Concepts, Rules, and Examples | WILEY IAS 2003: Interpretation and Application of International Accounting Standards

Importance of Comparability and Consistency in Financial Reporting

Generally accepted accounting principles have long held that an important objective of financial reporting is to encourage comparability among financial statements produced by essentially similar enterprises. This is necessary to facilitate informed economic decision making by investors, creditors, prospective employees, joint venturers, and others. While complete comparability will not be achieved as long as alternative principles of accounting and reporting remain acceptable for like transactions and events, a driving force in developing new accounting standards is to enhance comparability. The IASC's efforts in the early 1990s (the comparability project) did, in fact, narrow the range of acceptable alternative methods of accounting, and further narrowing has occurred as the core set of standards were developed to comply with the agreement with IOSCO, as described in Chapter 1. Furthermore, as the IASB prepares itself to accomplish the objective of bringing about convergence of national accounting standards and IAS (the objective enshrined in the new constitution of the IASC), further elimination of alternatives can be anticipated.

Comparability refers to the quality of information that enables users to identify similarities in and differences between two sets of economic phenomena. Normally, comparability is a quantitative assessment of a common characteristic.

An important implication of the qualitative characteristic of comparability is that users be informed of the accounting policies employed in the preparation of the financial statements, any changes in those policies, and the effects of such changes. Disclosure of accounting policies was discussed in Chapters 2, 3, and 4; this chapter addresses the appropriate communications of changes in accounting policies and related matters.

Compliance with IAS helps in achieving comparability, since the adoption of IAS by enterprises facilitates relative evaluation of financial data using a common accounting language. The need for comparability, however, should not be confused with mere uniformity and should not be allowed to become a barrier or an impediment to the adoption of improved accounting methods.

As contrasted with comparability, consistency refers to a given reporting entity's conformity from period to period with unchanging policies and procedures. The quality of consistency enhances the utility of financial statements to users by facilitating analysis and understanding of comparative accounting data.

According to IAS 1 (revised),

...the presentation and classification of items in the financial statements should be retained from one period to the next unless a significant change in the nature of the operations of the enterprise or a review of its financial statement presentation demonstrates that more relevant information is provided in a different way.

It is, however, inappropriate for an enterprise to continue accounting for transactions in the same manner if the policies adopted lack qualitative characteristics of relevance and reliability. Thus, if more reliable and relevant alternatives exist, it is better for the enterprise to change its methods of accounting for defined classes of transactions.

Reporting Accounting Changes

IAS 8 describes three ways of reporting accounting changes and the type of change for which each should be used. These are

Retrospectively
Currently
Prospectively

Retrospective treatment requires an adjustment to all current and prior period financial statements for the effect of the accounting change. Prior period financial statements presented currently are to be restated on a basis consistent with the newly adopted principle.

Current treatment requires reporting the cumulative effect of the accounting change in the current year's income statement as a special item. Prior period financial statements are not restated.

Prospective treatment of accounting changes requires no restatement of prior financial statements and no computing or reporting of the accounting change's cumulative effect in the current period's income statement. Only current and/or future periods' financial report data will reflect the accounting change.

Each type of accounting change and the proper treatment prescribed for them are discussed in detail in the following sections.

Change in Accounting Policy

A change in any accounting policy means that a reporting entity has switched from one generally accepted accounting principle to another. According to IAS 8, the term accounting policy includes the accounting principles, bases, conventions, rules and practices used. For example, a change in inventory costing from weighted-average to first-in, first-out would be a change in accounting policy, as would a change in accounting for borrowing costs from capitalization to immediate expensing.

An interpretation of a similar definition under US GAAP provides a meaningful framework by establishing that a change in the components used to cost a firm's inventory is a change in accounting principle. This FASB interpretation also clarified that the preferability assessment (relating to the selection of the appropriate accounting policy or principle in particular circumstances) must be made from the perspective of financial reporting basis and not from the income tax perspective.

Changes in accounting policy are permitted if

The change in accounting principle will result in a more appropriate presentation of events or transactions in the financial statements of the enterprise, or
The change in accounting principle is required by an accounting standard-setting body, or
The change in accounting principle is required by statute.

IAS 8 does not regard the following as changes in accounting policies:

The adoption of an accounting policy for events or transactions that differ in substance from previously occurring events or transactions; and
The adoption of a new accounting policy to account for events or transactions that did not occur previously or that were immaterial

The provisions of IAS 8 are not applicable to the initial adoption of a policy to carry assets at revalued amounts, although such adoption is a change in accounting policy. Rather, it is dealt with as a revaluation in accordance with IAS 16 or IAS 38, as appropriate under the circumstances.

Benchmark and Allowed Alternative Accounting Treatments

IAS 8 prescribes two methods of reporting a change in accounting policy, depending on whether the benchmark treatment or the allowed alternative method is used. If the benchmark treatment is used, a change in accounting policy is to be applied retrospectively (unless the amount of the resultant adjustment from the change relating to the prior period is not reasonably determinable). With application of the retrospective effect to the change in accounting policy, the following adjustments will have to be made:

The comparative information presented for the prior periods will be restated to reflect the effect of the change in accounting policy; the effect will be computed under the assumption that the new accounting policy had always been in use.
The cumulative effect of the change (resulting from the retrospective application of the accounting policy to prior periods) net of income taxes, if any, will be reported as an adjustment to the opening balance of the retained earnings.
Any other information with respect to prior periods, such as historical summaries of financial data, is also restated.

If the allowed alternative treatment is chosen by the enterprise instead of the benchmark treatment

The cumulative effect of the change (resulting from the retrospective application of the accounting policy) net of income taxes, if any, will have to be included in the determination of the current year's net profit or loss.
The comparative information for the prior period presented alongside the current year's figures need not be restated as in the case of the application of the benchmark treatment above. In other words, the comparative information will be presented as reported in the prior years' financial statements.
Additional pro forma comparative information (prepared based on the guidelines above for the application of the benchmark treatment) will also need to be presented.

The cumulative effect of a change in accounting principle is to appear as a single amount in the income statement between extraordinary items and net income if the allowed alternative treatment is used, and as a single amount shown as an adjustment to the opening retained earnings balance if the benchmark treatment is applied. This single amount should be the difference between

The amount of retained earnings at the beginning of the period, and
The amount of retained earnings that would have been reported at that date if the new accounting principle had been applied retroactively to all prior periods affected.

The cumulative effect is generally determined by first calculating income before taxes for both the new principle and the old principle for all prior periods affected. The difference between the two incomes for each prior period is then determined. Next, these differences are adjusted for tax effects. Finally, the net of tax differences for each prior period are totaled. This total represents the cumulative effect adjustment at the beginning of the current period. The cumulative effect will either be an addition to or a subtraction from current income, depending on how the change to the new principle affects income.

Generally, only the direct effects of the change and the related income tax effect should be included in the cumulative effect calculation (i.e., if the company changes its method of costing inventories, only the effects of the change in cost of goods sold, net of tax, are considered to be direct effects). Indirect effects, such as the effect on a profit-sharing contribution or bonus payments that would have occurred as a result of the change in net income, are not included in the cumulative effect computation unless these are to be recorded by the firm (i.e., the expense is actually incurred).

The computation of income on a pro forma basis must be made for each period currently presented. The objective is to present income before extraordinary items and net income as if the new principle were being applied. This is achieved by adjusting each period's income before extraordinary items as reported previously (i.e., applying the old principle). The adjustment is made by adding or subtracting the difference in income net of tax for the period to income before extraordinary items as reported previously. The difference, net of tax, is the change in income that occurs when the new principle is applied instead of the old principle. This results in a figure for income before extraordinary items that reflects the application of the new principle. Net income is then calculated as normally done from the adjusted income before extraordinary items. The per share amounts required are based on the pro forma income before extraordinary items and net income amounts.

The pro forma calculation differs from that of the cumulative effect. It is to include both the direct effects of the change and the nondiscretionary adjustments of items based on income before taxes or net income. Examples of nondiscretionary items are profit-sharing expense or certain royalties. Both of these expenses are in some way based on net income, generally as a specified percentage. The related tax effects should be recognized for both the direct and nondiscretionary adjustments.

The following example illustrates the computations and disclosures necessary when applying the cumulative effect method.

Example of benchmark and alternative treatments of changes in accounting policy under IAS 8

In 2003, the Zircon Company adopted the percentage-of-completion method of accounting for long-term construction contracts. The company had used the completed-contract method for all prior years.

The following sections present extracts from the statements of earnings and retained earnings of Zircon Company before adjusting for the effects of the change in accounting policy. Net profit for 2003 was determined under the percentage-of-completion method of accounting.

	2003	2002
Profit from ordinary activities before income taxes	$120,000	$130,000
Income taxes	(20,000)	(26,000)
Net profit	100,000	104,000
Retained earnings, beginning	134,000	30,000
Retained earnings, ending	$234,000	$134,000

The effects of the change in accounting policy are presented below.

	Difference in income under the percentage-of-completion method	Effect of the change net of income taxes
Prior to 2002	$20,000	$14,000
For 2002	15,000	10,500
Total as of the beginning of 2003	35,000	24,500
For 2003	$20,000	$14,000

The following pages provide an illustration of the accounting treatment and presentation of financial statements under the benchmark treatment and the allowed alternative treatment of the changes in accounting policies in accordance with IAS 8.

Changes in Accounting Policies: Benchmark Treatment

Zircon Company Extracts from Income Statement
	2003	2002 restated
Profit from ordinary activities before income taxes	$120,000	$145,000
Income taxes	(20,000)	(30,500)
Net profit	$100,000	$114,500

Zircon Company Statement of Changes in Equity (Retained Earnings columns only)
Retained earnings, beginning, as reported previously	$134,000	$ 30,000
Change in accounting policy, net of income taxes of $ 10,500 for 2003 and $6,000 for 2002 (see Note 1)	24.500	14,000
Retained earnings, beginning, as restated	158,500	44,000
Net profit	100,000	114,500
Retained earnings, ending	$258,500	$158,500

Zircon Company Extracts from Notes to the Financial Statements

Note 1: During 2003, Zircon Company changed the accounting policy for revenue and costs for a long-term construction contract from the completed-contract method to the percentage-of-completion method, to conform with the accounting treatment of contract revenue and contract costs under IAS 11, Construction Contracts. This change in accounting policy has been accounted for retrospectively. The comparative financial statements for 2002 have been revised to conform to the changed policy. The effect of this change is to increase income from contracts by $20,000 in 2003 and $15,000 in 2002. Opening retained earnings for 2002 has been increased by $14,000, which is the amount of the adjustment relating to periods prior to 2002, net of income tax effect of $6,000.

Explanation. Under the benchmark treatment, a change in accounting policy should be applied retrospectively unless the amount of any resulting adjustment that relates to prior periods is not reasonably determinable. Any resulting adjustment should be reported as an adjustment to the opening balance of retained earnings. Comparative information should be restated unless impracticable to do so. The steps in preparing the revised financial statements and related disclosures are as follows:

The 2003 income statement is not adjusted, since it already reflects application of the new policy.

The 2002 income statement is restated as follows:

Profit from ordinary activities before income taxes, as previously reported	$130,000
Effect of the change in accounting policy	15,000
As restated	145,000
Income taxes as previous reported	26,000
Income tax effect of the change in accounting policy ($15,000 – $10,500)	4,500
As restated	30,500
Net income as restated	$114,500

As presented in the statement of retained earnings, the opening retained earnings for 2002 was restated to reflect an increase of $14,000, which represents the amount of adjustment related to periods prior to 2002, net of income tax effect of $6,000. The opening balance of 2003 was adjusted by $24,500, which represented the effect of the change at the beginning of 2003, net of income taxes.

Changes in Accounting Policy: Allowed Alternative Treatment

Under the allowed alternative treatment set forth in IAS 8, the amount computed from the retroactive application of the new accounting policy is included in income of the current period. Additional pro forma presentations are also required under this approach. Using the same facts as in the preceding discussion, the alternative treatment is illustrated as follows:

Zircon Company Extracts from Income Statement
			Pro forma
	2003	2002	(Restated) 2003	(Restated) 2002
Profit from ordinary activities, before income taxes and effect of change in accounting policy	$120,000	$130,000	$120,000	$145,000
Cumulative effect of change in accounting policy	35,000	--	--	--
Profit from ordinary activities, before income taxes	155,000	130,000	120,000	145,000
Income taxes (including effect of a change in accounting policy)	30,500	26,000	20,000	30,500
Net profit	$124,500	$104,000	$100,000	$114,500

Zircon Company Statement of Changes in Equity (Retained Earnings columns only)
			Pro forma
	2003	2002	(Restated) 2003	(Restated) 2002
Retained earnings, beginning, as previously reported	$134,000	$ 30,000	$134,000	$ 30,000
Change in accounting policy for construction contracts, net of income taxes of $10,500 for 2003 and $6,000 for 2002 (Note 1)	--	--	24,500	14,000
Retained earnings, beginning, as restated	134,000	30,000	158,500	44,000
Net profit	124,000	104,000	100,000	114,500
Retained earnings, ending	$258,500	$134,000	$258,500	$158,000

Zircon Company Extracts from Notes to the Financial Statements

Note 1: An adjustment of $35,000 has been made in the income statement for 2003, representing the effect of a change in the accounting policy with respect to revenue and costs for long-term construction contracts. The company now uses the percentage-of-completion method instead of the completed-contract method, to conform to the accounting treatment of contract revenue and costs prescribed by IAS 11. This change in accounting policy has been accounted for retrospectively. Restated pro forma information, which assumes that the new policy had always been in use, is presented. Beginning retained earnings in the pro forma information for 2002 has been increased by $14,000, which is the amount of adjustment relating to periods prior to 2002, net of income tax effect of $6,000.
Explanation. Under the allowed alternative, a retroactive computation is still required, but instead of including the cumulative effect of the change in the restated balance of opening retained earnings, it is included in income of the current period. Furthermore, if the alternative treatment is elected, additional pro forma information must be presented (effectively, this means that the benchmark treatment must also be presented if the allowed alternative is used) unless it is impracticable to do so.

Proposed change to reporting changes in accounting policies.

As part of the IASB Improvements Project, changes have been proposed for IAS 8. The central theme is the elimination of alternative treatments, consistent with the goal of achieving convergence among various standard setters' prescribed financial reporting requirements.

As amended, IAS 8 will delete the current allowed alternative treatment of voluntary changes in accounting policies. Under present rules, as explained above, both benchmark and allowed alternative methods have been prescribed. As is the case for corrections of errors, the benchmark approach requires that comparative prior period data be restated and the earliest reported retained earnings balance be adjusted for the effect of the voluntary change in accounting policy. The allowed alternative permits the reporting entity to include the effect of the change in policy in profit or loss for the current period and present comparative information as it was reported in the financial statements of prior periods, without restatement.

As amended, a reporting entity will no longer be permitted by IAS 8 to include the adjustment resulting from retrospective application of changes in accounting policies in profit or loss for the current period. Also, the exemption from presenting restated comparative financial statements would be based on "undue cost or effort," from the present "impracticability" standard.

In a related proposed change, the amended IAS 8 would require (rather than merely encourage) disclosure of the nature of a future change in an accounting policy when an entity has yet to implement a new standard that has been issued but not yet become effective. In addition, disclosure would be required of the planned date of adoption, as well as an estimate of the effect of the change on the entity's financial position, unless undue cost or effort would be needed to make such an estimate.

Adoption of International Accounting Standards

A special situation arises when an enterprise adopts international accounting standards for the first time. While it is possible to reason by analogy that this action represents a change in accounting principle (or more accurately, a simultaneous change in all accounting principles), it is more meaningful to view this event as a change in the basis of accounting, such as the change from the cash to the accrual basis of preparing financial statements would be. Just as it would be misleading, or at the least meaningless, to present comparative financial statements with one year on the cash basis and the next on the accrual basis, with the net adjustment to beginning balances in the second year's balance sheet either taken to second year income or shown as a charge or credit to beginning retained earnings, so it would be useless to present the first year under US GAAP and the second year in accordance with IAS.

With more reporting entities embracing IAS, the question arises as to how the initial application should be reported (i.e., as a change in accounting principles or as a retroactive adjustment). The IASC's Standing Interpretations Committee has clarified the accounting for the adoption of IAS in SIC 8. This interpretation finds that in the first period IAS are employed, the statements should be prepared as if IAS had always been utilized. Thus, retroactive application is required, except for those standards and interpretations which permit a different transitional treatment, or when the effects on prior periods cannot be determined. Comparative financial statements and information would be prepared in conformity with the IAS as well. Any net adjustment would be included in the opening balance of retained earnings of the earliest period reported upon.

Proposed change to standard on first-time adoption.

As noted, the current requirement set forth by SIC 8 requires that, in the period of first-time application of IAS as the primary accounting basis, the financial statements of an enterprise, including comparative information, should be prepared and presented as if the financial statements had always been prepared in accordance with the IAS effective for the period of first-time application. Therefore, the Standards and Interpretations are to be applied retrospectively, except when Standards or Interpretations require or permit a different transitional treatment or when the amount of the adjustment relating to prior periods cannot be reasonably determined. Adjustment amounts are to be treated as an adjustment to the opening balance of retained earnings of the earliest period presented in accordance with IAS. If adjustments relating to prior periods or comparative information cannot be determined, the fact must be disclosed in the notes.

SIC 8 thus requires that the body of IAS in effect in the period when the adoption is effected is to be applied to all prior periods being reported on, explicitly (via comparatives) or implicitly (in the adjustment to beginning retained earnings of the earlier comparative period displayed). It is not necessary, or permitted, to attempt to identify the effective dates when specific standards would have first impacted the financial statements. This was done as a pragmatic solution to what would have otherwise been for many reporting entities a massive undertaking (and one which might well have dissuaded some from adopting IAS).

Currently, IASB has exposed a proposed new standard, First-Time Application of IFRS, which would supersede SIC 8 and alter some of the present procedures for implementation of IAS-compliant financial reporting. The proposal differs from SIC 8 in (1) creating targeted exemptions, notably in specified areas where retrospective application is likely to cause undue cost or effort, while SIC 8 contained less specific exemptions that applied when retrospective application would be impracticable; (2) clarifying that an entity applies only the latest version of IFRS, if the exemptions are applied; (3) clarifying how a first-time adopter's estimates under IFRS relate to the estimates it made for the same date using its previous basis of accounting; (4) specifying that the transitional provisions in other IFRS do not apply to a first-time adopter; and (5) requiring enhanced disclosure about how the transition to IFRS affected an entity's reported financial position, financial performance, and cash flows.

If adopted, the standard will require that an entity adopting IAS (which are now called IFRS) for the first time will need to prepare an opening IFRS balance sheet at the beginning of the earliest comparative period presented in its first IFRS financial statements (to be known as the "date of transition to IFRS"). Thus, if an entity's first IFRS financial statements are for the year ended 31 December 2005, it will need to prepare an opening IFRS balance sheet at 1 January 2004 (or earlier, if it presents comparative information for more than a single year). It would

Recognize all assets and liabilities whose recognition is required by IFRS;
Not recognize items as assets or liabilities if IFRS do not permit such recognition;
Reclassify items that the entity recognized under its previous basis of accounting (previous GAAP) as one type of asset, liability or component of equity, but that are a different type of asset, liability or component of equity under IFRS; and
Apply IFRS in measuring all recognized assets and liabilities.

The proposed standard would permit limited exemptions from the above requirement, which would be optionally available to the reporting entity. The standard would, however, require that if an entity uses any of the exemptions, it would have to apply all applicable exemptions.

These proposed exemptions fall into three categories. First, since determination of cost-based measurements long after acquisition dates of assets (or incurrence date of liabilities) is expected to be problematic, the proposal would require an entity to measure some assets, liabilities, and components of equity on a different basis and use that measurement as a deemed cost. This requirement would apply only to (1) property, plant, and equipment; (2) goodwill and other assets and liabilities acquired in business combinations recognized before the date of transition to IFRS; (3) net employee benefit assets or liabilities under defined benefit plans (at the date of transition to IFRS, an entity would measure them in accordance with IAS 19, except that no actuarial gains or losses would remain unrecognized); and (4) cumulative translation differences relating to a net investment in a foreign operation.

Second, in acknowledgement of the fact that some amounts determined under previous GAAP may be based on a valuation and that some of these valuations may be more relevant to users than original cost, the proposed standard would permit an entity to use valuations as deemed cost in two cases, notwithstanding that a cost-based measurement under IFRS is without undue cost or effort. The first of these pertains to prior revaluations accomplished by means of general or specific price indices applied to a cost that is broadly comparable to cost determined under IFRS, or prior revaluations to amounts broadly comparable to fair values determined under IFRS. A reporting entity could treat such revalued amounts as deemed cost under IFRS at the date of the revaluation.

The other case involves the situation where an entity had established a deemed cost under previous GAAP for some or all of its assets and liabilities by measuring them at their fair values at one particular date, because of an event such as a privatization or initial public offering. Such event-driven measurements would establish a deemed cost at that date for subsequent accounting under IFRS.

Third, the standard would prohibit the full retrospective application of IAS 39 in one area that relies on designation by management—namely, hedge accounting.

If a reporting entity chooses to not use the exemptions discussed above, it would apply the IFRS that were effective in each period. This means that it might, therefore, need to consider superseded versions of IFRS if later versions required prospective application. By contrast, if an entity uses the exemptions, it would apply only the latest version of IFRS.

The proposal states that an entity's estimates under IFRS at the date of transition would be consistent with estimates made for the same date under previous GAAP (after adjustments to reflect any difference in accounting policies), unless there were objective evidence that those estimates had been in error. If estimates under IFRS at the date of transition need to be made, and corresponding estimates were not required under previous GAAP, those estimates would not be permitted to reflect conditions that arose after that date. In particular, estimates of market prices, interest rates, or foreign exchange rates at the date of transition to IFRS would reflect market conditions at that date. Hindsight would not be permitted, in other words.

Change in Amortization Method

Another special case in accounting for a change in principle takes place when a company chooses to change the systematic pattern of amortizing the costs of long-lived assets to expense. When a company adopts a new method of amortization for newly acquired identifiable long-lived assets and uses that method for all new assets of the same class without changing the method used previously for existing assets of the same class, there is a change in accounting principle. Obviously, there is no adjustment required to the financial statements or any cumulative type of adjustment. In these special cases, a description of the nature of the method changed and the effect on net income, income before extraordinary items, and related per share amounts should be disclosed in the period of the change.

If the new method is, instead, adopted for all assets, both old and new, the change would appear to be a change in accounting principle which should be accounted for as described above. However, under the provisions of IAS 16, Property, Plant, and Equipment, and IAS 38, Intangible Assets, this is not the case. These standards, discussed in greater detail in Chapters 8 and 9, establish that a change in depreciation method or amortization method should be made only if there has been a significant change in the expected pattern of economic benefits from the use of the assets; in such case, the change is to be accounted for as a change in accounting estimate, not a change in policy. (Change in accounting estimate is discussed in the following section.) It does not appear to be contemplated by international accounting standards that there could be a change in depreciation method or amortization method to a better method that would justify change in accounting policy treatment. Since such changes in depreciation method are fairly common under US GAAP, the treatment of this topic under international standards is certain to generate at least some controversy.

Change in Accounting Estimates

The preparation of financial statements requires frequent use of estimates for such items as asset service lives, salvage values, collectibility of accounts receivable, warranty costs, pension costs, and so on. These future conditions and events and their effects cannot be perceived with certainty; therefore, changes in estimates will be inevitable as new information and more experience is obtained. IAS 8 requires that changes in estimates be handled currently and prospectively. It states that, "The effect of the change in accounting estimate should be accounted for in (a) the period of change if the change affects that period only or (b) the period of change and future periods if the change affects both." For example, on January 1, 1998, a machine purchased for $10,000 was originally estimated to have a ten-year life. On January 1, 2003 (five years later), the asset is expected to last another ten years. As a result, both the current period and the subsequent periods are affected by the change. The annual depreciation charge over the remaining life would be computed as follows:

A permanent impairment affecting the cost recovery of an asset should not be handled as a change in accounting estimate but should be treated as a loss of the period. (See the discussion in Chapter 8.)

In some situations it may be difficult to distinguish between changes in accounting policy and changes in accounting estimates. For example, a company may change from deferring and amortizing a cost to recording it as an expense when incurred because the future benefits of the cost have become doubtful. In this instance, the company is changing its accounting principle (from deferral to immediate recognition) because of its change in the estimate of the future value of a particular cost.

Although the international accounting standards do not address this matter per se, useful guidance is available by reference to the parallel standard under US GAAP, which is APB 20. In that standard, the board concluded that a change in accounting estimate that is in essence effected by a change in accounting principle should be reported as a change in accounting estimate, the rationale being that the effect of the change in accounting principle is inseparable from the effect of the change in estimate. In the example in the preceding paragraph, the company is changing its accounting principle (from deferral to immediate recognition) because of its change in the estimate of the future value of a particular cost. The amount of the cumulative effect would be the same as that attributable to the current or future periods.

Because the two changes are indistinguishable, changes of this type should logically be considered changes in estimates and accounted for in accordance with IAS 8. However, the change must be clearly indistinguishable to be combined. The ability to compute each element independently would preclude combining them as a single change. Also, for generally accepted auditing standards such a change is deemed a change in accounting principle for purposes of applying the consistency standard.

Correction of Fundamental Errors

Although good internal control and the exercise of due care will serve to minimize the number of errors made, these safeguards cannot be expected to completely eliminate errors in the financial statements. As a result, it was necessary for the accounting profession to promulgate standards that would ensure uniform treatment of accounting for error corrections.

IAS 8 is the promulgated international accounting standard dealing with the accounting for error corrections. It outlines the two methods of accounting for the correction of the fundamental errors, one of which is the preferred benchmark approach. IAS 8 indicates that fundamental errors are to be treated as prior period adjustments if the benchmark treatment is followed (i.e., the amount of the correction, net of the tax effect, if any, should be reported as an adjustment to the opening balance of the retained earnings). Comparative information should also be restated unless it is impracticable to do so.

If the allowed alternative treatment is opted by an enterprise, the amount of the correction of the fundamental error should be included in the determination of net profit or loss for the current period. The comparative information need not be restated under this method; instead, the comparative figures should be presented as reported in the financial statements of the prior period. In such a case, additional pro forma information (prepared in accordance with the foregoing guidelines for the application of the benchmark treatment) should also be presented (unless it is impracticable to do so).

IAS 8 identifies examples of fundamental errors as resulting from mathematical mistakes, mistakes in the application of accounting principles, or the oversight or misinterpretation of facts known to the accountant at the time the financial statements were prepared. A change from an unacceptable (or incorrect) accounting principle to a correct principle is considered a correction of an error, not a change in accounting principle. This should not be confused with the preferability dilemma discussed earlier, which involves two or more acceptable principles.

Although errors occur that affect both current and future periods, we are concerned primarily with the reporting of the correction of an error occurring in financial statements issued previously. Errors affecting current and future periods require correction but do not require disclosure, as they are presumed to be discovered prior to the issuance of financial statements. The correction of an error in the financial statements of a prior period discovered subsequent to their issuance should be reported as a prior period adjustment.

The essential distinction between a change in estimate and the correction of an error depends on the availability of information. An estimate requires correction because by its nature it is based on incomplete information. Later data will either confirm or contradict the estimate, and any contradiction will require correction. An error misuses existing information available at the time of the decision and is discovered at a later date. However, this discovery is not a result of additional information.

Under the benchmark treatment the required disclosures regarding the correction of a fundamental error include

The nature of the error.
The amount of the correction for the current period and for each period presented.
The amount of the correction relating to periods prior to those included in the comparative information.
The fact that comparative information has been restated or that it is impracticable to do so.

Under the allowed alternative treatment the disclosures differ since the accounting treatment differs. Under this method the clauses 2., 3., and 4. above will be replaced with

The amount of the correction recognized in the net profit or loss for the current period.
The amount of the correction included in each period for which the pro forma information is presented and the amount of the correction relating to periods prior to those included in the pro forma information. If the pro forma information could not be presented due to impracticality, this fact should be disclosed, too.

The major criterion for determining whether or not to report the correction of the error is the materiality of the correction. There are many factors to be considered in determining the materiality of the error correction. Materiality should be considered for each correction individually as well as for all corrections in total. If the correction is determined to have a material effect on income before extraordinary items, net income, or the trend of earnings, it should be disclosed in accordance with the requirements set forth in the preceding paragraph.

Thus, under benchmark treatment, the prior period adjustment should be presented in the financial statements as follows:

Retained earnings, 1/1/03 as reported previously	xxx
Correction of error (description) in prior period(s) (net of $___ tax)	xxx
Adjusted balance of retained earnings at 1/1/03	xxx
Net income	xxx
Retained earnings, 12/31/03	xxx

In comparative statements, prior period adjustments should also be shown as adjustments to the beginning balances in the retained earnings statements. The amount of the adjustment on the earliest statement shall be the cumulative effect of the error on periods prior to the earliest period presented. The later retained earnings statements presented should also show a prior period adjustment for the cumulative amount as of the beginning of the period being reported on.

Example of accounting for fundamental errors under IAS 8

In 2003, the bookkeeper of Dhow Corp. discovered that in 2002 the company failed to record in the accounts depreciation expense in the amount of $20,000, relating to a newly constructed building. The following presents extracts from the statement of income and retained earnings for 2003 and 2002 before correction of the error:

	2003	2002
Gross profit	$200,000	$230,000
General and administrative expenses, including depreciation	(80,000)	(80,000)
Net income from ordinary activities, before income taxes	120,000	150,000
Income taxes	(20,000)	(30,000)
Net profit	100,000	120,000
Retained earnings, beginning	150,000	30,000
Retained earnings, ending	$250,000	$150,000

Dhow Corp.'s income tax rate was 20% for both years.

The following provides an illustration of the accounting treatment and presentation of financial statements under the benchmark treatment and the allowed alternative treatment, in accordance with IAS 8.

Correction of Fundamental Error: Benchmark Treatment

Dhow Corp. Extracts from Income Statement
	2003	2002 restated
Gross profit	$200,000	$230,000
General and administrative expenses, including depreciation	(80,000)	(100,000)
Net income from ordinary activities, before income taxes	120,000	130,000
Income taxes	(20,000)	(26,000)
Net profit	$100,000	$104,000

Dhow Corp. Statement of Changes in Equity (Retained Earnings columns only)
	2003	2002 restated
Retained earnings, beginning, as reported previously	$150,000	$ 30,000
Correction of fundamental error, net of income taxes of $4,000 (see Note 1)	(16,000)	--
Retained earnings, beginning, as restated	134,000	30,000
Net profit	100,000	104,000
Retained earnings, ending	$234,000	$134,000

Dhow Corp. Extracts from Notes to the Financial Statements

Note 1: The company failed to record a depreciation charge in the amount of $20,000 in 2002. The financial statements for 2002 have been restated to correct this error.

Explanation. Under the benchmark treatment of fundamental errors, the amount of correction of a fundamental error that relates to prior periods should be reported by adjusting the opening balance of retained earnings. Comparative information should be restated unless it is impracticable to do so. The steps in preparing the revised financial statements and related disclosures are as follows:

As presented in the statement of retained earnings, the opening retained earnings was adjusted by $16,000, which represented the amount of error, $20,000, net of income tax effect of $4,000.

The comparative amounts in the income statement were restated as follows:

General and administrative expenses, including depreciation, before correction	$ 80,000
Amount of correction	20,000
As restated	$100,000
Income taxes before correction	$ 30,000
Amount of correction	4,000
As restated	$ 26,000

Correction of Fundamental Error: Allowed Alternative Treatment

Dhow Corp. Extracts from Income Statement
			Pro forma
	2003	2002	(Restated) 2003	(Restated) 2002
Gross profit	$200,000	$230,000	$200,000	$230,000
General and administrative expenses, including depreciation (see Note 1)	(80,000)	(80,000)	(80,000)	(100,000)
Correction of entry (Note 1)	(20,000)	--	--	--
Profit from ordinary activities, before income taxes	100,000	150,000	120,000	130,000
Income taxes (including effect of a correction of a fundamental error)	16,000	30,000	20,000	26,000
Net profit	$ 84,000	$120,000	$100,000	$104,000

Dhow Corp. Statement of Changes in Equity (Retained Earnings columns only)
			Pro forma
	2003	2002	(Restated) 2003	(Restated) 2002
Retained earnings, beginning, as reported previously	$150,000	$ 30,000	$150,000	$ 30,000
Correction of fundamental error, net of income taxes of $4,000 (Note 1)	--	--	16,000	--
Retained earnings, beginning, as restated	150,000	30,000	134,000	30,000
Net profit	84,000	120,000	100,000	104,000
Retained earnings, ending	$234,000	$150,000	$234,000	$134,000

Dhow Corp. Extracts from Notes to the Financial Statements

Note 1: The company failed to record a depreciation charge in the amount of $20,000 in 2002. An adjustment has been made in the income statement for 2002, representing the correction of the fundamental error. Restated pro forma information for 2003 and 2002 is presented as if the error had been corrected in 2002.
Explanation. Under the allowed alternative treatment of fundamental errors, the amount of correction of a fundamental error that relates to prior periods should be included in the determination of net profit or loss for the current period. Comparative information should be presented as reported in the financial statements of the prior period. Additional pro forma information (effectively, the benchmark treatment) should be presented, unless impracticable to do so.

Proposed change to reporting the effect of accounting errors.

The proposed amendments to IAS 8 would redefine accounting errors and would also eliminate the available alternative treatment for the financial statement effects of accounting errors being corrected.

The amendment, if adopted, will remove the distinction between fundamental errors and other errors, as had formerly been made. The current standard defines "fundamental errors" as those identified in the current period that are of such significance that financial statements of one or more prior periods could no longer be deemed reliable as of the date of their original issue. Under the amended standard, a more expansive definition will be adopted, as follows:

Errors are omissions from, and other misstatements of, the entity's financial statements for one or more prior periods that are discovered in the current period and relate to reliable information that (a) was available when those prior period financial statements were prepared; and (b) could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements.
Errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud.

Proposed amendments to IAS 8 will also remove the allowed alternative treatment of corrections of errors set out in the current standard. As discussed earlier in the present chapter, IAS 8 established both a benchmark and an allowed alternative method of correcting errors. The benchmark approach (which will be the sole permitted method under the provisions of the proposed amended IAS 8) requires that comparative prior period data be restated and the earliest reported retained earnings balance be corrected for the effect of the error. The allowed alternative permits the reporting entity to include the amount of the correction of an error in profit or loss for the current period and present comparative information as it was reported in the financial statements of prior periods, without restatement. This will be banned under the proposed amended IAS 8.

In some cases, restatement of comparative data cannot be accomplished, and IAS 8 offers an exemption when it is "impracticable" to do so. Under revised IAS 8, if the proposed change is enacted, this exemption would exist only if it could not be accomplished without "undue cost or effort." It would only apply to those prior periods to which the described condition applied; other prior periods would have to be restated.