1. Changes in Accounting Estimates and Errors
Accounting Policies,
Changes in Accounting Estimates and Errors
(MFRS 108)

2. Learning Objectives
Describe the accounting for changes in accounting policies.
Understand how to account for retrospective accounting changes.
Understand how to account for impracticable changes.
Describe the accounting for changes in estimates.
Describe the accounting for correction of errors.
Identify economic motives for changing accounting policies.
Analyze the effect of errors.

3. Objective
To prescribe the criteria for selecting and changing accounting policies and the accounting treatment of changes in accounting policies, accounting estimates and errors...
… To enhance comparability over time (historical trends) and with other entities (benchmarking)

4. FRS108 Overview Objective and scope
Selection and application of accounting policies
Changes in accounting policies
Changes in accounting estimates
Corrections of errors

5. Selection and Application of Accounting Policies
For a specific transaction or event -
First, look to the standard that deals specifically with that situation:
MFRS
IFRS
Interpretations developed by IFRIC (IFRS Interpretations Committee) or predecessor SIC (Standing Interpretations Committee)
Appendices and implementation guidance attached to these are an integral part of each only if stated on the specific standard.

6. Selection and Application of Accounting Policies
MFRS/IFRS standards and interpretations - top of the hierarchy
When applied – information is assumed to be relevant and reliable
What if no specific MFRS/IFRS that applies?

7. Selection and Application of Accounting Policies
If no specific MFRS that applies:
Use judgment
Develop a policy that results in relevant and reliable information
Hierarchy of sources to use:
Other standards dealing with similar situations and issues
Conceptual framework basics
If not in conflict with above, use other sources:
Pronouncements of other standard setters with similar frameworks, accounting literature, accepted industry practice, etc.

8. Consistency of Accounting Policies
Accounting policies selected should enable users to make a comparative study of the FS
Applied consistently for similar transactions, events & conditions
A standard may specifically require or permit categorisation of items for which different policies may be appropriate
E.g. Different depreciation methods for different PPE categories

9. Changes in Accounting Policies – Why?
“specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements”
 Source of changes in accounting policy:
required by a new or revised MFRS (most common)
voluntary change for reliable and more relevant information

10. Changes in Accounting Policies outside MFRS 108
Changes in accounting policies not within MFRS108:
MFRS 116 PPE – initial application to revalue assets
MFRS 138 Intangible assets - initial application to revalue assets

11. Changes in Accounting Policies – What are NOT changes?
If change due to:
different economic conditions
E.g. Change in contract (in substance) from operating lease to finance lease - accounting policy for finance leases will now be applied
new events or conditions
E.g. Adopting an inventory method (e.g. FIFO) for newly acquired items of inventory, even if FIFO differs from that used for previously recorded inventory
previously immaterial effects
E.g. certain marketing expenditures that were previously immaterial and expensed in the period incurred, but now have become material and so may be acceptably deferred and amortised.
Then NOT a change in accounting policy

12. Changes in Accounting Policies

13. Changes in Accounting Policies – Accounting Treatment
Initial application of an MFRS
if transitional accounting method provided – follow it
if no transitional method – retrospective application
 Voluntary change in policy
retrospective application
Retrospective application
means apply new policy as if it had always been applied
change past amounts

14. Changes in Accounting Policies – Accounting Treatment
Retrospective application:
for the earliest prior period presented
adjust opening balance of equity affected
adjust opening balance of other comparative amounts disclosed
Unless
impracticable to determine effects on specific prior periods or cumulative effect of change

15. Changes in Accounting Policies – Accounting Treatment
Impracticable: not able to determine adjustments needed after making reasonable effort, i.e.
Company cannot determine the effects of the retrospective application.
Retrospective application requires assumptions about management’s intent in a prior period.
Retrospective application requires significant estimates that the company cannot develop.
Example: need to estimate fair value of private company 3 years ago.
Need to know expectations that existed then re: cash flows and risk-adjusted discount rate.
Not possible in many situations.

16. Changes in Accounting Policies – Accounting Treatment
If impracticable to apply full retrospective treatment, then
apply the change to assets, liabilities, and equity accounts at beginning of earliest possible period for which effects are known
If impracticable to determine cumulative effect even on current period opening balances, then
apply new policy prospectively (in the future)

17. Change in Accounting Policy with Retrospective Application (Example)
During 20X2, Gamma changed its accounting policy for the treatment of borrowing costs that are directly attributable to the acquisition of a hydro-electric power station under construction for use by Gamma.
In previous periods, Gamma had capitalised such costs.
Gamma has now decided to treat these costs as an expense, rather than capitalise them. Management judges that the new policy is preferable because it results in a more transparent treatment of finance costs and is consistent with local industry practice, making Gamma’s financial statements more comparable.
Gamma capitalised borrowing costs incurred of CU2,600 during 20X1 and CU5,200 in periods before 20X1. All borrowing costs incurred in previous years in respect of the acquisition of the power station were capitalised.

18. Change in Accounting Policy with Retrospective Application (Example)
Gamma’s accounting records for 20X2 show profit before interest and income taxes of CU30,000; interest expense of CU3,000 (which relates only to 20X2); and income taxes of CU8,100.
Gamma has not yet recognised any depreciation on the power station because it is not yet in use.

19. 20X1 Income statement before change
opening retained earnings was CU20,000 and closing retained earnings was CU32,600.
Gamma’s tax rate was 30 per cent for 20X2, 20X1 and prior periods.
Gamma had CU10,000 of share capital throughout, and no other components of equity except for retained earnings.
Its shares are not publicly traded and it does not disclose earnings per share.

20. Income statements after change

21. Statement of changes in equity after change

22. Extracts from the notes
During 20X2, Gamma changed its accounting policy for the treatment of borrowing costs related to a hydro-electric power station under construction for use by Gamma. Previously, Gamma capitalised such costs. They are now written off as expenses as incurred. Management judges that this policy provides reliable and more relevant information because it results in a more transparent treatment of finance costs and is consistent with local industry practice, making Gamma’s financial statements more comparable. This change in accounting policy has been accounted for retrospectively, and the comparative statements for 20X1 have been restated. The effect of the change on 20-1 is tabulated below. Opening retained earnings for 20X1 have been reduced by CU3,640, which is the amount of the adjustment relating to periods prior to 20X1.

23. Change in Accounting Policy – Prospective Application (Example)
During 20-2, Delta Co changed its accounting policy for depreciating property, plant and equipment, so as to apply much more fully a components approach, whilst at the same time adopting the revaluation model.
In years before 20-2, Delta’s asset records were not sufficiently detailed to apply a components approach fully. At the end of 20-1, management commissioned an engineering survey, which provided information on the components held and their fair values, useful lives, estimated residual values and depreciable amounts at the beginning of 20-2.
However, the survey did not provide a sufficient basis for reliably estimating the cost of those components that had not previously been accounted for separately, and the existing records before the survey did not permit this information to be reconstructed.

24. Change in Accounting Policy – Prospective Application (Example)
Delta’s management considered how to account for each of the two aspects of the accounting change. They determined that it was not practicable to account for the change to a fuller components approach retrospectively, or to account for that change prospectively from any earlier date than the start of 20-2.
Also, the change from a cost model to a revaluation model is required to be accounted for prospectively. Therefore, management concluded that it should apply Delta’s new policy prospectively from the start of 20-2.

25. Additional Information

26. Extract from the Notes
From the start of 20-2, Delta changed its accounting policy for depreciating property, plant and equipment, so as to apply much more fully a components approach, whilst at the same time adopting the revaluation model. Management takes the view that this policy provides reliable and more relevant information because it deals more accurately with the components of property, plant and equipment and is based on up-to-date values. The policy has been applied prospectively from the start of 20-2 because it was not practicable to estimate the effects of applying the policy either retrospectively, or prospectively from any earlier date. Accordingly, the adoption of the new policy has no effect on prior years.
The effect on the current year is to
increase the carrying amount of property, plant and equipment at the start of the year by CU6,000;
increase the opening deferred tax provision by CU1,800;
create a revaluation reserve at the start of the year of CU4,200;
increase depreciation expense by CU500; and
reduce tax expense by CU150.

27. Change in Accounting Policy – Prospective Application (Example)
During 2013, Cooper Company, Inc.’s (CCI) management installed a new computerized inventory accounting system.
The new system allows management for the first time to determine the specific costs for each product in the 2013 ending inventory, but not for any date prior to the 2013 year-end. CCI turns its entire inventory three times a year. There were no lower-of-cost-or-market issues with inventory in 2012 or 2012.
CCI’s effective income tax rate is 50%.
CCI has had 2.0 million shares of common shares outstanding since its inception in 2008.
Management decided to change its accounting policy for inventory costing from FIFO to the specific-identification method in Management believes this change will better match costs and revenues and is, therefore, a preferable change.
In 2012, CCI’s accounting policy for inventory was as follows: inventory is stated at the lower of cost, FIFO or market.

28. Change in Accounting Policy – Prospective Application
Additional information (amounts in millions):
2012
2013
Year-end inventory value using FIFO
$ 10
$ 11
Year-end inventory value using specific identification
N/A
$ 13
Cost of sales using FIFO
$ 30
$ 33
Cost of sales using specific identification
$ 31
Retained earnings using FIFO
$110
$120
Retained earnings using specific identification

29. Change in Accounting Policy – Prospective Application
Example 2 solution:
Management cannot apply the new inventory accounting policy to the inventory balance at the end of 2012, nor to the beginning inventory balance in 2013, because the system needed to make the determination of specific identification of costs did not exist at that time.
Therefore, neither the 2012 ending retained earnings balance nor the 2013 beginning retained earnings would be restated.
The earliest date at which the change in accounting policy can be reflected is on the 2013 year-end balance sheet.
The impact of the change is to decrease cost of sales by $2.0 million.
The after-tax impact on the 2013 year-end financial information would be to increase net income and retained earnings by $1.0 million.

30. Changes in Accounting Policies - Disclosure
For all changes in accounting policy, disclose
nature of the change
amounts of adjustments to all F/S items and EPS (current & prior periods)
if judged impracticable to apply retrospectively, explain why, and how applied
 If on application of a new/revised MFRS, also report
name of MFRS, that transitional provisions are applied, any likely future effects
For voluntary change, also disclose
Reasons why new policy provides reliable & more relevant info

31. Changes in Accounting Policies - Disclosure
Disclosures are not required for subsequent periods
If a new MFRS has been issued but not yet effective, and not yet applied by entity, to disclose:
This fact
Known or reasonably estimable info relevant to assessing the possible impact that application of the new standard will have on the FS in the period of initial application

32. Changes in Accounting Estimates
Accounting estimates needed to prepare F/S
Changes in estimates
Due to changes in circumstances and judgments used in estimates
Uncertainties inherent in business activities
Change in an accounting estimate is done prospectively, i.e. included in the
period of the change and/or
future periods (if change affects future periods)
The carrying amounts of affected assets, liabilities & equity are adjusted for the change in accounting estimates in the period of change
Same income statement classification as was used previously for the estimate
LO 5 Describe the accounting for changes in estimates.

33. Changes in Accounting Estimate
Examples of Estimates
Uncollectible receivables.
Inventory obsolescence.
Useful lives and salvage values of assets.
Periods benefited by deferred costs.
Liabilities for warranty costs and income taxes.
Recoverable mineral reserves.
Change in depreciation methods.
LO 5 Describe the accounting for changes in estimates.

34. Changes in accounting policies vs. changes in estimates
Situation AE AP 1
The management of a hotel changed its strategic plans and as a result the rooms had to be refurbished within 2 years instead of 4. Consequently the period over which the 7 years refurbishment is depreciated has decreased. X 2
A trade company decided to change the calculation of its allowance for bad debts. In previous years the calculation of the allowance for bad debts was based on fixed percentages multiplied by the total outstanding balance over 90 days. Now, the company calculates the allowance for bad debts on a review of individual balances. 3
An enterprise dealing in electronic equipment decided to change the valuation of inventories from FIFO to Weighted Average.

35. Changes in accounting policies vs. changes in estimates
Situation AE AP 4
In 2013, an enterprise adopts MFRS 19, Employee Benefits. Previously, retirements benefits were already provided for using an actuarial valuation method. However, some adjustments result from the application of MFRS19. X 5
In order to better reflect the depreciation pattern of a machine, the depreciation method of this machine is changed from the straight-line method to the reducing balance method.

36. Change in Estimate Example
Illustration: Arcadia High School purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2013 (year 8), it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time.
Required:
What is the journal entry to correct prior years’ depreciation expense?
Calculate depreciation expense for 2013.
No Entry
Required
LO 5 Describe the accounting for changes in estimates.

37. Change in Estimate Example
After 7 years
Equipment cost $510,000
Salvage value ,000
Depreciable base 500,000
Useful life (original) years
Annual depreciation $ 50,000
First, establish NBV at date of change in estimate.
x 7 years = $350,000
Balance Sheet (Dec. 31, 2012)
Fixed Assets:
Equipment
$510,000
Accumulated depreciation
350,000
Net book value (NBV)
$160,000
LO 5 Describe the accounting for changes in estimates.

38. Change in Estimate Example
Net book value $160,000
Salvage value (if any) ,000
Depreciable base 155,000
Useful life years
Annual depreciation $ 19,375
Second, calculate depreciation expense for 2013.
Journal entry for 2013
Depreciation expense 19,375
Accumulated depreciation 19,375
LO 5 Describe the accounting for changes in estimates.

39. Changes in Accounting Estimate
Disclosures
Disclose:
Nature of the change
Amount of the change that has an effect in current period or is expected to have an effect in future periods
If effect on future periods impracticable to estimate, this fact should be disclosed
LO 5 Describe the accounting for changes in estimates.

40. Correction of Errors Types of Accounting Errors:
A change from an accounting principle that is not generally accepted to an accounting policy that is acceptable.
Mathematical mistakes.
Changes in estimates that occur because a company did not prepare the estimates in good faith.
Failure to accrue or defer certain expenses or revenues.
Misuse of facts.
Incorrect classification of a cost as an expense instead of an asset, and vice versa.
LO 7 Describe the accounting for correction of errors.

41. Correction of Errors Prior period errors
= omissions from, and misstatements in the entity’s FS for 1 or more prior periods arising from the failure to use, or misuse of, reliable information that:
Was available when FS for those periods were authorised for issue, and
Could reasonably be expected to have been obtained and taken into account in the preparation & presentation of those FS
LO 7 Describe the accounting for correction of errors.

42. Correction of Errors All material errors must be corrected.
Record corrections of errors from prior periods as an adjustment to the beginning balance of retained earnings (and affected assets and liabilities) in the current period (corrected retrospectively).
Such corrections are called prior period adjustments.
For comparative statements, a company should restate the prior statements affected, to correct for the error.
LO 7 Describe the accounting for correction of errors.

43. Correction of Errors Disclosure Nature of the prior period error
The amount of the correction at the beginning of the earliest prior period presented
For each prior period presented, to the extent practicable, the amount of the correction:
For each FS line item affected
If MFRS 133 Earnings per share applies, for basic & diluted EPS
If retrospective restatement is impracticable for a particular prior period, to state:
Circumstances that led to the condition
Description of how and from when the error is corrected
LO 7 Describe the accounting for correction of errors.

44. Correction of an error example
When preparing a comparative analysis of income tax expense in 2013, the Modern Art Company (MAC) discovered that the 2012 calculation did not include foreign income taxes of $2.0 million. Management determined this error is material and that the financial statements need to be corrected.

45. Correction of an error example
Example (continued): Extracts from the statements of income and retained earnings, before correcting the error, are as follows (amounts in millions):
2013
2012
Net income before income taxes
$20
$14
Income taxes 8 5
Net income
$12
$ 9
Opening retained earnings
$52
$50 12 9
Dividends paid
(10)
(7)
Ending retained earnings
$54

46. Correction of an error example
Example solution:
2013
Restated
2012
Net income before income taxes
$20
$ 14
Income taxes 8 7
Net income
$12
$ 7
Opening retained earnings
$50 12
Dividends paid
(10)
(7)
Ending retained earnings
$52

47. Retrospective Restatement of Errors
During 20-2, Beta Co discovered that some products that had been sold during 20-1 were incorrectly included in inventory at 31 December 20-1 at CU6,500.
Beta’s accounting records for 20-2 show sales of CU104,000, cost of goods sold of CU86,500 (including CU6,500 for the error in opening inventory), and income taxes of CU5,250.
In 20-1 Beta reported the following

48. Retrospective Restatement of Errors
20-1 opening retained earnings was CU20,000 and closing retained earnings was CU34,000.
Beta’s income tax rate was 30 per cent for 20-2 and It had no other income or expenses.
Beta had CU5,000 of share capital throughout, and no other components of equity except for retained earnings. Its shares are not publicly traded and it does not disclose earnings per share.
Restated Income statement is as follows

49. Statement of changes in Equity
Extracts from the Notes: Some products that had been sold in 20-1 were incorrectly included in the inventory at 31 December 20-1 at CU6,500. The financial statements of 20-1 have been restated to correct this error. The effect of the restatement on those financial statements is summarised below (see next slide). There is no effect in 20-2.

50. Effect of the correctionRM
Increase in cost of sales
(6,500)
Decrease in tax expense
1,050
Decrease in profit
5,450
Decrease in inventory
Decrease in tax payable
Decrease in retained earnings

51. Error Analysis Companies must answer three questions:
What type of error is involved?
What entries are needed to correct for the error?
After discovery of the error, how are financial statements to be restated?
Companies treat errors as prior-period adjustments and report them in the current year as adjustments to the beginning balance of Retained Earnings.
LO 9 Analyze the effect of errors.

52. Balance Sheet Errors
Balance sheet errors affect only the presentation of an asset, liability, or stockholders’ equity account.
Current year error - reclassify item to its proper position.
Prior year error - restate the balance sheet of the prior year for comparative purposes.
LO 9 Analyze the effect of errors.

53. Income Statement Errors
Improper classification of revenues or expenses.
Current year error - reclassify item to its proper position.
Prior year error - restate the income statement of the prior year for comparative purposes.
LO 9 Analyze the effect of errors.

54. Balance Sheet and Income Statement Errors
Counterbalancing Errors
Will be offset or corrected over two periods.
If company has closed the books:
If the error is already counterbalanced, no entry is necessary.
If the error is not yet counterbalanced, make entry to adjust the present balance of retained earnings.
For comparative purposes, restatement is necessary even if a correcting journal entry is not required.
LO 9 Analyze the effect of errors.

55. Balance Sheet and Income Statement Errors
Counterbalancing Errors
Will be offset or corrected over two periods.
If company has not closed the books:
If error already counterbalanced, make entry to correct the error in the current period and to adjust the beginning balance of Retained Earnings.
If error not yet counterbalanced, make entry to adjust the beginning balance of Retained Earnings.
LO 9 Analyze the effect of errors.

56. Balance Sheet and Income Statement Errors
Non-Counterbalancing Errors
Not offset in the next accounting period.
Companies must make correcting entries, even if they have closed the books.
LO 9 Analyze the effect of errors.