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Section 8 – Accounting Policies, Estimates and Errors
Section 8 provides guidance for selecting and applying the accounting policies used in preparing financial statements. It also covers changes in accounting estimates and corrections of errors in prior period financial statements.
Selection and application of accounting policies
Extract from FRS 105 – Section 8.2 – 8.5
8.2 Accounting policies are the specific principles, bases, conventions, rules and practices applied by a micro-entity in preparing and presenting financial statements.
8.3 If this FRS specifically addresses a transaction, other event or condition, a micro-entity shall apply this FRS. However, the micro-entity need not follow a requirement in this FRS if the effect of doing so would not be material. This exemption does not apply to the disclosures required by paragraph 6.2(a).
8.4 If this FRS does not specifically address a transaction, other event or condition, a micro-entity’s management shall use its judgement in developing and applying an accounting policy that results in information that:
- represents faithfully the transactions, other events or conditions;
- reflects the economic substance of the transactions, other events and conditions, and not merely the legal form;
- is neutral, i.e. free from bias; and
- is prudent.
8.5 In making the judgement described in paragraph 8.4, management shall refer to and consider the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses and the pervasive principles in Section 2 Concepts and Pervasive Principles. A micro-entity is not required to provide any disclosures other than those required by Section 6 Notes to the Financial Statements in respect of these transactions or events.
OmniPro comment
It is clear that where a transaction is not specifically dealt with by the FRS then the following should be utilised as stated in Section 8.5:
- Management should use its judgement in developing and applying an accounting policy that results in information that:
- Represents faithfully the transactions, other events or conditions;
- Reflects the economic substance of the transactions, other events and conditions, and not merely the legal form;
- Is neutral, i.e. free from bias; and
- Is prudent
- Refer to the recognition criteria and measurement concepts in Section 2.
There is no requirement to refer to FRS 102 unless stated in the standard.
Consistency of accounting policies
Extract from FRS 105 – Section 8.6
8.6 A micro-entity shall select and apply its accounting policies consistently for similar transactions, other events and conditions.
OmniPro comment
FRS 105 requires consistency in application of accounting policies. Where a change in accounting policy is made this requires a prior year adjustment to restate the prior year figures so as to allow for comparability. This is discussed further below. A change can only be made on the basis that it results in providing more reliable information to the readers of the financial statements.
Changes in accounting policies
Extract from FRS 105 – Section 8.7 – 8.8
8.7 A micro-entity shall change an accounting policy only if the change:
- is required by this FRS; or
- results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the micro-entity’s financial position and financial
8.8 The following are not changes in accounting policies:
- the application of an accounting policy for transactions, other events or conditions that differ in substance from those previously occurring; and
- the application of a new accounting policy for transactions, other events or conditions that did not occur previously or were not material.
OmniPro comment
A change in accounting policy encompasses changes in the recognition and measurement principals for assets, liabilities, income and expenses. It also includes ways in which items are classified within the financial statements even where there is no impact on the net results.
Given the lack of accounting policy choice the only realistic time where a change in accounting policy applies will be where it is mandated by the FRC/FRS 105 itself or there is a change in classification from the prior year. The reason for this is that FRS 105 is very prescriptive on how assets and liabilities of various types must be accounted for. See examples of this prescriptive nature below. Under FRS 105:
- assets are not permitted to be carried at fair value or revalued amounts;
- all amounts on the balance sheet must be recognised at historic cost;
- development expenditure must be expensed;
- investment property must be held at cost and depreciated;
- no deferred tax is permitted to be recognised.
- Borrowing costs to be expensed
- Equity settled share based payments not recognised until issued
- Goodwill impairments cannot be reversed
An entity must select the accounting policy on transition and then apply them consistently. An entity can choose to voluntarily change, but where this is done it must result in more relevant and reliable information for the readers of the financial statements.
An entity should decide on its policy choice/presentation on transition to FRS 105. For ROI companies the entity should include an accounting policy note in the financial statements detailing how the entity has treated such costs (UK law does not require accounting policies to be disclosed for a micro entity). If an entity wishes to change going forward a prior year adjustment will be required i.e. it must be adjusted retrospectively.
Other examples which would be considered to be a change in accounting policy are:
- A change in classification of expenses within the profit and loss (e.g. in the prior year certain costs were posted to cost of sales whereas in the current year these are shown in other expenses/tax and vice versa)
- A change in classification on the balance sheet this year versus the prior year
Refer to Section 8.8 of FRS 105 above for examples of items which are not changes to an accounting policy and therefore retrospective adjustment is not required.
Applying changes in accounting policies
Extract from FRS 105 – Section 8.9
8.9 A micro-entity shall account for changes in accounting policy as follows:
- a micro-entity shall account for a change in accounting policy resulting from a change in the requirements of this FRS in accordance with the transitional provisions, if any, specified in that amendment; and
- a micro-entity shall account for all other changes in accounting policy retrospectively (see paragraph 8.10).
OmniPro comment
Change in accounting policy due to a change to requirements issued by the FRC
Where a change in accounting policy arises as a result of a change in the requirements of the FRS then this accounting policy should be adjusted in accordance with the guidance issued with the change as to how this should be accounted for.
The new guidance contained in the FRS, will instruct how this should be treated.
Change in accounting policy due to other reasons
Where a change of accounting policy arises for a reason other than the above reason, then the change should be accounted for retrospectively.
Disclosure consideration:
FRS 105 itself does not require a change in accounting policy to be disclosed in the financial statements. The UK legislation does not require it to be disclosed either.
However in ROI, Companies Act 2014 requires a change in accounting policy to be disclosed, more specifically Schedule 3B(5)(19) of CA 2014. It requires the particulars of the adjustment (impact of profit and loss and balance sheet) and the reasons for the adjustment to be disclosed in the notes to the financial statements. This is discussed further below. Where it specifically relates to a change in accounting policy then it must be included in the accounting policies note in the financial statements as stated in Section 321 of Companies Act 2014.
The concepts and journals with regard to making a prior year adjustment due to a change in accounting policy are the same as those required for a prior period error. See the prior period error section for a worked example.
Retrospective application – Change in accounting policy
Extract from FRS 105 – Section 8.10
8.10 When a change in accounting policy is applied retrospectively in accordance with paragraph 8.9, the micro-entity shall apply the new accounting policy to comparative information for prior periods to the earliest date for which it is practicable, as if the new accounting policy had always been applied. When it is impracticable to determine the individual-period effects of a change in accounting policy on comparative information for one or more prior periods presented, the micro-entity shall apply the new accounting policy to the carrying amounts of assets and liabilities as at the beginning of the earliest period for which retrospective application is practicable, which may be the current period, and shall make a corresponding adjustment to the opening balance of each affected component of equity for that period.
OmniPro comment
Retrospective application involves:
- adjusting the carrying amount of the assets and liabilities (as at the earliest prior period presented), with a corresponding adjustment to profit and loss reserves
- adjusting the prior periods to show the affect the change in policy had on the prior year results. There is only a need to show the comparative balance sheet restated, there is no need to disclose balance sheets after that date.
As stated above UK Companies are not required to include any disclosures in the financial statements with regard to the change in accounting policy.
However Companies in ROI are required to provide details of the change. In the financial statements of ROI Companies, the financial statements should show the adjustment in the ‘movement on profit and loss reserves’ note in the notes to the financial statements (or if this note is shown on the face of the P&L then include it there) with a note so that a reader of the financial statements can see how the profit and loss reserves moved from the prior year reported numbers to the current year, give the reasons for the change and the impact on the profit and loss and balance sheet (required under Schedule 3B(5)(19) CA 2014). Where a change in accounting policy is adopted it will affect tax and it is likely the prior year tax return will have to be restated. Where it specifically relates to a change in accounting policy then it must be included in the accounting policies note in the financial statements as stated in Section 321 of Companies Act 2014.
Changes in accounting estimates
Extract FRS 105 – Section 8.11 – 8.13
8.11 A change in accounting estimate is an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors. When it is difficult to distinguish a change in an accounting policy from a change in an accounting estimate, the change is treated as a change in an accounting estimate.
8.12 A micro-entity shall recognise the effect of a change in an accounting estimate, other than a change to which paragraph 8.13 applies, prospectively by including it in profit or loss in:
(a) the period of the change, if the change affects that period only; or
(b) the period of the change and future periods, if the change affects both.
8.13 To the extent that a change in an accounting estimate gives rise to changes in assets and liabilities, or relates to an item of equity, the micro-entity shall recognise it by adjusting the carrying amount of the related asset, liability or equity item in the period of the change.
OmniPro comment
Given that estimates are a fundamental feature in financial statements, Section 8 recognises this and states where a change in estimate occurs then this is adjusted for prospectively i.e. a prior year adjustment is not required.
A change in estimate can occur due to developments in a situation which occurred after the date the last financial statements were issued. At the time of issue, the estimate included was based on the facts and circumstances at that time. It was not a correction of errors.
Examples of a change in accounting estimates include:
- a reassessment of the residual value, useful life of property, plant and equipment and similar assets
- an over/understatement of a bad debt provision where more or less was received than what was expected but the provision was based on the best available evidence at the time of preparing the prior year accounts.
- Change in estimated payment for contingent consideration
- Over/under accruals in the prior year which were not due to errors but instead due to facts coming to light after the financial statements were signed
- Provision for obsolete, slow moving stock
- Warranty provisions
- Recoverability of deferred tax assets
- Change in functional currency due to a change in circumstances.
UK law nor FRS 105 requires UK companies to provide a disclosure on the change in accounting estimate.
ROI companies however are required under Company law (Schedule 3B(19) Companies Act 2014) to disclose changes in accounting estimates, detailing the reason for the change and impact of the change in the current year.
Example 2: Revising a residual value of an asset
In year 1 an asset was purchased for CU100,000. It had an estimated life of 6 years. Its estimated residual value was estimated to be CU10,000. This residual value was assessed for indicators of change at each year end and there were no issues up to the end of year 4. During year 5 and at the end of year 5, due to a change in the market for this type of asset the residual value increased to CU20,000 (being the present value of future residual amount). At the end of year 4, the asset had a carrying amount as follows:
|
Cost |
CU100,000 |
|
Residual Value |
(CU10,000) |
|
Depreciable Amount |
CU90,000 |
|
Depreciation (90,000 / 6 yrs * 4 yrs) |
(CU60,000) |
|
Carrying Amount |
CU30,000 |
In year 5, the residual amount is CU20,000, therefore the depreciable amount is CU80,000. Deducting depreciation charged to date of CU60,000 leaves CU20,000 to be depreciated over the remaining useful life of 2 years. Therefore, depreciation of CU10,000 is charged in year 5 and year 6. Disclosure of the change in estimate would be required in the financial statements for ROI Companies only detailing the effect on current years result.
If we take this example and assume the residual value increases to CU50,000, then the carrying amount in year 5 of CU30,000 is in excess of the residual amount. Therefore no depreciation is required in year 5 and 6 and any over depreciation is not reversed. Disclosure of the change in estimate would be required in the financial statements for ROI Companies only (not required under UK law).
Example 3: Revising a useful life of an asset
In year 1 an asset was purchased for CU100,000. It had an estimated life of 10 years with a nil residual value. At the start of year 6, the company re-assessed the useful lives and determined that only two years remained. The carrying value at the end of year 5 was CU50,000. Therefore with effect from the start of year 6, depreciation of CU25,000 would be charged i.e. CU50,000/2 years remaining life.
Disclosure of the change in estimate would be required in the financial statements for ROI Companies only (not required under UK law).
Detailed below is an example of a disclosure requirement for a change in the depreciation rates used (i.e. a change in estimate) for ROI Companies only (not required under UK law):
Example 4: Change in accounting estimate disclosure – ROI only
During the year ended 31 December 201X the company changed its depreciation method for freehold buildings and leasehold improvements to depreciating same over 50 years on a straight line basis as opposed to 10 years. The effect of same was to reduce the depreciation charge by CU680,000 for the current year. The reason for the change in depreciation method is that the new policy more correctly reflects the useful life of these assets.
Example 5: – Change in functional currency due a change in circumstance i.e. adjusted prospectively – extract from notes to the financial statements for an ROI company – not applicable for a UK company as disclosures not required:
The company changed functional currency from Sterling (“£”) to United States Dollar (“US$”) on 31 December 2014. This change arose as a result of the acquisition of the company by a larger group. As a result a change was made to the cost and funding structure such that the primary economic environment in which the company operates resulted in a change in functional currency to US$.
The 2014 results and financial position for comparative purposes were retranslated to US$ as follows:
– Assets and liabilities at the closing rate of 1.6184 as at 31 December 2014
– Income and expenses for 2014 are retranslated at the 2014 average rate of 1.6259
– All resulting exchange differences were recognised as a separate component of equity, described as the exchange rate reserve.
Corrections of prior period errors
Extract from FRS 105 – Section 8.14 – 8.17
8.14 Prior period errors are omissions from, and misstatements in, a micro-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
- could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements.
8.15 Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud.
8.16 To the extent practicable, a micro-entity shall correct a material prior period error retrospectively in the first financial statements authorised for issue after its discovery by:
- restating the comparative amounts for the prior period(s) presented in which the error occurred; or
- if the error occurred before the earliest prior period presented, restating the opening balances of assets, liabilities and equity for the earliest prior period presented.
8.17 When it is impracticable to determine the period-specific effects of a material error on comparative information for one or more prior periods presented, the micro-entity shall restate the opening balances of assets, liabilities and equity for the earliest period for which retrospective restatement is practicable (which may be the current period).
OmniPro comment
From the guidance above, the point to consider in determining whether a prior year adjustment/restatement is required as a result of a prior year error is whether the error is material to the current and/or past periods.
As stated above UK Companies are not required to include any disclosures in the financial statements with regard to the prior period adjustment
However Companies in ROI are required to provide details of the error. In the financial statements of ROI Companies, the financial statements should show the adjustment in the ‘movement on profit and loss reserves’ note in the notes to the financial statements (or if this note is shown on the face of the P&L then include it there) with a note so that a reader of the financial statements can see how the profit and loss reserves moved from the prior year reported numbers to the current year, give the reasons for the error and the impact on the profit and loss and balance sheet (required under Schedule 3B(5)(19) CA 2014). Where an error occurs it may affect tax and it is likely the prior year tax return will have to be restated.
When disclosing this in the financial statements, the word ‘restated’ should be shown in the prior year comparatives in the balance sheet and profit and loss. Note this is not required under UK company law however ROI Company law would encourage this in order to meet the above requirements.
Where an error arose on transition, there is on specific disclosure required as it is a new accounting framework so all figures are restated.
See below the application of the above guidance.
Example 6: Prior period error
During the 31 December 2016 year end, Company A noticed that the prior year financial statements omitted stock of CU100,000 which was material to the financial statements. Stock in the same location was also omitted at year ended 31 December 2014. The inventory in this location at that time was CU95,000. Given the materiality, this error requires a prior year adjustment. Assume a corporation tax rate of 10%. The adjustments required to correct this error are:
In the 31 December 2015 accounts to restate the opening balance
|
|
CU |
CU |
|
Dr Inventory |
95,000 |
|
|
Cr Profit and Loss Reserves (CU95,000-CU9,500 of current tax) |
|
85,500 |
|
Cr Corporation Tax Liability (CU95,000*10%) |
|
9,500 |
Being journal to reflect adjustment in respect of prior years’ including the additional tax payable
|
|
CU |
CU |
|
Dr Inventory |
5,000 |
|
|
Cr Cost of Sales |
|
5,000 |
|
Dr Current Income Tax in P&L (CU5,000*10%) |
500 |
|
|
Cr Corporation Tax Liability |
|
500 |
Being journal to reflect movement on stock incorrectly excluded from 2014 to 2015 and the related corporation tax payable as a result
See below an example of how this should be disclosed so as to meet the ROI disclosure requirements. The UK does not require this disclosure.
Example disclosure: (Applicable to ROI companies only)
Profit and Loss Account
|
2016 |
2015 Restated |
|
|
|
CU |
CU |
|
|
|
|
|
Turnover |
1,600,000 |
1,500,000 |
|
Other income |
5,000 |
5,000 |
|
Cost of raw materials and consumables |
(1,220,000)
|
(1,100,000)
|
|
Staff costs |
(1,000)
|
(10,000)
|
|
Tax |
(38,400)
|
(39,500)
|
|
|
|
|
|
Profit for the financial year |
345,600
|
355,500
|
Note the lines ‘Prior year adjustment – change in accounting policy (see note X)’ is just included for illustrative purposes. The below disclosures are only required for ROI Companies.
Movement on profit and loss reserves[1]
|
|
|
2016
CU |
|
2015 Restated CU |
|
Profit and loss reserves brought forward at 1 January as previously reported [2] |
|
414,600 |
|
63,600 |
|
Prior year adjustment – correction of material error (see note X) |
|
90,000 |
|
85,500 |
|
Prior year adjustment – change in accounting policy (see note X) |
|
– |
|
– |
|
Profit and loss reserves brought forward at 1 January as restated |
|
504,600 |
|
149,100 |
|
Profit for the financial year as previously reported |
|
345,600 |
|
351,000 |
|
Prior year adjustment – correction of material error (see note X) |
|
– |
|
4,500 |
|
Prior year adjustment – change in accounting policy (see note X) |
|
– |
|
– |
|
Profit for the financial year as restated |
|
345,600 |
|
355,500 |
|
Dividend declared and paid (for illustrative purposes) [3] |
|
(x) |
|
(x) |
|
Transfer (to)/from other reserves (for illustrative purposes) |
|
– |
|
– |
|
Purchase/redemption of own shares (if applicable) |
|
– |
|
– |
|
Profit and loss reserve at 31 December |
|
850,200 |
|
504,600 |
[1] Sch 3B(33) requires disclosure of change in P&L reserves and any transfers and dividend to show the balance at the start and end of each year. If not shown in P&L then must be disclosed in the notes. Required to be disclosed in abridged financial statements.
[2] Sch 3B of CA 2014 as amended by CAB 2016 requires the movement on profit and loss reserves to be shown on the face of the P&L.
This can also be called an income statement
[3] Sch 3B(48) requires disclosure of the dividend per share and what shares were declared and paid or declared by not paid in the year in the notes.
Example 7: Prior year adjustment – Change in functional currency – extract from notes to the financial statements for an ROI company – not applicable for a UK company as disclosures not required:
Historically, financial statements for the company were prepared on the basis that the FC was the functional currency of the entity. During the current year the directors considered further the functional currency and have determined that the CU is, and always was, the functional currency that most accurately portrays the economic results of the company and thereby achieves the objective of foreign currency translation. As a result, the financial statements for the year ended 31 December 2015 are prepared in CU and the comparative numbers restated.
The 2014 results and financial position for comparative purposes were restated to CU as follows:
-Assets and liabilities which were denominated in CU are shown at the actual CU balance at 31
December 2014 and non CU denominated balances were retranslated at the year end spot rate
|
Balance Sheet |
||||||
|
As restated |
||||||
|
2014 |
2014 |
|||||
|
$ |
CU |
|||||
|
Creditors: amounts falling due within one year |
(100,155) |
(175,118) |
||||
|
Creditors: amounts falling due after more than one year |
(416) |
(666) |
||||
|
(100,571) |
(175,784) |
|||||
|
Capital and Reserves |
(100,571) |
(175,874) |
||||
|
|
|
|
||||
|
Profit and Loss Account |
||||||
|
As restated |
||||||
|
2014 |
2014 |
|||||
|
$ |
CU |
|||||
|
Other expenses |
(4,039) |
(8,241) |
||||
|
Loss for the financial year |
(4,039) |
(8,241) |
||||
|
|
||||||
Principal transition adjustments
- Prior year adjustment due to an item which was material in the prior year not being corrected as it was not a fundamental error under FRSSE.
Under FRSSE a prior year adjustment was only required where a fundamental error arose. Fundamental was a higher threshold to meet than material. Under Section 8, a prior year adjustment is required for a material error. Therefore if in the 2015 financial year (assuming 2016 is the first year preparing the financial statements) there was not an error corrected on the basis that it was not fundamental, a prior year restatement will be required such that the comparative years balance sheet will have to be adjusted. An example of a prior year error has been included in the example above. No specific disclosure is required on transition to FRS 105 as a result of this error as it is the first year on transition.
Note this difference is not applicable for a company transitioning from FRS 102 as all material adjustments have to be made.
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