In this blog I want to address the meaning of the term “accounting policy” and the distinction between accounting policy and accounting estimate.
There is a current IASB project to revise and clarify IAS 8 (ED 2017/5), and experience in the class or conference room tells me that this is not before time as there is confusion about what is a change in an accounting policy, as opposed to a change in an accounting estimate.
I shall review and explain the IASB’s proposed amendments to IAS 8 (and IAS 1) in the follow-up blog, but in this first item I want to explore what is understood about accounting policy, and therefore set out the background as to why IAS 8 needs to be revisited.
One of my regular challenges is to ask a class “If an entity changes its method of depreciation from straight-line to reducing balance, is this a change in an accounting policy or not?”
To remove any sense of suspense, the correct answer is that this is a change in accounting estimate. IAS 16 is quite clear in paragraph 61 that a change in the method of depreciation (and earlier in paragraph 51, a change in the estimated residual value and/or useful life) is a change in an accounting estimate. If I had a dollar for every answer that said “change of accounting policy”, I could make a reasonable contribution towards the national debt of some countries! Perhaps the difficulty is compounded by the fact that most accountants would talk about changing the depreciation policy from straight line to reducing balance. However, the accounting policy is to depreciate an asset (less its estimated residual value) on a systematic basis over its (finite) useful life. Straight-line or reducing balance are simply ways of doing this, attempting to reflect the pattern of future economic benefits.
The distinction is important, because a change in an accounting policy is (in general) effected by a retrospective application of the new policy as if it had always been applied, whereas a change in accounting estimate is applied prospectively.
Let’s look to see whether the GAAP sheds insight on accounting policies and accounting estimates.
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 IAS 8 definition of accounting policy includes references to “specific principles”. In IFRS the word “recognition” is often paired with the word “principle” as “recognition principle(s)”. For example, IAS 16 refers to a “recognition principle” (paras 10 and 12) when referring to the accounting for initial and subsequent costs incurred on an item of PP&E. Further examples can be seen in IAS 40 paras 17 and 18, in IFRIC 21 para 13 and in IFRS 15 B4C para BC16 (a). This list is not exhaustive.
The word “disclosure” is sometimes paired with “principle(s)”. For example in IAS 34 BC1. Or in Practice Statement 1. The IFRS for SMEs also refers to “presentation principles”.
The IAS 8 definition of accounting policy includes references to “specific ….bases”. The word “measurement” is often paired with the word “base (or bases)” for example as in “measurement bases”. Examples include (but are not limited to) IAS 41 BC28, IFRIC 19 BC19, IAS 37 IE example10 (2) and IAS 1 para 59.
The ED of amendments to IAS 8 ED/2017/5 proposes to add the word “measurement” before the word bases.
IAS 8, when setting out the issue of “Impracticability” (paras 50-53) in respect of retrospective application (this refers to a change of accounting policy), and retrospective restatement (this refers to the correction of an error) links the three terms “recognised, measured or disclosed” in the context of applying hindsight to the application of a new accounting policy in the first sentence of paragraph 53.
Conclusion: The existing use of the term “accounting policy” refers to the selection (to comply with a Standard, or to present relevant reliable information in the context of an issue not dealt with in a Standard) of suitable “principles and bases (interalia)…” for the
of transactions in the financial statements.
Thus, on this understanding (excuse the crazy suggestions… I’m not advocating them!!), the following would be accounting policies:
To recognise revenue from a contract with a customer at the time a contract was signed (RECOGNITION basis)
To recognise a provision only when it was virtually certain (RECOGNITION basis)
To recognise all subsequent expenditure on an item of P,P&E as an addition to cost (RECOGNITION basis)
To present financial assets and financial liabilities net (PRESENTATION basis)
To present non-current assets held for sale, and any related liabilities, as separate line items in the Statement of Financial Position (PRESENTATION basis)
To present all items of deferred taxation as non-current (PRESENTATION basis)
To carry items of P,P&E using either the cost model, or the revaluation model (MEASUREMENT basis)
To compute items of provisions as discounted, or not (MEASUREMENT basis)
To carry items of inventory at selling price (MEASUREMENT basis)
A change in an accounting policy is the application (in a material context) of a new principle or basis for the recognition, measurement or presentation/disclosure of an element of financial statements – asset, liability, income, expense or equity. This only occurs when required by a new rule in IFRS or to provide reliable and more relevant information (IAS 8. 14). These days there are few areas where IFRS allows a choice of accounting policy for a particular transaction and even then there might be further limitation placed on that choice.
A change in an accounting policy is a big deal. It usually involves (to the extent practicable), a restatement of the previous period and opening equity to that period – crucially the current and comparative periods are prepared and presented on a consistent basis.
Accounting estimates are not defined, although change in accounting estimate is defined, so by inference, so is accounting estimate.
An accounting estimate, given the description in IAS 8 for a change in an accounting estimate, is the application of the current knowledge or information relating to uncertain circumstances in order to make judgements or estimates about an item that cannot currently be measured with a high degree of precision.
Thus, a change in an accounting estimate is a reflection, in the current estimation process, of new information or circumstantial developments to bring the previous estimate “up to speed”. Therefore, given that the previous (original) estimate was made in good faith using the information that was available at that time, a change in an accounting estimate does not involve a restatement of that previous attempt.
It is a general principle of financial reporting that hindsight (being knowledgeable after the event) is not applied to recomputing previous valiant attempts to make the best estimate possible. So, although a change in an accounting estimate does relate to prior periods, it is not accounted for as a revision of those periods.
For example, an entity might measure and recognise a current tax liability in accordance with IAS 12. The estimate of this liability would be based on the best information available at the time of its preparation. Such an estimate might be revised in a subsequent accounting period as new information becomes available. IAS 12 paragraph 80 makes it clear that the adjustment to current tax of previous periods is part of the current year tax expense (income) and is a change in an accounting estimate.
In the same way, the change to the various assumptions made to compute a depreciation expense (residual value, useful life, and pattern of future economic benefits (method)) represents a change in an accounting estimate.
Accounting policies cover, recognition, measurement, presentation and disclosure. The accounting policies applied are dictated to a large extent by the need to follow the detailed rules and guidance in IFRS. Accounting policies only change in order to provide better quality information whether at the decision of the preparer in the limited circumstances allowed in IFRS or when required as and when the great and good at the IASB change a Standard.
Accounting estimates are about taking uncertainty in account when measuring items in financial statements. These can change from one period to the next to reflect the change of information available.
As I said above there is a current IASB project which proposes amendments to IAS 8 in order to add clarity to the distinction between accounting policy and accounting estimate.
I will talk about these proposed amendments in my next blog.
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