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Paper F7 (INT)
Financial reporting
CHAPTER
6
Reporting financial
performance
Contents
1 IAS8: Accounting policies, changes in accounting
estimates and errors
2 Reporting financial performance
3 IFRS5: Non-current assets held for sale and
discontinued operations
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IAS8: Accounting polices, changes in accounting estimates and errors
Changes in accounting policies
Retrospective application of a change in accounting policy
Disclosure of a change in accounting policy
Accounting estimates
Changes in accounting estimates
Errors
The correction of prior period errors
Disclosure of prior period errors
1 IAS8: Accounting policies, changes in accounting
estimates and errors
IAS8 Accounting policies, changes in accounting estimates and errors deals with
several different issues in financial reporting:
selecting and applying accounting policies (dealt with in an earlier chapter)
accounting for changes in accounting policies
changes in accounting estimates
corrections of errors in a prior accounting period.
Much of IAS8 is therefore concerned with how changes or corrections should be
reported in the financial statements.
1.1 Changes in accounting policies
Users of financial statements need to be able to compare financial statements of an
entity over time, so that they can identify trends in its financial performance or
financial position. Frequent changes in accounting policies are therefore undesirable
because they make comparisons with previous periods more difficult. IAS8
therefore states that a change in accounting policy is permitted only in the following
circumstances:
When a change in accounting policy is required by an IFRS or revised IAS (or an
Interpretation of an IFRS), or
If a change in accounting policy results in the financial statements providing
reliable and more relevant financial information.
When a change in accounting policy is required by a new Standard, the Standard
will often include specific ‘transitional provisions’. These explain how the change
should be introduced.
In the absence of specific transitional provisions, a change in policy should be
applied retrospectively.
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Determining when there is a change in accounting policy
How should an entity decide whether it would be introducing a change in
accounting policy, if it decided to account for a particular type of transaction in a
particular way?
IAS8 specifies that when a new accounting policy is applied for transactions or
events that did not occur previously, in earlier financial periods, this is not a change
of accounting policy; it would simply be the application of a suitable accounting
policy to a new type of transaction.
A change in accounting policy can be established as follows. The accounting policies
chosen by an entity should reflect transactions and events through:
recognition (e.g. capitalising or writing off certain types of expenditure)
measurement (e.g. measuring non-current assets at cost or valuation)
presentation (e.g. classification of costs as cost of sales or administrative
expenses)
If at least one of these criteria is changed, then there is a change in accounting
policy.
Example
A company has previously written off borrowing costs as incurred in the income
statement. It is now proposed that any relevant finance costs should be capitalised
as allowed by IAS 23.
This affects:
recognition – the interest cost is now recognised as an asset rather than an
expense
presentation – the interest cost is now presented in the statement of financial
position rather than the statement of comprehensive income.
In this example, there has been no change to the measurement of the finance costs
but this is still a change in accounting policy due to a change in recognition and
presentation.
1.2 Retrospective application of a change in accounting policy
When a change in accounting policy is required, and there are no transitional
provisions relating to the introduction of a new accounting standard, the change in
policy should be applied retrospectively.
The entity should adjust the opening balance for each item of equity affected by the
change, for the earliest prior period presented, and the other comparative amounts for
each prior period, as if the new accounting policy had always been applied. For
example, suppose that a change in accounting policy is required from Year 3 onwards,
and the earliest prior period presented in the Year 3 financial statements is Year 2, for
which comparative prior year figures are presented. The change in accounting policy
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should be applied retrospectively, which means that the change should be applied to
the opening balances at the start of Year 2 (in the comparative prior period
information), as if the new policy had always been applied.
Similarly, any other comparative amounts in previous periods should be adjusted as
if the new accounting policy had always been applied.
If this is impracticable, retrospective application should be applied from the earliest
date that is practicable.
1.3 Disclosure of a change in accounting policy
When an entity makes a change in an accounting policy, a note to the financial
statements should disclose the following information about the change:
If the change is due to a new Standard
or a new Interpretation
If the change in policy is voluntary
The title of the Standard or
Interpretation
The nature of the change in
accounting policy
The nature of the change in
accounting policy
A description of any transitional
provisions
The reason why the new accounting
policy provides reliable and more
relevant information
For the current and previous
period(s), to the extent practicable,
the amount of the adjustment to
each item in the financial statements
and the adjustment to the basic and
fully diluted earnings per share
For the current and previous
period(s), to the extent practicable,
the amount of the adjustment to
each item in the financial statements
and the adjustment to the basic and
fully diluted earnings per share
To the extent practicable, the
adjustment relating to accounting
periods before those presented in
the financial statements
To the extent practicable, the
adjustment relating to accounting
periods before those presented in
the financial statements
If retrospective application is
impracticable, an explanation of
how the accounting policy change
has been applied
If retrospective application is
impracticable, an explanation of
how the accounting policy change
has been applied
1.4 Accounting estimates
An accounting estimate is made for an item in the financial statements when the
item cannot be measured with precision, and there is some uncertainty about it. An
estimate is therefore based, to some extent, on management’s judgement.
Management estimates might be required, for example, for the following items:
bad debts
inventory obsolescence
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the fair value of financial assets or liabilities
the useful lives of non-current assets
the most appropriate depreciation pattern (depreciation method) for a category
of non-current assets
warranty obligations.
It is important to distinguish between an accounting policy and an accounting
estimate.
As an example a company may have an accounting policy to depreciate plant and
equipment over its useful life. However whether the company uses the straight line
method of depreciation or the reducing balance method will be a choice of
accounting estimate.
IAS 8 requires a change in an accounting policy to be accounted for retrospectively
whereas a change in an accounting estimate is normally recognised in the current
period (and there is no requirement for retrospective application).
1.5 Changes in accounting estimates
A change in accounting estimate may be needed if changes occur in the
circumstances on which the estimate was based, or if new information becomes
available. A change in estimate is not the result of discovering an error in the way
an item has been accounted for in the past and it is not a correction of an error.
The effect of a change in accounting estimate should be recognised prospectively, by
including it:
in profit or loss for the period in which the change is made, if the change affects
that period only, or
in profit or loss for the period of change and future periods, if the change affects
both.
Prospective application of a change in estimate
A change in accounting estimate is not applied retrospectively. There is
prospective application of the change. This means that the effect of the change is
recognised in the current period and the future periods affected by the change.
To the extent that a change in estimate results in a change in assets and liabilities, it
should be recognised by adjusting the carrying amount of the affected assets or
liabilities in the period of change.
Example
A non-current asset was purchased for $200,000 two years ago, when its expected
economic life was ten years and its expected residual value was $0. The asset is
being depreciated by the straight-line method.
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A review of the non-current assets at the end of year 2 revealed that due to
technological change, the useful life of the asset is only six years in total, and the
asset therefore has a remaining useful life of four years.
The original depreciation charge was $20,000 per year ($200,000/10 years) and at the
beginning of Year 2, its carrying value was $180,000 ($200,000 - $20,000).
The change in the estimate occurs in Year 2. The change in estimate should be
applied prospectively, for years 2 onwards (years 2 – 6). From the beginning of year
2, the asset has a revised useful remaining life of five years.
The annual charge for depreciation for year 2 (the current year) and for the future
years 3 – 6 will be changed from $20,000 to $36,000 (= $180,000/5 years).
Example
The carrying value of an item of inventory is $7,000. The inventory is no longer used
due to a change in materials specifications for the products that used to contain the
inventory item. The inventory has no scrap value and is now considered worthless.
A change in accounting estimate should reduce the value of the inventory to zero.
The change affects the current year only, and the write-off of $7,000 should be
treated as an expense for the year.
1.6 Errors
Errors might happen in preparing financial statements. If they are discovered
quickly, they are corrected before the finalised financial statements are published.
When this happens, the correction of the error is of no significance for the purpose
of financial reporting.
A problem arises, however, when an error is discovered that relates to a prior
accounting period. For example, in preparing the financial statements for Year 3, an
error may be discovered affecting the financial statements for Year 2, or even Year 1.
Errors might be:
the effect of a mathematical mistake
a mistake in applying an accounting policy
an oversight
a misinterpretation of facts
caused by fraud.
Prior period errors are defined in IAS8 as: ‘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:
was available when financial statements for those periods were authorised for
issue; and
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could reasonably be expected to have been obtained and taken into account in
the preparation and presentation of those financial statements.’
1.7 The correction of prior period errors
IAS8 states that all material prior period errors should be corrected retrospectively
in the first set of financial statements following the discovery of the error.
Comparative amounts for the previous period should be re-stated at their corrected
amount.
If the error occurred before the previous year, the opening balances of assets,
liabilities and equity for the previous period should be re-stated at their corrected
amount.
The correction of a prior period error is excluded from profit or loss in the period
when the error was discovered.
For example, suppose that an entity preparing its financial statements for Year 3
discovers an error affecting the Year 2 financial statements. The error should be
corrected in the Year 3 financial statements by re-stating the comparative figures for
Year 2 at their correct amount. If the error had occurred in Year 1, the comparative
opening balances for the beginning of Year 2 should be re-stated at their correct
amount. The reported profit for Year 3 is not affected.
Example
DEF is preparing its financial statements for Year 3. The draft profit for Year 3 is
$547,000 before tax. During Year 3 DEF:
(a) paid dividends of $100,000
(b) revalued a non-current asset, creating a revaluation reserve of $40,000
(c) raised $300,000 by issuing new shares ($200,000 nominal value and $100,000
share premium).
At the end of Year 2 owners’ equity totalled $890,000, consisting of share capital of
$500,000, share premium $50,000, revaluation reserve $100,000 and retained
earnings of $240,000.
(At the end of Year 1, owners’ equity totalled $740,000; retained profits for the year
were $150,000 and there were no dividend payments, no share issues and no non-
current asset revaluations during Year 1.)
DEF has now discovered an error in its inventory valuation. This has resulted in an
overstatement of inventory at 31 December Year 3 of $67,000 and at 31 December
Year 2 of $60,000.
The rate of tax on profits was 30% in both Year 2 and Year 3.
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The error in Year 2 should be corrected retrospectively, as follows.
Retrospective correction of the statement of comprehensive income
The error in the valuation of opening and closing inventory in Year 3 is corrected
before the publication of the Year 3 financial statements. As a result of this
correction, the draft profit for Year 3 before tax will be $547,000 - $67,000 + $60,000 =
$540,000. After deducting tax at 30%, the profit is $378,000.
The comparative figures for Year 2 should also be changed, and because closing
inventory at the end of Year 2 was overstated by $60,000, the profit before tax in
Year 2 was actually $60,000 lower. Profit after tax at 30% would therefore be $42,000
lower (and the tax liability $18,000 lower).
In the statement of comprehensive income for Year 3, the comparative figures for
Year 2 should therefore be re-stated to show cost of sales higher by $60,000, gross
profit lower by $60,000, taxation lower by $18,000 and profit after tax lower by
$42,000.
Statement of changes in equity
The reduction in profit in Year 2 affects some of the opening balances in the
statement of financial position in Year 3. The tax liability will be $18,000 lower and
retained profits will be $42,000 lower. Restating the opening balance for the current
year the opening shareholders’ funds will now be $848,000 ($890,000 – $42,000).
The statement of changes in equity for the year would be shown as follows:
Share
capital
Share
premium
Revaluation
reserve
Retained
earnings
Total
$000
$000
$000
$000 $000
Balance at 31 December
Year 1
500
50
100
90 740
Profit for the year ended
31 December Year 1, as
re-stated
-
-
-
108 108
–––
–––
–––
––––
–––
Balance at 31 December
Year 2
500
50
100
198 848
Year 3
Dividends
(100) (100)
Issue of shares 200
100
300
Profit for the year
378 378
Gain on property
revaluation
40
40
–––
–––
–––
––––
–––
Balance at 31 December
Year 3
700
150
140
476 1,466
–––
–––
–––
––––
–––
In this statement, the retained profit for the year has bee re-stated as $108,000, to
correct the error in Year 2, and the opening balance of retained profits is also re-
stated. There is no re-statement in Year 3 because the error was corrected before the
final financial statements were published.
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1.8 Disclosure of prior period errors
IAS8 requires the following disclosures for material prior period errors:
the nature of the prior period error
for each period presented in the financial statements, and to the extent
practicable, the amount of the correction for each financial statement item and
the change to basic and fully diluted earnings per share
the amount of the correction at the beginning of the earliest prior period in the
statements (typically, a the start of the previous year)
if retrospective re-statement is not practicable for a prior period, an explanation
of how and when the error has been corrected.
IAS8 therefore requires that a note to the financial statements should disclose details
of the prior year error, and the effect that the correction has had on ‘line items’ in
the Year 2 figures. In the previous example, the effect of the error should be
disclosed in a note to the financial statements as:
Effect
on Year 2
$
(Increase) in cost of goods sold (60,000)
Decrease in tax 18,000
––––––
(Decrease) in profit (42,000)
––––––
(Decrease) in closing inventory (60,000
Decrease in tax payable 18,000
––––––
(Decrease) in equity (42,000)
––––––
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Reporting financial performance
What is financial performance?
IFRSs and financial performance
2 Reporting financial performance
2.1 What is financial performance?
One of the purposes of financial statements is to provide users with relevant and
reliable information about an entity’s financial performance. But what should be
included in financial performance?
One possible view is that an entity’s financial performance is its normal, recurring
earnings. This is its profit or loss for the period, excluding any unusual items that
are not expected to recur in future.
Another possible view is that an entity’s financial performance is its comprehensive
income. This is the difference between closing equity and opening equity after
adjusting for transactions with equity owners (shareholders). Therefore an entity’s
financial performance includes all the gains and losses that occur during the period:
Normal, recurring income and expenses
Unusual gains and losses that are included in profit and loss and are not
expected to occur regularly (for example, profits and losses on the sale of non-
current assets; costs of a major restructuring)
Gains and losses that are not included in profit and loss (for example, gains on
the revaluation of assets).
The IASB (and most other major standard setters) have adopted this second view of
performance. This is reflected in the ‘accounting equation’ approach (which has
also been called the balance sheet approach) of the IASB Framework: income and
expenses (gains and losses) are recognised as a result of changes in assets and
liabilities.
2.2 IFRSs and financial performance
The structure of the main financial statements was covered in an earlier chapter.
IAS1: Presentation of financial statements sets out the items that should be
included and disclosed in the statement of financial position statement of
comprehensive income and statement of changes in equity.
Users of the financial statements need information about the various components of
an entity’s financial performance. There are several ways in which IASs and IFRSs
ensure that this information is provided:
Disclosure of material items included in the income statement (IAS 1)