PACC6004 Financial Accounting 2 Essay Example


Accounting Policies and Entities

Accounting Policies and Entities

The selection of an entity’s accounting policy cannot be underestimated since it leads to the preparation of the correct financial statements. Financial statements are importance to the company and other users outside it. They are an indicator of a company’s performance, which could be estimated on profits (Tiffin, 2010). They also indicate the value of a firm precisely from the value of its assets compared to its liabilities. Another importance is that it provides useful information that could be employed in comparing it to other companies in the industry. Therefore, users of the financial statements’ information are interested in the application of the correct accounting policy.

Financial statement users may draw economic, as well as political decisions from this information. A company has many users of financial data such as shareholders and potential investors and is thus obliged to use its prior experience in order to provide the required information (Whittington & Pany, 2000). On this basis, companies should provide important information to aid in decision-making without overlooking any shareholder’s interest in the information.

Professional judgment is significant in the selection of an entity’s accounting policies. The ability to analyze information at hand enables the formulation of well-reasoned decision. Therefore, entities must employ qualified and experienced individuals to make sound decisions. It involves the consideration of information at hand, as well as the evaluation of alternatives to reach a conclusion. However, professional skepticism is important in this process since it enables those preparing financial information to be more rational and consider all approaches to the problem (Gray & Manson, 2005).

Given that financial statements provide information to users, the preparer has to decide the important information and disclose while he or she may opt to overlook the not so important information (International Accounting Standards Board, 2003). Information with the ability to influence users’ decisions by users is material and must be disclosed. Materiality denotes the ability of information to influence decisions. In this context, deciding material information requires considerable judgment. Information could be considered material due to its size or effects on other variables in the financial statement. For example, remuneration to management and employees may be important, the cost of acquisition of a fixed asset may be considered important while some sundry expenses may be considered trivial (Buckley & Caple, 2009). Materiality is important in determining information to be disclosed in a statement of comprehensive income and statement of financial position and information to be included as notes. Furthermore, it helps in determining stand-alone items and those to be consolidated together.

In the selection and application of an accounting policy, a firm must apply the Standard or Interpretation that particularly affects a given transaction. Without an accounting policy, which directly affects a transaction, a firm must use professional judgment to determine the accounting policy to apply. In making sound decisions, the management must consider the requirements of Standards and Interpretations dealing with similar issues and the set criteria of accessing fixed assets, income, liabilities, and expenses (Benke & Tax Management Inc, 2008).

Accounting principles are conventions applied by a firm in preparing and presentation of financial statements to its users. A firm is allowed to change its accounting policy if the new accounting policy provides more useful information regarding information in the financial statements. Another circumstance is when a new IASB or interpretation is in place, necessitating a firm to change its accounting policy (Tiffin, 2010). However, a change in accounting policy does not imply applying the new one to an item that was immaterial.

Entities should follow the stipulations of the IAS 8 when changing accounting policies. Where a change is required by a new IASB or interpretation, the change is applied to the transactions as stipulated in the new pronouncement, and if no new pronouncement is in place, it is effected retrospectively (International Accounting Standards Board, 2003). Effecting the change retrospectively means adjusting the opening balance of the earliest transaction on book and recording of other subsequent transactions as if the change had been in place.

However, it is difficult to adjust prior periods; for example, if no data had been collected or is unavailable when the change in accounting policy happens. This could be attributed to the obsoleteness of a firm technology where data of prior periods was recorded. Often than not, this involves complex estimation to facilitate comparability of prior and current periods. Nonetheless, this does not deter reliable adjustment of prior periods. The estimates for prior periods should reflect firsthand circumstances that existed during that time (Porter, Hatherly, & Simon, 2008). This becomes increasingly difficult with changes in time, for example, a currency could have depreciated or appreciated since then. This makes it difficult to make accurate estimations. In order to ensure relatively correct estimates, it requires the knowledge of events that happened over time. IAS 8 discourages making inferences of a prior period when applying a new accounting policy (Tiffin, 2010). In this context, hindsight can recognize the situation of a prior period. That is, make assumptions of the value of transactions in a prior period.

When the basis of measurement of value of an item is unclear, the entity is allowed to apply an estimation technique. This is a strategy to value an item without either underestimating or overstating its value. Estimates involve considerable judgment using present reliable information. This could be used to estimate life of property, plant and equipment in addition to valuing other fixed assets.

There is a clear distinction between accounting estimates and change in accounting policy. Accounting estimates are reflected in the statement of comprehensive information, whereas changes in accounting policy are reflected by the adjustment of prior periods. In the case of a change in condition in which the estimate was based on, it may necessitate adjusting the value of the estimate accordingly (Tiffin, 2010). A change in the method of measurement is not an estimated change, but rather a change in the accounting policy. This would lead to the adjustments of prior periods. For example, when there is a positive valuation in the amount of a fixed asset e.g., a firm’s van acquired in the prior period, this is a change in accounting policy, whereas a change from a straight line method to a reduction method of depreciation or vice-versa is an accounting estimate.

In addition, accounting estimates should be recognized from the provided date of the change. This may only influence the current period or future period altogether. Financial statements do not adhere to IFRS if they have material and immaterial inclusions or omissions in attempt to maintain a particular position (Tiffin, 2010). Material errors should be adjusted retrospectively in the financial statements issued upon their discovery. When an item makes a retrospective adjustment, it should be accompanied with a supporting balance sheet. However, it is in the firm’s discretion firm not to prepare the supporting balance sheet if it is immaterial. A firm is not required to present notes relating to the additional balance sheet under the amended standard applying to items adjusted respectively on or after 1 January 2013.

IAS 8 provides that an entity correct material errors of prior periods retrospectively. As mentioned earlier, this adjustment is done to financial statements issued first after the discovery of the material error. This is achieved through restating comparative figures of prior periods and adjusting opening balances of assets, liabilities, and equity of earlier periods at hand (Benke & Tax Management Inc, 2008).

A firm is obliged to make disclosures about errors in prior periods. It should disclose the nature of the prior period error. It should disclose the size and extent to which the error is applicable. It should also disclose the amount of correction in the first financial statement adjusted retrospectively upon discovery of the material error (Tiffin, 2010).

The current treatment of prior period errors could lead to earnings management by the company. Selection and change of accounting policies could result in material errors, which when adjusted for, could lead to deficits in the financial statement (International Accounting Standards Board, 2003). This serves to reduce the revenue of the company, thereby necessitating the management to adopt a conservative approach including reduction of dividends.

The current treatment of prior period errors could also be costly and time consuming. This is because retrospective adjustment of opening balances of items when the error is first realized could be expensive since this information could be lacking (Gray & Manson, 2005). Therefore, the company has to employ estimation techniques and professionals to examine conditions that were present during such prior periods, thus, adding expenses to a firm. This leads to earning’s management.

Given that humans are prone to errors, estimates are most likely to veer off from the reality. When these incorrect estimates are used for retrospective adjustments, the resultant financial information can be incorrect. This misleads users who might rely on it to make political and economic decisions.

The events described can be shown in Zack’s financial statements for the year ended 30th November 2013 as follows:

First, the events can be described as borrowing costs:

According to the IAS borrowing costs, this aspect should be attributed directly the construction, acquisition, or the production of a qualifying asset. This implies the asset, which consumes a considerable time before becoming ready for its purposed use. The three are included in the asset’s cost. The extra borrowing costs are identified as expenditure. Thus, IAS 23 would necessitate that the borrowing expense of $3 million incurred during the construction of the shopping centre be capitalized. In the event of the $2 million borrowing cost spent on the 2012 asset, the asset’s balance would have a material misstatement due to failure of capitalizing the borrowing costs. Evidently, IAS 23 necessitates that borrowing costs must be capitalized. Zack had previously used a wrong accounting treatment since it was noncompliant with IAS 23. As a result, changing to the new one, which is the correct policy will be like correcting an error instead of modifying the accounting policy in reference to the 2012 asset. The error, which occurred prior the current financial period has to be corrected retrospectively. The process entails restatement of the financial statements for the year, which ended 30th November 2012. The contract was completed during this period. Therefore, the opening balances for the year 2013 will be restated such that the financial statements appear as if the error had not happened. During year 2013, the borrowing costs of $3 million must be capitalized in line with IAS 23, which is complying with IFRS contrary to an accounting policy change. Presumably, no depreciation occurs since the asset is undergoing construction.

Restating the year ending 30th November 2012 has the following effects:

  • The carrying figure of the equipment, plant, as well as property is restated upwards by $2 million, which is less yearly depreciation.

  • The loss/profit for the year has increased correspondingly with a similar amount.

  • Disclosures are necessary associating with the previous period error.

In this, the nature of the period error before is paramount. Of significance too is the correction amount for every financial statement line item, which is affected in the previous period, and for basic as well as diluted earnings per share. Further, the effect is felt on the number of corrections done during the start of the presented earliest phase. In case retrospective restatement is unfeasible, there should be a clarification, as well as highlight of the manner the error has been rectified.

Secondly, the events can be elaborated as a change in the method of depreciation:

A change to reducing balance from the straight-line depreciation represents a transformation in the accounting estimate contrary to one in accounting policy. An accounting estimate change denotes a modification of the carrying figure of an asset or a liability. It may also include associated expenses, which result from reevaluation of the anticipated future gains, as well as obligations related to that liability or asset.

Accounting estimates’ changes are not employed accordingly, as well as retrospectively. Furthermore, the financial data issued for the previous periods does not undergo restatement. Rather, the influence of a modification in an accounting estimate is identified prospectively. This means starting from the time the change occurs. It included the profit and/or loss recorded during the time the change occurred. This happens when the change affects that period alone. If it is at a future date, then the same is done for the future periods. In the event the influence on future periods in undisclosed due to its impracticability, that fact ought to be revealed. Revising the depreciation figures as premeditated by management are incorrect since they encompass a modification of $ 5 million for that time to 30th November 2012, which represents a retrospective adjustment. As at 1st December 2012, the carrying figure will be depreciated depending on the application of the prospective reducing balance.

Thirdly, the events can be described as accruals error:

This kind of error would be regarded as a prior period error according to the IAS 8. In this, Zack ought to correct it through restatement of the prior period data for the year, which ended 30th November 2012. For the same year, he can raise the profit/loss by $2 million, modify trade payables by the same figure to do away with the overstatements, and lastly through restatement of the reserves note’s movement. Notably, this a non-accounting estimate, it is an error correction method.


Benke, R. L., & Tax Management Inc (2008). Accounting changes and error corrections. Arlington, VA: Tax Management.

Buckley, R., & Caple, J. (2009). The theory & practice of training. London: Kogan Page.

Gray, I., & Manson, S. (2005). The audit process: Principles, practice and cases. London: Thomson Learning.

International Accounting Standards Board (2003). Improvements to international accounting standards. London, U.K: IASCF Publications Dept.

Porter, B., Hatherly, D. J., & Simon, J. (2008). Principles of external auditing. Chichester, England: John Wiley.

Tiffin, R. (2010). The complete guide to international financial reporting standards: Including IAS and interpretation. London: Thorogood.

Whittington, R., & Pany, K. (2000). Principles of auditing and other assurance services. Boston: Irwin/McGraw-Hill.