Financial statements are only useful if they can be compared from one year to the next. That is why a business cannot swap its accounting rules at will, why a better estimate is treated differently from a mistake, and why an error found years later is corrected in a particular way.
International Accounting Standard (IAS) 8 sets the rules for all three: accounting policies, changes in accounting estimates, and prior period errors.
The skill examined is classification. Given a change, you must decide whether it is a change in policy, a change in estimate or an error, because each is reported differently. This topic links to inventory valuation, where the choice of first in, first out (FIFO) or weighted average is a policy, and to the topics on depreciation and the statement of changes in equity.
The next topic covers International Financial Reporting Standard (IFRS) 18, the new presentation standard.
In 30 seconds
A Change in accounting policy (recognition, measurement or presentation) is allowed only if an IFRS requires it or it gives more reliable and relevant information. It is applied Retrospectively: opening equity and comparatives are adjusted as if the new policy had always applied.
A Change in accounting estimate (useful life, allowance for doubtful debts, warranty provision) is applied Prospectively: it is included in profit or loss for the period of the change and future periods. A Material prior period error is corrected Retrospectively by restating comparatives, and it is not put through the current year’s profit. Changing the depreciation method, such as straight-line to reducing balance, is a change in estimate.
Accounting policies
Accounting policies are the specific principles, bases, conventions, rules and practices an entity applies in preparing its statements (IAS 8, paragraph 5). Examples are the valuation of inventory, the depreciation method, the measurement of non-current assets at cost or valuation, and the treatment of research costs. Policies must be applied consistently within each period and from one period to the next (paragraph 13).
A change in policy is permitted only in two circumstances (paragraph 14): when it is required by an IFRS, or when it results in financial statements that give reliable and more relevant information. Frequent changes would make comparison difficult, so convenience is not a reason.
How to tell. A policy reflects transactions through Recognition (for example capitalising or writing off a cost), Measurement (for example cost or valuation) and Presentation (for example classifying a cost as cost of sales or administration). If at least one of these changes, there is a change in policy. Applying a suitable policy to a new type of transaction that did not occur before is not a change (paragraph 16).
Example. A company has always written off borrowing costs as incurred and now capitalises them as IAS 23 requires. Recognition and presentation have changed, so it is a change in policy even though the measurement of the cost is the same.
Treatment. If a new standard sets transitional provisions, follow them. If not, the change is applied Retrospectively (paragraph 19). The entity adjusts the opening balance of each affected component of equity for the earliest prior period presented, and restates the comparative amounts, as if the new policy had always been applied (paragraph 22). If this is impracticable, it is applied from the earliest date practicable.
The notes disclose the nature of the change, the amount of the adjustment for each line item affected, the adjustment for periods before those presented, and, for a new standard, its title and transitional provisions, or, for a voluntary change, why the new policy is more relevant.
Accounting estimates
An accounting estimate is needed when an item cannot be measured precisely and some uncertainty exists, so management judgement is used. Examples are bad debts, inventory obsolescence, the fair value of financial assets, the useful lives of non-current assets, the depreciation pattern, and warranty obligations.
The exam wording is that a change in estimate is an adjustment of the carrying amount of an asset or liability, or of the related expense, from reassessing the expected future benefits and obligations (May Diet 2023, Question 3(b)).
The line between policy and estimate matters. A company may have a Policy to depreciate plant over its useful life. Whether it uses straight-line or reducing balance is a choice of Estimate, as is the length of the life. So a move from straight-line to the sum-of-digits method is Not a change in policy (November Diet 2019, Section A, Question 4).
Treatment. A change in estimate arises because circumstances change or new information appears. It is not the correction of an error. Its effect is recognised Prospectively: in profit or loss of the period of the change if that period only is affected, or of the period of the change and the future periods if both are affected (paragraph 36).
Earlier years are not restated, and the carrying amount of the affected asset or liability is adjusted in the period of the change.
Depreciation example. An asset cost ₦200,000 with a ten-year life and no residual value, depreciated at ₦20,000 a year. At the end of year 2 the carrying amount is ₦160,000, and technology change means only four more years of use remain. From year 3 the charge becomes 160,000 ÷ 4 = ₦40,000 a year, and years 1 and 2 are left alone. Some versions of this example switch between four and five remaining years and show ₦36,000, so use the consistent figure above.
A second example: inventory of ₦7,000 that becomes worthless because specifications changed is written off in the current year as an expense.
Prior period errors
Errors may come from a mathematical mistake, a mistake in applying a policy, an oversight, a misreading of facts or fraud. A prior period error is an omission or misstatement in the statements of an earlier period caused by failure to use, or misuse of, reliable information that was available when those statements were authorised and could reasonably have been obtained (paragraph 5).
An error found quickly, before the statements are published, is simply corrected.
A Material prior period error is corrected Retrospectively in the first set of statements after it is found (paragraph 42). The comparatives for the period in which it occurred are restated. If it occurred before the earliest period presented, the opening balances of assets, liabilities and equity are restated. The correction is excluded from the profit or loss of the period in which it was discovered.
The notes disclose the nature of the error and the amount of the correction for each line item affected, and the adjustment to opening retained earnings.
Example (KTC). Kano Transport Company is preparing its 20X4 statements. Draft profit is ₦150,000 for 20X3 and ₦385,000 for 20X4, with retained earnings of ₦90,000 at 31 December 20X2. Inventory is found to have been overstated by ₦60,000 at the end of 20X3 and by ₦70,000 at the end of 20X4.
A closing figure that is too high overstates that year’s profit, and it is also next year’s opening inventory, so it understates next year’s profit.
| ₦000 | 20X4 | 20X3 |
|---|---|---|
| Draft profit | 385 | 150 |
| Error in closing inventory | (70) | (60) |
| Error in opening inventory | 60 | |
| Adjusted profit | 375 | 90 |
The restated retained earnings are 90 + 90 = 180 at the end of 20X3 (draft 240) and 180 + 375 = 555 at the end of 20X4 (draft 625). Total equity at 31 December 20X4 is 500 + 50 + 555 = ₦1,105,000.
The ideas in more depth
An exam key to read carefully. May Diet 2022, Section A, Questions 3 and 4 describe plant bought for ₦300,000 on 1 January 2017 with a ten-year life, reviewed on 31 December 2018 when the total life is cut to five years and three years remain. Question 3 is a change in estimate (the key is A). For Question 4 the key is E, ₦80,000, which is (300,000 − 60,000) ÷ 3, the annual charge on the revised basis.
Strictly, a review at 31 December 2018 changes the charge from 2019, and 2018 was charged at the old ₦30,000, but the key shows E, so know both figures.
Background (IAS 8). A change is not treated as a change in policy when the new policy applies to events that differ in substance from earlier ones (paragraph 16). Prospective treatment of a policy change, or of an error, is allowed only where retrospective treatment is impracticable. Ordinary changes in estimate, including doubtful debts and warranty provisions, remain prospective.
Sources: IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, paragraphs 5, 13, 14, 16, 19, 22, 36 and 42.
Worked example: Warri Haulage Ltd
Scenario. Warri Haulage Ltd has three matters. (1) A truck cost ₦12,000,000 with an eight-year life and no residual value, depreciated straight-line. After three years the remaining life is revised to three more years. (2) In year 3 the company finds that inventory at the end of year 1 was overstated by ₦400,000. Draft profits were ₦2,000,000 for year 1 and ₦2,600,000 for year 2.
(3) It now shows delivery costs in distribution costs instead of administrative expenses, to give more relevant information. Required: classify each matter and show its treatment.
- Truck: change in estimate.
Annual charge was 12,000,000 ÷ 8 = 1,500,000, so after three years the carrying amount is 12,000,000 − 4,500,000 = 7,500,000.
From year 4 the charge is 7,500,000 ÷ 3 = ₦2,500,000.
Years 1 to 3 are not restated. - Inventory: prior period error. Year 1 profit was overstated and year 2 profit understated by 400,000. Restate year 1 profit to ₦1,600,000 and year 2 profit to ₦3,000,000. Retained earnings at the end of year 2 are unchanged, because the two effects cancel. The comparatives in the year 3 statements are restated, and year 3 profit is not affected.
- Delivery costs: change in policy. It changes presentation, so it is a change in policy. It is permitted because it gives more relevant information. Apply it retrospectively: reclassify the comparative figures and disclose the nature of the change and the amounts.
Common mistakes in the exam
- Calling a change in depreciation method or useful life a change in policy.
- Restating prior years for a change in estimate.
- Putting the correction of a prior period error through the current year’s profit.
- Forgetting that an overstated closing inventory also understates the next year’s profit.
- Allowing a change in policy because the owner prefers the new one.
- Treating a first-time policy for a new type of transaction as a change in policy.
- Using the original carrying amount instead of the current one when revising depreciation.
- Not disclosing the nature and amount of a change or error.
Quick revision
- Policy: recognition, measurement, presentation. Change only if an IFRS requires it or the result is more reliable and relevant. Retrospective.
- Estimate: useful life, depreciation method, allowances, warranties. Prospective.
- Material prior period error: retrospective restatement of comparatives, outside current profit.
- Revised depreciation = carrying amount ÷ remaining life.
Practice questions
These are original questions in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one first.
Section A style: multiple choice
Question 1. Which of these is a change in accounting estimate?
- Revising the useful life of a machine
- Changing from the cost model to the revaluation model
- Changing from FIFO to weighted average
- Capitalising borrowing costs previously expensed
Show the answer
A. A useful life is an estimate. The others change recognition or measurement bases, so they are policies.
Question 2. A change in accounting estimate is recognised:
- Retrospectively
- By restating opening equity
- Prospectively
- As a prior period error
Show the answer
C. It is included in profit or loss in the period of change and future periods affected.
Question 3. A new IFRS requires a change in policy and has no transitional provisions. The change is applied:
- Prospectively
- In the current period only
- Retrospectively
- Not applied until the next standard
Show the answer
C. Without transitional provisions, a change in policy is applied retrospectively.
Question 4. A material prior period error is corrected:
- Through the current year’s profit
- By ignoring it
- Prospectively from the next year
- By restating the comparative amounts
Show the answer
D. It is corrected retrospectively in the first statements after it is found, outside current profit.
Question 5. A change from straight-line to reducing balance depreciation is:
- A change in accounting policy
- A change in accounting estimate
- The correction of an error
- The adoption of a new policy
Show the answer
B. The depreciation method is an estimate of the pattern of consumption of benefits.
Question 6. An asset costing ₦200,000 has a ten-year life and nil residual value. After two years the remaining life is revised to four years. The annual charge from year 3 is:
- ₦40,000
- ₦20,000
- ₦50,000
- ₦16,000
Show the answer
A. Carrying amount = 200,000 − 40,000 = 160,000. Charge = 160,000 ÷ 4 = 40,000.
Question 7. An entity may change an accounting policy when:
- The managers prefer another method
- It will increase reported profit
- Never
- An IFRS requires it, or it gives more reliable and relevant information
Show the answer
D. These are the only two circumstances permitted by paragraph 14.
Question 8. Closing inventory at the end of year 1 is overstated by ₦70,000. Before correction, the effect on profit is:
- Year 1 and year 2 both overstated
- Year 1 overstated and year 2 understated
- Year 1 understated and year 2 overstated
- Year 1 and year 2 both understated
Show the answer
B. The overstated closing inventory lowers year 1 cost of sales. As year 2’s opening inventory it raises year 2 cost of sales.
Question 9. An error in last year’s accounts is found this year. Its correction is shown:
- In this year’s profit or loss
- By restating the comparatives, outside this year’s profit
- Nowhere
- In drawings
Show the answer
B. Prior period errors are corrected retrospectively and do not go through current profit.
Question 10. Which of these is NOT a change in accounting policy?
- Changing the measurement basis of an asset
- Changing whether a cost is capitalised
- Applying a suitable policy to a new type of transaction for the first time
- Changing the classification of a cost between expense lines
Show the answer
C. A policy for a new type of transaction is not a change. Options B, C and D change measurement, recognition and presentation.
Section B style: written questions
Question 11 (10 marks). (a) Define an accounting policy and a change in accounting estimate, with two examples of each. (6 marks) (b) Outline the accounting treatment of a change in accounting estimate. (4 marks)
Question 12 (20 marks). Zaria Motors Ltd has share capital of ₦400,000 and share premium of ₦40,000. Retained earnings were ₦120,000 at 31 December year 1. Draft profits were ₦180,000 for year 2 and ₦330,000 for year 3, with no dividends. In preparing year 3 it is found that closing inventory was overstated by ₦40,000 at the end of year 2 and by ₦50,000 at the end of year 3.
(a) Calculate the adjusted profit for each year. (8 marks) (b) Prepare the statement of changes in equity for years 2 and 3 as restated, with columns for share capital, share premium, retained earnings and total. (8 marks) (c) State the disclosures required. (4 marks)
A further written question
Question 13 (10 marks). Plant cost ₦300,000 with a ten-year life and nil residual value, depreciated straight-line. After two years, the total life is revised to five years. (a) Classify the change. (2 marks) (b) Calculate the annual depreciation from year 3. (4 marks) (c) Explain why earlier years are not restated. (4 marks)
Model answers
Show the model answer to Question 11
(a) Accounting policies are the specific principles, bases, conventions, rules and practices applied in preparing and presenting financial statements. Examples are the valuation of inventory and the depreciation method. A change in accounting estimate is an adjustment of the carrying amount of an asset or liability, or the related expense, from reassessing expected future benefits and obligations.
Examples are the allowance for doubtful receivables and the useful life of a depreciable asset. (b) It is recognised prospectively, by including the effect in profit or loss in the period of the change if only that period is affected, or in the period of the change and future periods if both are affected. Prior periods are not restated.
Show the model answer to Question 12
(a)
- Year 2: draft 180,000 − 40,000 = 140,000.
- Year 3: draft 330,000 − 50,000 + 40,000 (opening inventory error reverses) = 320,000.
(b) Retained earnings: balance at the end of year 1, 120,000. Profit year 2, 140,000, giving 260,000 at the end of year 2. Profit year 3, 320,000, giving 580,000. Share capital stays at 400,000 and share premium at 40,000. Total equity is 520,000 at the end of year 1 (400,000 + 40,000 + 120,000), 660,000 at the end of year 2 and 1,020,000 at the end of year 3. The draft retained earnings were 630,000, so the correction reduces them by 50,000.
(c) The nature of the error; the amount of the correction for each line item affected in each prior period presented; the amount at the beginning of the earliest period presented; and the effect on earnings per share where applicable.
Show the model answer to Question 13
(a) A change in accounting estimate (useful life).
(b)
- Depreciation for two years.
2 × 30,000 = 60,000, so the carrying amount is 240,000. - The remaining life is 5 − 2 = 3 years, so the annual charge from year 3 is 240,000 ÷ 3 = ₦80,000.
(c) Changes in estimate result from new information or changed circumstances and are not errors. The earlier charge was correct on the information then available, so it is not restated.
The effect is recognised prospectively, in the period of the change and the future periods.
Pathfinder on IAS 8: accounting policies, estimates and prior-year errors
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the previous syllabus. Asks which change in method does not give rise to a change in accounting policy. The answer is the change in depreciation from straight line to the sum-of-digits method, which is a change in estimate.
Revise first: Accounting estimates
From the previous syllabus. Asks which of four changes are changes in accounting estimates, including a change in useful life, a change in the allowance for doubtful receivables, a move from cost to revaluation and a move from FIFO to weighted average.
Revise first: Accounting policies
From the previous syllabus. A plant bought for ₦300,000 with a ten-year life is reviewed after two years and the total life cut to five years. Question 3 asks the type of adjustment under IAS 8, and Question 4 asks for the depreciation amount.
Revise first: The ideas in more depth
From the previous syllabus. Asks you to define an accounting policy and a change in accounting estimates with two examples each (6 marks), and to outline the treatment of changes in estimates (2 marks).
Revise first: Accounting estimates
Asks you to explain the distinction between accounting policies and accounting estimates under IAS 8.
Revise first: Accounting policies
Expect an item that asks you to classify a change as a policy, an estimate or an error, or to compute a revised depreciation charge. Check Section A of every diet you practise.
Revise first: Prior period errors
Source: ICAN Pathfinder, Financial Accounting. Diets covered: November Diet, 2019, May Diet, 2021, May Diet, 2022, May Diet, 2023 and November Diet, 2023 (the later ones are not all on the previous syllabus). Diets before November 2014, and November Diet, 2024 onwards, are not covered here.
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