING] Trap 1: Putting a prior period adjustment through this year's profit or loss. The correction belongs in the statement of changes in equity and in the restated comparative. It never appears as a current-year expense or income.

[!WARNING] Trap 2: Restating comparatives for a change in estimate. A revised useful life, residual value, allowance or provision estimate is prospective. Restating last year is wrong and costs presentation marks.

[!WARNING] Trap 3: Applying retrospective restatement to a first revaluation. A change to the revaluation model is handled under IAS 16 or IAS 38 as a revaluation, not under the IAS 8 retrospective mechanism.

[!WARNING] Trap 4: Forgetting that an inventory error self-corrects. An overstated closing inventory in one year becomes an overstated opening inventory in the next, so the profit effect reverses. Both years move, in opposite directions, by the same net-of-tax amount.

[!TIP] Ask two questions in order. First: has the entity changed what it measures or how it presents (policy) or the numerical inputs to an existing measurement (estimate)? Second: was reliable information available at the time that should have been used (error)? If the answer to the first question is genuinely unclear, IAS 8 tells you to call it an estimate.