Tuesday 22 May 2018

POLICIES VS ESTIMATES

Ian Charles continues from his last blog post "Policies or Estimates - How to Distinguish Them" by reviewing and commenting on the IASB Proposals to amend IAS 8.

My previous blog was on accounting policies and accounting estimates. In this follow up I want to explain and comment on how the IASB proposes to amend the guidance on these.

The IASB published their proposed amendments to IAS 8 in September last year.  The closing date for formal response to the IASB was mid-January 2018, and we expect a feedback summary to be published perhaps as early as March 2018.

The ED covers four specific things:

  1. Changes to the definition of accounting policy;
  2. Introduction of a definition of accounting estimate;
  3. Clarification about how policies and estimates interact; and
  4. Clarification about how these changes affect the inventories cost formula selection.

Changes to the definition of accounting policies

Currently, IAS 8 defines accounting policies as the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements.

The revised definition of accounting policies becomes  “Accounting policies are the specific principles, measurement bases, and practices applied by an entity in preparing and presenting financial statements”.

In short, the phrase specific principles, bases, conventions, rules and practices changes to specific principles, measurement bases, and practices.

In my view the removal of the two terms “rules” and “conventions” is not a great loss. In fact the two terms are not used elsewhere in the IASB literature. Also, changing “bases” to “measurement bases” is a positive step. “Bases” is a term typically only referred to when we accountants talk about measurement so the proposed change seems uncontroversial.

The phrase “specific principles” has been retained. This term is I believe, well understood by our community. The preparation and presentation of financial statements fundamentally require the application of recognition principles, and a presentation principle. 

Recognition principles are broadly described in the Conceptual Framework, and then dealt with in detail in individual Standards. They concern issues of “when” and “what” is being captured and described, ultimately as line items, in the primary financial statements. 

Presentation principles concern “where and how” items will be displayed in those financial statements. I would be surprised if the changes proposed to the definition of accounting policies have been received with a negative response.

So overall, the proposed changes seem to make sense to me and undoubtedly tighten the definition up a little. However, it seems to me that the inclusion of a series of reasoned examples to illustrate what are and what are not accounting policies would have added valuable content to the standard.

Definition of accounting estimates

The current version of IAS 8 defines “A change in accounting estimate” but not an accounting estimate.

The IASB propose to address this somewhat unusual situation by adding a definition of accounting estimates, and removing the current definition of change in accounting estimates. 

This makes complete sense because, although the idea of an accounting estimate could be imputed from the understanding of what is a change in an accounting estimate, it made no sense to have a definition implied from defining a change in that thing. 

The ED proposes to define accounting estimates as: judgements or assumptions used in applying an accounting policy when, because of estimation uncertainty, an item in financial statements cannot be measured with precision. 

From this, it becomes a straightforward matter for the proposed Standard to explain what a change in an accounting estimate is.  Thus paragraph 34 of IAS 8 needs only a minor adjustment to its existing wording to emphasis that a change in an accounting estimate is triggered by either a change in the circumstances surrounding the estimation, or a development by way of new information/experience in the process of making the estimate. 

Again, I do not expect any great level of adverse response to this proposal.

How accounting policies and accounting estimates relate to each other

The proposed definition of “accounting estimate also helps to clarify how accounting policies and accounting estimates relate to each other. 

Thus, the application of an accounting policy often requires the use of an estimate.  For example, an accounting policy for the depreciation of items of property, plant and equipment that have finite useful lives necessarily involves making an estimate of the pattern of consumption of the economic benefits, and the life of those benefits (in the absence of a meter attached to the machine that continuously measures the using up of that asset, and a “kill” process that expires the machine at an instant in time in the future!!). 

Furthermore, and clearly closely linked to the definition of accounting estimate, the IASB are proposing to clarify that when an item in the financial statements cannot be measured with any high degree of precision, then the process of selecting an estimation technique or a valuation technique represents the making of an accounting estimate to use in the application of an accounting policy for that item.  Hardly likely to be considered controversial, I suggest.

Choice of cost formula for inventory items ordinarily interchangeable (IAS 2)

Finally, the IASB are proposing to add two paragraphs to IAS 8 (with a cross reference to IAS 2 Inventories) to explain the status of the selection of a cost flow assumption when items of inventory are interchangeable (First in first out (FIFO) versus Weighted Average (WAVCO) method).

The amendment makes the point that this selection does not imply a judgement or assumption about the sequence in which items are physically drawn from a bin or storage facility – the whole point is that items are indistinguishable one from another, so who would be able to tell whether 100 items of inventory had just been issued to a production process from the top (or bottom) of the store!?

Therefore, the selection of a cost formula does not involve the making of an accounting estimate – it is the selection of a measurement basis from the two available acceptable bases.  Therefore the selection of FIFO as opposed to WAVCO is the selection of an accounting policy. 

Although this may represent the opposite of what many in the accounting community would have currently concluded, it is in fact correct, and should receive no adverse response.

So have the IASB done all that is necessary to improve IAS 8?

Perhaps it is clear from my comments that I am of the view that an opportunity has been missed to more clearly identify exactly what the selection of an accounting policy actually means. 

This could be achieved by a fuller description of the activities involved in, ultimately, including something within or as a line item in the financial statements…

  • What is it that is being recognised (asset or expense, liability or income)?
  • When is it to be recognised in terms of the application of accruals concepts and the probability recognition threshold (probable flow)? 
  • Where is an item most appropriately to be presented (for example as income or negative cost)?
  • And how should it be presented (for example net or gross)?

Perhaps additional examples should be developed to achieve this.  

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Ian Charles continues from his last blog post "Policies or Estimates - How to Distinguish Them" by reviewing and commenting on the IASB Proposals to amend IAS 8.

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