Why is retrospective application required for changes in accounting policy?

Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements. (IAS 8)

Following are Examples of accounting policies:

• Valuation of inventory using FIFO, Average Cost or other suitable basis as per IAS 2
• Classification, presentation and measurement of financial assets and liabilities under categories specified under IAS 32 and IAS 39 such as held to maturity, available for sale or fair value through profit and loss
• Timing of recognition of assets, liabilities, expenses and income
• Basis of measurement of non-current assets such as historical cost and revaluation basis
• Accruals basis of preparation of financial statements

Management must consistently review its accounting policies to ensure they comply with the latest pronouncements by IASCF and that the adopted policies result in presentation of most relevant and reliable financial information for users.

Changes in Accounting Policies

Accounting Policies must be applied consistently to promote comparability between financial statements of different accounting periods. However, a change in accounting policy may be necessary to enhance the relevance and reliability of information contained in the financial statements. Such changes may be required as a result of changes in IFRS or may be applied voluntarily by the management.

As a general rule, changes in Accounting Policies must be applied retrospectively in the financial statements. Retrospective application means that entity implements the change in accounting policy as though it had always been applied.

Consequently, entity shall adjust all comparative amounts presented in the financial statements affected by the change in accounting policy for each prior period presented.

Exemption from Retrospective Application of Accounting Policies

Retrospective application of a change in accounting policy may be exempted in the following circumstances:

• A change in accounting policy is required by a new IFRS or a change to an existing IFRS / IAS and the transitional provisions of those standards allow or require prospective application of a new accounting policy. Specific transitional guidance of IFRS must be followed in such circumstances.
• The application of a new accounting policy is in respect of transactions, events and circumstances that are substantially different from those that transpired in the past.
• The effect of retrospective application of a change in accounting policy is immaterial.
• The retrospective application of a change in accounting policy is impracticable. This may for example be the case where entity has not collected sufficient data to enable objective assessment of the effect of a change in accounting estimate and it would be unfeasible or impractical reconstruct such data.

Where impracticability impairs an entity’s ability to apply a change in accounting policy retrospectively from the earliest prior period presented, the new accounting policy must be applied prospectively from the beginning of the earliest period feasible which may be the current period.

Disclosures

Following must be disclosed in the financial statements of the accounting period in which a change in accounting policy is implemented:

This article was first published in the July/August 2018 international edition of Accounting and Business magazine.

There are plenty of jokes at the expense of accountants, but hardly any about accounting standards – and the few that do exist are invariably terrible. My personal favourite involves a piece of land feeling upset because of mistreatment by its owner, which has the punchline of ‘you don’t depreciate me’. It hardly ever raises a laugh – stunned silence or a groan of derision are the usual reactions.

The question ‘when is an accounting policy not an accounting policy?’ may sound suspiciously like the start of another poor joke. Unfortunately, it isn’t; it is one of the issues that crops up in considerations of how to apply IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors.

IAS 8 is one of the oldest surviving accounting standards currently in use, having first been issued in 1993 and then revised in 2003. Its principles have stood for years, and continue to be relevant in the face of the new suite of IFRS Standards issued in recent years. Like many an accounting lecture, IAS 8 may not be fun, but it is useful.

The key principle in IAS 8 is that any changes to an accounting estimate are applied prospectively from the date of the change, whereas changes in accounting policies are applied retrospectively. Retrospective application often involves restating the prior-year financial statements, as if the policy had always been in place.

When the International Accounting Standards Board (IASB) issues new standards, it often refers to IAS 8 in deciding whether retrospective application should be required. The recent release of IFRS 15, Revenue from Contracts with Customers, and the proposed release of IFRS 16, Leases, applicable to accounting periods beginning from 1 January 2019, both allow a choice of application.

One option is to strictly follow the rules of IAS 8, with an adjustment to each prior reporting period to replace a previous account treatment with the updated requirements.

But there is an alternative approach: while still applying the principles of retrospective application for the new accounting policy, users will be allowed to apply the standard retrospectively, with the cumulative effect of initially applying it recognised at the date of initial application. This would require no restatement of any prior-year financial statements. Instead, the entity would recognise the cumulative effect of applying the new standard to the balance of opening retained earnings at the date of the initial application.

There is space here for the preparer to apply judgment. In some cases, users may feel that the most relevant information, and most faithful representation, would be shown in a full restatement of the prior-.period financial statements for comparative purposes. In other cases, users may feel that this level of restatement would provide little relevance and would instead be content with seeing the overall impact of the new policy on retained earnings.

This is consistent with the approach the IASB is taking to other projects such as the disclosure initiative. The IASB wants to allow preparers to exercise judgment in decision-making, while recognising the possible impact of this on comparability. Offering choices of approach in retrospective application is an attempt to hold to the principles of the standard while managing the tension of comparability and judgment.

The retrospective change rules of IAS 8 have often been discussed, and the costs and benefits weighed up when new accounting policies are applied. A long-standing exception to the accounting policies rule is when an entity chooses to apply the revaluation model for property, plant and equipment rather than the cost model. While this is clearly a change in accounting policy, it is always applied prospectively, as retrospective application is often impracticable.

Identity crisis

So far, so sensible, but the problems in the application of IAS 8 are less to do with applying the standard and more to do with identifying whether an item represents an accounting estimate or an accounting policy. An example of this difficulty can be found in the accounting for depreciation, as shown in the following three areas:

• The assessed useful life of an asset is clearly an estimate, so this raises little problem for preparers. If the asset life is changed for any reason, then this change is applied prospectively, from the date the new life is assessed.
• More contentious is the method of depreciation applied by an entity. Its decision to use the straight-line or reducing-balance method of depreciation is often referred to as its depreciation policy. This makes sense, as it is the method chosen by the entity for recording depreciation, but the ‘policy’ wording is misleading. The depreciation method selected should represent an estimate of how the benefits will be provided by the asset. The choice of depreciation method therefore falls into the category of an accounting estimate, not an accounting policy, so an entity moving from straight-line to reducing-balance depreciation applies the change prospectively from the date the decision was made, rather than applying it to previous periods or to the opening retained earnings.
• This potential problem deepens when looking at where the depreciation is charged in the statement of financial performance. An entity that changes from recording depreciation in cost of sales to recording it in administrative expenses must apply the change retrospectively because it is deemed an accounting policy change (on the basis that it is a fundamental change in the presentation of items).

All in the definition

To combat these issues, the IASB is proposing adjusting the definitions of accounting estimates and policies. The existing definition of an accounting policy includes five terms: principles, bases, conventions, rules and practices. The IASB is now proposing that accounting policies are the specific principles, measurement bases and practices applied by an entity.

In addition, it proposes that IAS 8 should replace the definition of a change in accounting estimate with the definition of accounting estimates themselves. Accounting estimates will then be defined as ‘judgments or assumptions used in applying an accounting policy when, because of measurement uncertainty, an item in financial statements cannot be measured with precision’.

The proposed changes include specifically outlining that the selection of a cost formula (ie first-in first-out, or weighted average cost) in relation to accounting for inventory would constitute an accounting policy. Most commenters agree that this constitutes an accounting policy, but many want it put in the illustrative examples rather than the standard itself.

The response to both changes is generally positive, but many commenters note that further illustrative examples would be helpful in determining the distinction between an accounting estimate and an accounting policy, with some even suggesting that IAS 8 is not really understandable without such examples.

Alongside this discussion, the International Auditing and Assurance Standards Board (IAASB) is proposing revisions to ISA 540, Auditing Accounting Estimates and Related Disclosures. Its proposals are more detailed and comprehensive than the changes to IAS 8, but the IASB has been discussing the IAS 8 changes with the IAASB project team to achieve consistency of approach in both the financial reporting and auditing worlds.

In a nutshell

The principles of IAS 8 remain robust, with common sense application at its core. In an ever changing corporate landscape it is not the principles which will be subject to change, but clarification on its terminology. The introduction of contemporary illustrative examples is surely a sensible addition to the standard to aid preparers and auditors in faithfully representing items in the financial statements in current and comparative periods. If these are not provided, the answer to ‘when is an accounting policy not an accounting policy?’ may remain unclear, and unfunny, for some time to come.

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