- 15 Marks
Question
International Accounting Standard 8 (IAS 8) Accounting Policies, Changes in Accounting Estimates and Errors prescribes the criteria for selecting and changing accounting policies, accounting for changes in estimates, and reflecting corrections of prior period errors. Changes in accounting policies and corrections of errors are generally accounted for retrospectively unless this is impracticable; whereas changes in accounting estimates are generally accounted for prospectively.
Required:
(a) Advise the CFO on the circumstances where an entity may change its accounting policies, setting out how a change in accounting policy is applied and the difficulties faced by entities when a change in accounting policy is made. (8 Marks)
(b) Discuss why the current treatment of prior period errors could lead to earnings management by companies, together with any further arguments against the current treatment. (7 Marks)
Answer
(a) Circumstances Where an Entity May Change Its Accounting Policies:
An entity can change its accounting policy only if:
- It is required by a standard (e.g., IFRS requires the change).
- The change results in more reliable and relevant financial information.
Application of Change in Accounting Policy:
- Retrospective application if no specific transitional provisions exist.
- Adjust opening balances of assets, liabilities, and equity for prior periods.
- If retrospective application is impracticable, apply the policy prospectively.
Difficulties in Changing Accounting Policies:
- Data for prior periods may not be available.
- Complex estimations needed for retrospective application.
- Restatements may require assumptions about past conditions, which may not reflect current realities.
- Use of hindsight is prohibited by IAS 8, adding to complexity.
(b) Prior Period Errors and Earnings Management:
Potential for Earnings Management:
- Errors are corrected retrospectively, impacting retained earnings rather than current profits.
- Managers may intentionally misstate earnings, knowing future corrections will not affect current performance metrics.
Arguments Against Current Treatment:
- Use of Hindsight: Managers may exploit retrospective adjustments to manipulate financial results.
- Reduced Transparency: Errors corrected through retained earnings may obscure their impact on performance.
- User Confusion: Users may find it challenging to track the impact of errors on profitability and financial stability.
- Uploader: Dotse