Chapter 5 HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors

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1.1 1.2 1.3

Ob ecti!es
Define and identify accounting policies, change in accounting estimates, prior period errors, retrospective application, retrospective restatement and prospective application. Distinguish between changes in accounting estimates and changes in accounting policies. Describe the treatments for accounting errors and changes in accounting policy.

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#e$initions
Definitions a! Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements. ! " change in accounting estimates ( ) is an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and e#pected future benefits and obligations associated with, assets and liabilities. $hanges in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors. !"#$%/ &'/%()*+,-. 01234567.089 !%(:;<=>?@ ABC7DEF!GHIJ$.0KL3! Prior period errors ( ) are omissions from, and misstatements ! in, the entity%s financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that& i! was available when financial statements for those periods were authorised for issue' and ii! could reasonably be e#pected to have been obtained and ta(en into account in the preparation and presentation of those financial statements. )uch errors include the effects of mathematical mista(es, mista(es in applying accounting policies, oversights or misinterpretations of facts, and fraud. Retrospective application ( ) is applying a new accounting policy to transactions, other events and conditions as if that policy had always been applied. MNOPQRS$TUVWXYP<Z[\]^_`abc dPef3gh<Z[O"ijklmnopnOP3! Retrospective restatement ( ) is correcting the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior period error had never occurred. Impracticable ( ) * "pplying a re+uirement is impracticable when the entity cannot apply it after ma(ing every reasonable effort to do so. ,or a particular prior period, it is impracticable to apply a change in an accounting policy retrospectively or to ma(e a retrospective restatement to correct an
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b!

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error. Prospective application ( ) of a change in accounting policy and of recognising the effect of a change in an accounting estimate, respectively, are& i! applying the new accounting policy to transactions, other events and conditions occurring after the date as at which the policy is changed' and ii! recognising the effect of the change in the accounting estimate in the current and future periods affected by the change.

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(A) 3.1

Accounting Policies
Selection and Application of Accounting Policies -hen an "ccounting )tandard or an .nterpretation specifically applies to a transaction, other event or condition, the accounting policy or policies applied to that item should be determined by applying the Accounting Standard or Interpretation and considering any relevant .mplementation /uidance for the "ccounting )tandard or .nterpretation. .f there is no specific Accounting Standard or an Interpretation to follow , management should use its judgement in developing and applying an accounting policy that results in information that is& a! relevant to the economic decision-ma(ing needs of users' and b! reliable in that the financial statements& i! represent faithfully the financial position, financial performance and cash flows of the entity' ii! reflect the economic substance of transactions, other events and conditions, and not merely the legal form' iii! are neutral, that is, free from bias' iv! are prudent' and v! are complete in all material respects. .n ma(ing the 0udgement, management should refer to, and consider the applicability of, the following sources in descending order& a! the re+uirements and guidance in "ccounting )tandards and .nterpretations dealing with similar and related issues' and b! the definitions, recognition criteria and measurement concepts for assets, liabilities, income and e#penses in the ,ramewor(. !onsistency of Accounting Policies
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( )

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"n entity shall select and apply its accounting policies consistently for similar transactions, other events and conditions, unless a )tandard or an .nterpretation specifically re+uires or permits categorisation of items for which different policies may be appropriate. .f a )tandard or an .nterpretation re+uires or permits such categorisation, an appropriate accounting policy shall be selected and applied consistently to each category.

(!) 3.5

!hanges in Accounting Policies !hanges in Accounting Policies "n entity shall change an accounting policy only if the change& a! is re"uired by a Standard or an Interpretation' or b! results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity%s financial position, financial performance or cash flows. c! 2his includes the recognition# presentation and measurement basis to be applied to assets, liabilities, gains, losses and changes to shareholders funds. 2he following are not changes in accounting policies& a! the application of an accounting policy for transactions, other events or conditions that differ in substance from those previously occurring ' q ! and WX%(UVr7stuvqwxy#zP<Z[3 b! the application of a new accounting policy for transactions, other events or conditions that did not occur previously or were immaterial. $m{% |}JWX%(UVzP<Z[3!

3.3

.n the case of tangible non-current assets, if a policy of revaluation is adopted for the first time then this is treated, not as a change of accounting policy under 45") 6, but as a revaluation under 45") 13 7roperty, plant and e+uipment. Applying !hanges in Accounting Policies ,or applying changes in accounting policies, 45") 6 provides the following& a! an entity shall account for a change in accounting policy resulting from the initial application of a )tandard or an .nterpretation in accordance with the
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(D) 3.8

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specific transitional provisions, if any, in that )tandard or .nterpretation' and when an entity changes an accounting policy upon initial application of a )tandard or an .nterpretation that does not include specific transitional provisions applying to that change, or changes an accounting policy voluntarily, it shall apply the change retrospectively.

3.6

$ey Point -hen a change in accounting policy is applied retrospectively, the entity shall adjust the opening balance of each affected component of e+uity for the earliest prior period presented and the other comparative amounts disclosed for each prior period presented as if the new accounting policy had always been applied.

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-hen retrospective application is re+uired, a change in accounting policy shall be applied retrospectively e#cept to the e#tent that it is impracticable to determine either the period-specific effects or the cumulative effect of the change. -hen it is impracticable to determine the period-specific effects of changing an accounting policy on comparative information for one or more prior periods presented, the entity shall apply the new accounting policy to the carrying amounts of assets and liabilities as at the beginning of the earliest period for which retrospective application is practicable, which may be the current period, and shall ma(e a corresponding ad0ustment to the opening balance of each affected component of e+uity for that period. -hen it is impracticable to determine the cumulative effect, at the beginning of the current period, of applying a new accounting policy to all prior periods, the entity shall ad0ust the comparative information to apply the new accounting policy prospectively from the earliest date practicable. -hen it is impracticable for an entity to apply a new accounting policy retrospectively, because it cannot determine the cumulative effect of applying the policy to all prior periods, the entity applies the new policy prospectively from the start of the earliest period practicable. .t therefore disregards the portion of the cumulative ad0ustment to assets, liabilities and e+uity arising before that date. %&ample ' "n entity has previously charged interest incurred in connection with the construction of tangible non-current assets to the statement of comprehensive income. ,ollowing
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the revision of 45") 23 during ;une 2::8, and in accordance with the revised re+uirements of that standard, it now capitali<es this interest. )ince the change in recognition and presentation of interest incurred in connection with the construction of asset is re+uired by the revised 45") 23. 2herefore it is a change in accounting policy. 3.11 %&ercise ' =n 1 ;anuary 2::5, /amma $o changed its accounting policy for the treatment of borrowing costs that are directly attributable to the ac+uisition of a hydro-electric power station under construction for use by /amma. .n previous periods, /amma had capitali<ed such costs. /amma has now decided to treat these costs as an e#pense, rather than capitali<e them. >anagement 0udges that the new policy is preferable because it results in a more transparent treatment of finance costs and is consistent with local industry practice, ma(ing /amma%s financial statements more comparable. 1! 2! /amma capitali<ed borrowing costs incurred of ?2,3:: during 2::1 and ?5,2:: in periods before 2::1. /amma%s accounting records for 2::5 show profit before interest and income ta#es of ?3:,:::' interest e#pense of ?3,::: which relates only to 2::5!' and income ta#es of ?6,1::. /amma has not yet recognised any depreciation on the power station because it is not yet in use. .n 2::1, /amma reported& ? 7rofit before interest and ta# 16,::: .nterest e#pense 7rofit before ta# .ncome ta#es 7rofit for the year 5! 3! 16,::: 5,1::! 12,3::

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2::1 beginning retained earnings was ?2:,::: and ending retained earnings was ?32,3::. /amma%s ta# rate was 3:@ for 2::5, 2::1 and prior periods.

Re"uired(

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7repare e#tract to the income statements and statements of changes in e+uity for 2::5 and 2::1, showing the cumulative effect of the change in accounting policy. Disclosure notes are re+uired.! Solution(

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1.1

Changes in accounting estimates

$ey Point
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"s a result of the uncertainties inherent in business activities, many items in financial statements cannot be measured with precision but can only be estimated. Astimation involves 0udgements based on the latest available, reliable information. ,or e#ample, estimates may be re+uired of& a! bad debts' b! inventory obsolescence' c! the fair value of financial assets or financial liabilities' d! the useful lives of, or e#pected pattern of consumption of the future economic benefits embodied in, depreciable assets' and e! warranty obligations. 1.2 !hanges in accounting estimates will be inevitable as a result of new information, more e&perience or subse"uent developments. 2he revision of an estimate, by its nature, does not relate to prior periods and is not the correction of an error. "pplying changes in accounting estimates, the effect of the change should be recognised by including in profit or loss in& a! the period of change, if the change affects that period only' and b! the period of the change and future periods, if the change affects both. ,or e#ample, the effect of a change in estimate of the useful life of a depreciable asset affects the depreciation e#pense in the current period and in each period during the remaining useful life of the asset. 2hus, the effect of the change relating to the current period should be included in the depreciation e#pense in the current period%s income statement. 2he effect, if any, on future periods is recognised in those future periods. " change in an accounting estimate applies the change to transactions, other events and conditions from the date of the change in estimate, and hence the financial statements of the prior period presented as comparative figures are not restated. -here a change in an accounting estimate gives rise to changes in assets and liabilities, or relates to an item of e+uity, 45") 6 provides that it should be recognised by ad0usting the carrying amount of the related asset, liability or e+uity item in the period of the change. .f the change in an accounting estimate has an effect in the current period or is e#pected to have an effect in future periods, an entity should disclosure the nature and amount of the change, e#cept for the disclosure of the effect on future periods when it is impracticable to estimate that effect. .f the amount of the effect in future periods is not disclosed because estimating it is impracticable, that fact should be disclosed.

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%&ercise ) -hich of the following is a change in accounting policy as opposed to a change in estimation techni+ueB a! "n entity has previously depreciated vehicles using the reducing balance method at 1:@ pa. .t now uses the straight line method over a period of five years. "n entity has previously shown certain overheads within cost of sales. .t now shows those overheads within administrative e#penses. "n entity has previously measured inventory at weighted average cost. .t now measures inventory using the ,.,= method.

b! c!

Solution(

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Prior Period Errors

Arrors discovered during a current period which relate to a prior period may arise through& a! >athematical mista(es b! >ista(es in the application of accounting policies c! >isinterpretation of facts d! =versights e! ,raud 2he correction of material errors that relates to prior periods should be accounted for CretrospectivelyD, in the first set of financial statements authori<ed for issue after their discover by& a! restating the comparative amounts for the prior period s! presented in which the error occurred' or b! if the error occurred before the earliest prior period(s) presented, restating the opening balance of assets, liabilities and e+uity for the earliest prior period presented. 2he following disclosures are re+uired& a! the nature of the prior period error' b! for each prior period presented, to the e#tent practicable, the amount of the correction for each financial statement line item affected' and if 45") 33 CAarnings per )hareD applies to the entity, for basic and diluted earnings per share'
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the amount of the correction at the beginning of the earliest prior period presented' and if retrospective restatement is impracticable for a particular prior period, the circumstances that led to the e#istence of that condition and a description of how and from when the error has been corrected.

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%&ample ) a! During 2::5, EFG Htd. discovered that certain products that had been sold during 2::1 were incorrectly included in inventory at 31 December 2::1 at ?3,5::. EFG Htd.%s accounting records for 2::5 show sales of ?1:1,:::, cost of goods sold of ?63,5:: including ?3,5:: for error in opening inventory!, and ta#ation of ?5,25:. .n 2::1, EFG Htd. reported& ? 83,5:: 53,5::! 2:,::: 3,:::! 11,:::

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)ales $ost of goods sold 7rofit from ordinary activities before ta#ation 2a#ation Net profit d! e!

2::1 opening retained earnings was ?2:,::: and closing retained earnings was ?31,:::. EFG Htd. profit ta# rate 3:@ for 2::5 and 2::1.

Re"uired( 7repare e#tract to the income statements and statements of changes in e+uity for 2::5 and 2::1, showing the cumulative effect of the change in accounting policy. Disclosure notes are re+uired.! Solution( *+, -td. %&tract from the Income Statement 2::5
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)ales $ost of goods sold 7rofit from ordinary activities before ta#ation 2a#ation Net profit *+, -td. Statement of !hanges in %"uity

? 1:1,::: 6:,:::! 21,::: 8,2::! 13,6::

? 83,5:: 3:,:::! 13,5:: 1,:5:! 9,15:

2::5 ? =pening retained earnings as previously reported $orrection of fundamental error net of ta#ation of ?1,95:! =pening retained earnings as restated Net profit $losing retained earnings A#tract from notes to the financial statements 1. 31,::: 1,55:! 29,15: 13,6:: 13,25:

2::1 ? restated! 2:,:::

2:,::: 9,15: 29,15:

$ertain products that had been sold in 2::1 were incorrectly included in inventory at 31 December 2::1 for ?3,5::. 2he financial statements of 2::1 have been restated to correct this error.

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%&ercise / During 2::8 a company discovered that certain items of research e#penditure had been incorrectly capitali<ed as development e#penditure at 31 December 2::3. 2he amount of e#penditure capitali<ed was ?1 million. 2his research e#penditure should have been included in cost of sales. 2he original figures reported for year ending 31 December 2::3 and the figures for the current year 2::8 are given below& 2::8 ?:::
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2::3 ?:::

)ales $ost of sales /ross profit Distribution and administrative e#penses 2a# Net profit

3:,::: 1:,:::! 2:,::: 1,:::! 1,:::! 15,:::

5:,::: 32,:::! 16,::: 3,:::! 1,:::! 11,:::

2he opening retained earnings at 1 ;anuary 2::3 were ?5: million. 2he ad0ustment has no effect on the ta# for the year. Re"uired( )how the 2::8 statement of comprehensive income and statement of changes in e+uity with comparative figures and the retained profits for each year. Solution(

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#isclosure
-hen initial application of a )tandard or an .nterpretation has an effect on the current period or any prior period, would have such an effect e#cept that it is impracticable to determine the amount of the ad0ustment, or might have an effect on future periods, an entity shall disclose& a! the title of the )tandard or .nterpretation' b! when applicable, that the change in accounting policy is made in accordance with its transitional provisions' c! the nature of the change in accounting policy' d! when applicable, a description of the transitional provisions' e! when applicable, the transitional provisions that might have an effect on future periods' f! for the current period and each prior period presented, to the e#tent practicable, the amount of the ad0ustment& i! for each financial statement line item affected' and ii! if 45") 33 CAarnings per )hareD applies to the entity, for basic and diluted earnings per share' g! the amount of the ad0ustment relating to periods before those presented, to the e#tent practicable' and h! if retrospective application is impracticable for a particular prior period, or for periods before those presented, the circumstances that led to the e#istence of that condition and a description of how and from when the change in accounting policy has been applied. -hen a voluntary change in accounting policy has an effect on the current period or any prior period, would have an effect on that period e#cept that it is impracticable to determine the amount of the ad0ustment, or might have an effect on future periods, an entity shall disclose& a! the nature of the change in accounting policy' b! the reasons why applying the new accounting policy provides reliable and more relevant information' c! for the current period and each prior period presented, to the e#tent practicable, the amount of the ad0ustment& i! for each financial statement line item affected' and
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if 45") 33 applies to the entity, for basic and diluted earnings per share' d! the amount of the ad0ustment relating to periods before those presented, to the e#tent practicable' and e! if retrospective application is impracticable for a particular prior period, or for periods before those presented, the circumstances that led to the e#istence of that condition and a description of how and from when the change in accounting policy has been applied. -hen an entity has not applied a new )tandard or .nterpretation that has been issued but is not yet effective, the entity shall disclose& a! this fact' and b! (nown or reasonably estimable information relevant to assessing the possible impact that application of the new )tandard or .nterpretation will have on the entity%s financial statements in the period of initial application.

ii!

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%&amination Style 0uestions

0uestion '
a! )et out below is a draft statement of retained profit for 2hame Htd for the year ended 31 >arch 2:1: and the comparative figures for the year ended 31 >arch 2::9. Statement of retained profit 2:1: ?::: Ietained profit for the year Ietained profit at the beginning of the year Ietained profit at the end of the year 1:: 5:: 9:: 2::9 ?::: 35: 15: 5::

2wo errors have 0ust been discovered which consist of unreported profit that had been omitted from the above statement of retained profit. .n the year ended 31 >arch 2::6 there was an unreported profit before ta# of ?6:,::: ta# ?1:,:::! and in the year ended 31 >arch 2::9 an unreported profit before ta# of ?1::,::: ta# ?15,:::!. Fou are re+uired to amend the above statement of retained profit in order to account for these two fundamental errors. b! 3 mar(s!

)tate, with reasons, whether you consider the following events, which are all material, should be accounted for as prior period ad0ustments& i! ii! " company changes its accounting policies in order to comply with a new 4ong 5ong "ccounting )tandard. "n error in the valuation of the closing inventories in the financial statements issued two years previously has been discovered. iii! 2he directors of a company engaged in a construction contract which had previously regarded it in the financial statements as a profitable contract and hence profit recogni<ed in accordance with 45") 11 C$onstruction $ontractsD! are now of the opinion that there will be a loss on the contract as a whole. iv! v! " computer, which was purchased three years ago for ?1::,:::, was being depreciated at 15@ per annum on the straight line basis, has been sold for ?15,:::. " company has leased premises for five years and the terms of the lease state that the tenant is responsible for all the repairs during the lease. 2he lease has e#pired and the landlord has re+uested a sum of ?1 million for repairs necessary to restore the property to
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its former condition. 2he company has agreed to pay this sum because it has failed to repair the property during the lease periods. 1: mar(s! 0uestion ) 45") 6 distinguishes between accounting policies and estimation techni+ues and the accounting for changes in each is very different. Re"uired( a! Distinguish between accounting policies and estimation techni+ues, as defined by 45") 6 and state the differences in accounting for a change in accounting policy and a change in an estimation techni+ue. b! ,or items i! to v! below, state in each case whether the proposed changes represent changes in accounting policies or estimation techni+ues, giving brief reasons. i! Depreciation of vehicles 1! "n entity has previously depreciated vehicles using the reducing balance method at 1:@ per year. .t now proposes to depreciate vehicles using the straight-line method over five years, since it believes this better reflects the pattern of consumption of economic benefits. 2! "s in 1!, an entity has previously depreciated vehicles using the reducing balance method at 1:@ per year and now proposes to depreciate vehicles using the straight-line method over five years. .n addition, it has previously recorded the depreciation charge within cost of sales, but now proposes to include it within administrative e#penses. ii! $lassification of overheads "n entity has previously shown certain overheads within cost of sales. .t now proposes to show those overheads within administrative e#penses. iii! .ndirect overheads recorded in the value of stoc( " manufacturing entity has three indirect cost centres ", J and $!. .t has previously assessed that the indirect costs attributable to production are 3:@ of " and 1:@ of J. 4aving reassessed the nature of those cost centres% activities, it now assesses that the indirect costs attributable to production are 25@ of ", 1:@ of J and 1:@ of $. iv! $apitalised finance costs "n entity has previously charged to profit and loss account interest incurred in connection with the construction of tangible fi#ed assets. .t now proposes to capitali<e such interest, as permitted by 45") 13 C7roperty, 7lant and A+uipmentD, since it believes this better reflects the cost of constructing those assets. v! 7rovisions
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"n entity has previously measured a particular provision on an undiscounted basis, in accordance with 45") 38 C7rovisions, $ontingent Hiabilities and $ontingent "ssetsD, as the effect of discounting was not material. 4owever, this year it has revised upwards its estimates of future cash flows associated with the provision and, as a result, the effect of discounting is now material. 45") 38 therefore re+uires it to report the provision at the discounted amount. 0uestion / a! b! Describe the circumstances in which an entity may change its accounting policies and how a change should be applied. 5 mar(s! 2he terms under which 7artway sells its holidays are that a 1:@ deposit is re+uired on boo(ing and the balance of the holiday must be paid si# wee(s before the travel date. .n previous years 7artway has recognised revenue and profit! from the sale of its holidays at the date the holiday is actually ta(en. ,rom the beginning of November 2::5, 7artway has made it a condition of boo(ing that all customers must have holiday cancellation insurance and as a result it is unli(ely that the outstanding balance of any holidays will be unpaid due to cancellation. .n preparing its financial statements to 31 =ctober 2::3, the directors are proposing to change to recognising revenue and related estimated costs! at the date when a boo(ing is made. 2he directors also feel that this change will help to negate the adverse effect of comparison with last yearKs results year ended 31 =ctober 2::5! which were better than the current yearKs. Re"uired( $omment on whether 7artwayKs proposal to change the timing of its recognition of its revenue is acceptable and whether this would be a change of accounting policy. 3 mar(s! "$$" 2.5 45/! ,inancial Ieporting December 2::3 L5 b!!

0uestion 1 Derringdo sells carpets from several retail outlets. .n previous years the company has underta(en responsibility for fitting the carpets in customers% premises. $ustomers pay for the carpets at the time they are ordered. 2he average length of time from a customer ordering a carpet to its fitting is 11 days. .n previous years, Derringdo had not recognised a sale in income until the carpet had been successfully fitted as the rectification costs of any fitting error would be e#pensive. ,rom 1 "pril 2::2 Derringdo changed its method of trading by sub-contracting the fitting to approved contractors. Mnder this policy the sub-contractors are paid by Derringdo and they the subcontractors! are liable for any errors made in the fitting.
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Jecause of this Derringdo is proposing to recognise sales when customers order and pay for the goods, rather than when they have been fitted. Details of the relevant sales figures are&

)ales made in retail outlets for the year to 31 >arch 2::3 )ales value of carpets fitted in the 11 days to 11 "pril 2::2 )ales value of carpets fitted in the 11 days to 13 "pril 2::3

?::: 23,::: 1,2:: 1,3::

Note& the sales value of carpets fitted in the 11 days to 11 "pril 2::2 are not included in the annual sales figure of ?23 million, but those for the 11 days to 11 "pril 2::3 are included. Re"uired( Discuss whether the above represents a change of accounting policy, and, based on your discussion, calculate the amount that you would include in sales revenue for carpets in the year to 31 >arch 2::3. 5 mar(s!
"$$" 2.5 45/! ,inancial Ieporting ;une 2::3 L3 d!!

0uestion 2 Fou are the financial controller of Delta. Four assistant is preparing the first draft of the financial statements for the year ended 31 >arch 2:11. 4e has a reasonable general accounting (nowledge but is not familiar with the detailed re+uirements of all relevant financial reporting standards. 2here is one issue on which he re+uires your advice and he has sent you a memorandum as shown below& =n 1 "pril 2::6 we bought a large machine for ?5 million. -e originally estimated a useful economic life of 5 years with no residual value. 2his estimate was used in previous years and the carrying value of the asset in the financial statements last year was ?3 million. "t 1 "pril 2:1: we loo(ed at these estimates again and now we thin( the original estimate was overoptimistic. 2he machine is unli(ely to generate economic benefits for us after 31 >arch 2:12 but on that date we could e#pect a scrap value of ?2::,:::. -e haven%t charged enough depreciation in 2::6N:9 and 2::9N1: but .%m not sure how to reflect this * should . change my brought forward figuresB 5 mar(s!
"$$" Diploma in .,I 7ilot 7aper L2!

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