IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors — Summary, Worked Example & Practice Questions

An accounting policy is the settled approach an entity uses to build a set of financial statements — the conventions, bases and practices it applies when recognising, measuring and presenting items (IAS 8.5). Where a standard or interpretation covers a transaction, the policy is simply whatever that standard requires, and there is no freedom to pick something else because it happens to suit the entity better (IAS 8.7).

Some standards deliberately offer a choice — the cost model or the revaluation model for property, plant and equipment being the obvious one. Selecting between permitted alternatives is itself a policy decision, and once made it must be applied to the whole class of items consistently and carried forward from period to period (IAS 8.13).

The harder case is a transaction no standard addresses. IAS 8 then sets out a descending order of sources management must work through, and the order is compulsory rather than a menu (IAS 8.10–12). The overriding aim is information that is useful for economic decisions and that faithfully reflects what actually happened.

• First, look at any standard or interpretation dealing with an issue that is similar in substance or related to the one in hand, and reason by analogy from it.
• Second, fall back on the definitions, recognition criteria and measurement concepts set out in the Conceptual Framework.
• Third — and only after the first two are exhausted — management may look outward to the recent pronouncements of other standard-setters that use a similar conceptual basis, to accepted industry practice, and to other accounting literature, provided nothing there conflicts with the two higher sources.

Consistency is the default state. The same policies are applied to items of a like nature unless a standard specifically requires or permits different treatment for different categories, in which case a separate appropriate policy is chosen for each category (IAS 8.13).

There are only two gateways to changing an accounting policy. Either a standard or interpretation obliges the entity to change, or the entity concludes voluntarily that a different approach would produce information that is more relevant to users and no less faithful in its representation of the entity's position, performance and cash flows (IAS 8.14). Preferring the profit profile the new approach happens to produce is not a reason.

Two things that look like policy changes are specifically excluded. Adopting a policy for a type of transaction the entity has never entered into before is not a change, and neither is adopting one for transactions that were previously immaterial (IAS 8.16). In both cases there was no earlier policy to move away from.

Where a new standard is being adopted, any transitional provisions written into that standard take priority. If the standard is silent on transition, or the change is a voluntary one, the general rule applies: the new policy is applied retrospectively (IAS 8.19). That means the comparatives are recast as though the new policy had always been in place, and the opening balance of each affected equity component for the earliest period presented is adjusted to absorb the cumulative effect of all earlier periods (IAS 8.22).

The logic behind pushing the change backwards is comparability. If the current year were prepared on the new basis and last year left on the old one, the two columns would not be measuring the same thing, and any trend a reader drew from them would be an artefact of the accounting rather than of the business.

Many amounts in a set of accounts cannot be observed directly and have to be arrived at by judgement using the best information available. IAS 8 describes these as monetary figures in the financial statements that carry measurement uncertainty — a definition sharpened by the 2021 amendment precisely because entities were struggling to separate estimates from policies (IAS 8.5, amendment effective 2023). An estimate is developed to achieve a measurement objective set by a policy; the policy says what is being measured, the estimate supplies the number.

Estimates are revised when the circumstances they rested on move on, or when better information, more experience or later developments come to light. Revising one is not the correction of a mistake — the earlier figure was appropriate on the evidence then available — and so nothing already reported is disturbed (IAS 8.34).

The effect of a revision is recognised prospectively: in the period of the change if it affects that period alone, and across the period of change and future periods where both are affected (IAS 8.36). Where the revision alters assets, liabilities or an equity item, it is dealt with by adjusting the carrying amount of that item in the period of change.

• Shortening or extending the useful life of an asset — the remaining carrying amount is spread over the revised remaining life from the current period onwards.
• Adjusting the loss allowance on receivables as collection experience develops.
• Remeasuring a warranty or restructuring provision as claims data or plans firm up.
• Reassessing the residual value of an asset, or the pattern in which its future benefits are expected to be consumed.

Techniques used to arrive at an estimate — a valuation model, or the way an expected credit loss is computed — are inputs to the estimate rather than policies in their own right. A change to such a technique, where the measurement objective itself is unchanged, is therefore treated as a change of estimate.

This is where marks are most often lost, because the two are handled in opposite directions: a policy change is pushed back through the comparatives, an estimate change is only carried forward. The workable test is to ask whether the entity has altered what it is measuring, or merely refined the figure it arrives at for something it was already measuring the same way.

• Moving inventory costing from first-in, first-out to a weighted average formula — a policy change, because the basis on which cost is determined has itself been replaced.
• Switching depreciation from straight line to reducing balance — an estimate change, because the policy (spread the cost over the useful life) is unchanged and only the expected pattern of consumption has been reassessed (IAS 16.61).
• Moving investment property from the cost model to the fair value model — a policy change, since a different measurement basis is being adopted.
• Increasing a warranty provision because claims are running higher than expected — an estimate change; the policy of providing for warranty obligations was already in place.
• Revising the useful life of a building from 40 years to 30 years — an estimate change, applied to the remaining carrying amount going forward.

IAS 8 also supplies a tie-breaker for the genuinely unclear case: where it cannot be determined whether something is a change of policy or a change of estimate, it is treated as a change of estimate (IAS 8.35). The practical effect is that the retrospective route is reserved for cases where the entity can positively demonstrate a shift in basis.

An error is an omission from, or a misstatement in, one or more earlier periods that arises from failing to use — or from misusing — reliable information that existed when those statements were authorised for issue and that the entity ought reasonably to have gathered and taken into account (IAS 8.5). The availability condition is what separates an error from an estimate revision: if the information simply did not exist at the time, the original figure was not wrong.

• Arithmetic slips and mistakes in applying a measurement basis.
• Misreading or overlooking facts that were on hand when the earlier statements were finalised.
• Applying the wrong accounting policy to a transaction.
• Deliberate misstatement — fraud always falls into this category.

A material error found in a later period is corrected retrospectively in the first set of statements authorised after its discovery (IAS 8.42). Where the error belongs to a period presented as a comparative, the comparative amounts for that period are restated. Where it originates before the earliest comparative shown, the opening balances of assets, liabilities and equity for that earliest period are restated instead (IAS 8.42(b)).

The key point of principle — and the one examiners test hardest — is that the correction never runs through the current year's profit or loss. Charging it there would misstate the current period in order to fix a past one, and would leave the reader unable to see the underlying performance of either year.

Correcting an error is also kept quite separate from revising an estimate: the fact that an estimate later proves to have been some distance from the outcome does not make the original figure an error, provided it was reasonable on the evidence available at the time (IAS 8.48).

Retrospective treatment sometimes cannot be achieved. IAS 8 treats a requirement as impracticable where the entity is unable to apply it despite exhausting the sensible avenues open to it, typically because the necessary information was never captured, can no longer be reconstructed, or would require assumptions about what management intended or knew in an earlier period that cannot now be made without hindsight (IAS 8.5, 8.50–53).

Where the effect on one particular prior period cannot be determined, the entity restates from the earliest period for which restatement is practicable, which may be the current period. Where the cumulative effect at the start of the current period cannot be determined at all, the policy is instead applied, or the error corrected, prospectively from the earliest date practicable (IAS 8.25, 8.45). Hindsight is expressly not permitted when reconstructing an earlier period.

• Policy change: the nature and reason for the change, the amount of the adjustment for each line item affected in the current and each prior period presented, and the effect on earnings per share where relevant (IAS 8.28–29).
• New standard adopted: its title, the transitional provisions applied, and the resulting adjustments.
• Estimate change: the nature of the change and its monetary effect in the current period, plus the effect on future periods unless estimating that effect is impracticable (IAS 8.39–40).
• Prior period error: the nature of the error, the amount of the correction for each line item affected and for earnings per share, and the correction made to the opening balance of the earliest period presented (IAS 8.49).
• Impracticability, wherever claimed: the circumstances behind it and how and from when the policy or correction has instead been applied.

A further disclosure catches standards that have been issued but are not yet in force: the entity must say so, and give the information a reader would need to assess the likely impact of the first application (IAS 8.30–31).