21.2 Changes in Accounting Policies

IAS 8 allows accounting policies to be changed in only two situations:

• The policy change is required by an IFRS.
• The new policy results in financial statements that are reliable and more relevant.

In the first case, the IFRS itself will usually provide guidance on how and when to implement the change. Sometimes these transitional procedures are quite complex, but IFRS generally allows reasonable amounts of time for companies to adapt to the new policies. As a general rule, the more complex the issues involved in the new policies, the longer the transition period allowed. For example, IFRS 15, the new revenue recognition standard, was published in May 2014, but companies are not required to implement it until January 1, 2018. Most new IFRSes allow for early adoption, that is, before the required transition date, and many companies will be proactive and implement the change early.

The second situation is referred to as a voluntary policy change. For this type of change the resulting information must still be considered sufficiently reliable and must also be more relevant. This condition obviously creates a situation where management must demonstrate logic and sound judgment. It is not generally sufficient to change accounting policies simply to create an effect in net income without providing any further justification. Management would need to demonstrate that the new policy better meets the needs of the financial statement readers in terms of helping them to understand the underlying economic reality of the company. As well, management would have to demonstrate that the level of reliability inherent in the information is still sufficient to meet the general requirement of representational faithfulness. A simple example of this type of change would be a company’s decision to report certain property, plant, and equipment assets under the revaluation model rather than the cost model. The company may think that current value information is more helpful to financial statement readers than historical cost information. While this justification is quite reasonable, the company would have to make sure that the information on fair values had sufficient reliability to justify the change in policy. Note that the new level of reliability does not have to equal that of the old policy, but must simply be considered sufficient. In our example, while it is unlikely that fair value information would be as reliable as historical cost information, the new information could still be considered sufficiently reliable under the requirements of the fair value hierarchy.

Of course, it is not always easy to prove that one type of information is more relevant than another. Relevance is very subjective, and readers of financial statements will have different ideas of what information they require. As well, the question of relevance is unique to each business, and different companies may come to different conclusions about the accounting policy choices that they need to implement. In each case, management and the accountants advising them will need to use sound judgment and good sense in order to choose the best accounting policies suited to the circumstances facing the company.

To summarize: under IFRS, one of the following two situations is required for a change in accounting policy to be acceptable:

1. the change is required by a primary source of GAAP.
2. a voluntary change results in the financial statements presenting reliable and more relevant information about the effects of the transactions, events, or conditions on the entity’s financial position, financial performance or cash flows.

ASPE allows a third type of accounting policy change to be made without having to meet the relevant and reliable test.  ASPE allows voluntary changes in policy to be made:

between or among alternative ASPE method of accounting and reporting for:

1. investments in subsidiary companies and in companies where the investor had significant influence, or joint control.
2. expenditures during the development phase on internally developed intangible assets.
3. defined benefit plans.
4. income taxes
5. measuring the equity component of a complex financial instrument.

21.2.1. Applying Voluntary Accounting Policy Changes

IAS 8 requires voluntary accounting policy changes to be treated retrospectively, meaning that after the new policy has been applied, the financial statements should appear as if the policy has always been in effect. The purpose of this approach is to maintain the comparability of current financial results with previous periods. Readers of financial statements need to make decisions regarding current results, and one of the criteria they may use is the change in performance from previous periods. Obviously, if an accounting policy was changed, and the prior periods were not restated, it would be impossible to make any meaningful comparisons.

Several steps are involved in retrospective application of policy changes:

1. The cumulative effect of the policy change on previous periods must be determined.
2. A journal entry is made to record the effect of this change. This adjustment will affect the appropriate category of equity and any other balance sheet amounts at the start of the current period.
3. Any financial statements that are presented for comparative purposes will also be restated to reflect the policy change. The opening balance of the relevant equity account on the earliest financial statement presented will need to be adjusted for the cumulative effect at that time. As well, any earnings per share disclosures will need to be adjusted.
4. Disclosures are made to provide details of the reasons and effects of the policy change.

These steps can be demonstrated with the following example. Dameron Inc. purchased a piece of vacant land on January 1, 2020. The company intended to develop the property into a commercial shopping mall. The original purchase price was $2,000,000 and the company chose to apply the cost method to the property. However, in 2022, the company decided to then apply the fair value method as allowed under IAS 40, as management believed that this method would provide more relevant information to financial statement readers. No development work had yet been performed on the property, but the company was able to obtain independent, reliable appraisals of the fair value of the property as follows:

On the 2020 and 2021 financial statements, the property was originally reported at its historical cost, which means there was no effect on the reported income in those periods. The company pays corporate income tax at the rate of 20%. The following information summarizes the effects of the change (take the income before tax figures as given):

Recall that the effect of applying IAS 40 is that every year, any changes in the fair value of the investment property will be reported as a gain or loss directly on the income statement. For example, in 2020 the property’s fair value drops by $150,000 () during the year, so net income is reduced accordingly from $680,000 to $530,000. In 2021, the fair value increases by $250,000 () so the income in that year is increased. Note as well that there is an income tax effect to the change each year. Although changes in fair value of an investment property are not usually directly taxable, there would still be an effect on the deferred taxes reported by the company.

In 2022, the company needs to record the effect of the change on opening balances. The books for 2020 and 2021 are already closed, but the books for 2022 are open. Thus, the cumulative effect up to the end of 2021 must be adjusted through retained earnings, net of the relevant tax effect. The fair value of the property on December 31, 2021 is $2,100,000 while the original cost is $2,000,000. A gain of $100,000 must be reflected in the carrying amount of the investment. The effect on the prior year’s net income would be $80,000 ($100,000 gain less the tax effect) and the remaining $20,000 is reported as a deferred tax liability. The following journal entry will record this effect:

This journal entry corrects the land and deferred tax liability balances to the values that would have existed had the policy been implemented when the land was first purchased. As adjustments under IAS 40 flow to the income statement, the correct equity account to capture the net effect of the adjustment is retained earnings. In 2022, now that the policy has been implemented, the company will simply report the adjustment to fair value in the normal fashion as required by IAS 40.

If 2020 and 2021 are both being presented as comparative information in the 2022 financial statements, then the revised statements above would be presented with the heading “restated,” along with note disclosures describing the change (this will be discussed later in the chapter). However, many companies only present one year as comparative information on current financial statements. If Dameron Inc. uses the former approach, then the retained earnings portion of the statement of changes in shareholders’ equity would look like this:

By identifying the effect of the change on opening retained earnings, the financial statements allow readers to compare the results to previously published financial statements. As well, IFRS requires the presentation of an opening restated balance sheet for the earliest comparative period. This presentation, along with the explanatory notes, should help maintain the consistency needed to satisfy the decision needs of those financial statement readers.

21.2.2. Impracticability

IAS 8 contemplates the possibility that it may be impracticable to apply an accounting change retrospectively. This may occur when, despite the accountant’s best efforts, the information needed to determine the effect on prior periods is not available. Additionally, it is possible that in order to determine the effect assumptions need to be made about management’s intentions in a prior period. Another possibility is that assumptions about conditions existing at the previous financial statement date need to be made in order to determine the effect. However, it is impossible for the accountant to determine if that information would have been available. When any of these circumstances occur, it is impossible for the accountant to reliably determine the effect of the policy change on prior period financial statements. It is important that the accountant not apply hindsight when determining the practicability of applying an accounting change. Information may have become available after a previous reporting period, but the accountant shouldn’t use this information to make estimates for that period or to determine management intent if it wasn’t available at the time.

Obviously, the accountant will need to apply reasoned judgment to determine if retrospective application is warranted or not. If, after careful consideration of all the facts, the accountant decides that retrospective application is impracticable, then the accountant can only apply the change to the earliest possible period where it is practicable. This means that the accountant may be able to partially apply the retrospective technique, that is to some previous years, but not to all. If there is no way to determine the effect of the change on prior periods, then the change will be applied prospectively, that is in the current year and in future years only. Additionally, full disclosure must be made for the reasons for not applying the change retrospectively.