The IASB is looking to finesse the fundamental rule of applying changes to accounting policies retrospectively and changes to estimates prospectively, as Adam Deller explains
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.
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.
Adam Deller is a financial reporting specialist and lecturer