Accounting Guideline

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1 Accounting Guideline GAP 3 Accounting Policies, Changes in Accounting Estimates and Errors All rights reserved. No part of this publication may be reproduced, stored in retrieval system, or transmitted, in any form or by any means, electronic mechanical, photocopying, recording, or otherwise, without the prior permission of the National Treasury of South Africa. Permission to reproduce limited extracts from the publication will not usually be withheld. Though National Treasury (NT) believes reasonable efforts have been made to ensure the accuracy of the information contained in the guideline, it may include inaccuracies or typographical errors and may be changed or updated without notice. NT may amend these guidelines at any time by posting the amended terms on NT's Web site. Note that this document is not part of the GAP standard. The GAP takes precedence while this guideline is used mainly to provide further explanations on the concepts already in the GAP.

2 Contents 1. INTODUCTION SCOPE BIG PICTUE ACCOUNTING POLICIES Initial setting of an accounting policy No standard of GAP available to apply to a transaction Consistent application of accounting policies Subsequent change in accounting policies Instances that will not result in a change in accounting policy Applying changes in accounting policies Disclosure Illustrative examples ACCOUNTING ESTIMATES Applying a change in an accounting estimate Disclosure Illustrative examples EOS Correction of errors Disclosure Illustrative examples LIMITATIONS TO ETOSPECTIVE APPLICATION DIECTIVES GAP reporting framework Transitional provisions SUMMAY OF KEY PINCIPLES Selection of accounting policy Change in accounting policy January 2014 Page 2

3 9.3 Change in accounting estimate Prior period error Difference between retrospective application and restatement January 2014 Page 3

4 1. INTODUCTION This document provides guidance on the criteria for selecting and changing of accounting policies, the accounting treatments and disclosure of changes in accounting policies, changes in accounting estimates and correction of errors. The content should be read in conjunction with GAP 3 (issued February 2010) and includes any changes made by the board in terms of the Improvements to Standards of GAP. For purposes of this guide, entities refer to the following bodies to which the standards of GAP relate to, unless specifically stated otherwise: Public entities Constitutional institutions Municipalities and all other entities under their control Parliament and the provincial legislatures Explanation of images used in the manual: Definition Take note Management process and decision making Example January 2014 Page 4

5 2. SCOPE GAP 3 is applicable to all entities preparing their financial statements on the accrual basis of accounting. Note that changes in accounting policies, changes in accounting estimates and corrections of prior period errors relating to taxation, where applicable, must be accounted for in accordance with the International Accounting Standard on Income Taxes (IAS 12). Entities will comply with GAP 3 for all changes in accounting policies, changes in accounting estimates and errors where no other specific standard or directive provides guidance and/or transitional provisions, e.g. where a specific standard or directive provides transitional provisions on adopting of a new standard of GAP or applying amendments to a standard of GAP, the provisions in that standard should be followed and not GAP 3. January 2014 Page 5

6 3. BIG PICTUE January 2014 Page 6

7 4. ACCOUNTING POLICIES Accounting policies are specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting its financial statements. Accounting policies describe the manner in which an entity has elected to account for similar types of transactions in its financial statements. 4.1 Initial setting of an accounting policy When an entity initially develops an accounting policy, the entity will use the specific standard of GAP to develop the accounting policy. Note that for this purpose, standard of GAP comprises the standards, interpretations and directives issued by the Accounting Standards Board (ASB). A good example is the development of the accounting policy for the recognition and measurement of property, plant and equipment in terms of GAP 17 on Property, Plant and Equipment. An accounting policy must always be in line with the applicable standard of GAP when initially adopted. Example 1: Accounting policy extract Property, plant and equipment Items of property, plant and equipment are recognised as assets on acquisition date and are initially recorded at cost. The cost of an item of property, plant and equipment is the purchase price and other costs attributable to bring the asset to the location and condition necessary for it to be capable of operating in the manner intended by the entity. What should be included in accounting policies Ensure that the following basic principles are addressed as a minimum when developing the policies, i.e.: Initial recognition, initial measurement, subsequent measurement, impairment, derecognition and presentation (where relevant). Take note that not all of these principles will necessarily be applicable to all items in the financial statements. A review of the accounting policies is necessary once the applicable standard of GAP changes. In many instances, the standard of GAP will provide for transitional provisions which will be used to apply the new requirements. The accounting policy therefore also needs to be changed to be in line with the relevant accounting standard to which it relates. Currently the transitional provisions are issued as part of the Directives issued by the ASB (refer to the section on Directives for detail). January 2014 Page 7

8 When an accounting policy is selected, any other relevant interpretations issued by the Accounting Standards Board (ASB) need to be considered. A very important source of information to consider is Directive 5 on Determining the GAP reporting framework issued by the ASB. This directive will be discussed later. Standards of GAP set out the requirements for accounting policies, but need not be applied when the effect of the application of these policies will not be material. However, an entity may not consider not complying with an accounting policy to misrepresent the entity s financial position, financial performance and cash flows. 4.2 No standard of GAP available to apply to a transaction In cases where no standard of GAP is available to initially develop an accounting policy, management must use their judgement when determining the accounting policy in line with the hierarchy provided in GAP 3 (refer to figure 2). The following key principles need to be considered: elevant to economic decision-making needs of users eliable financial statements which: represent faithfully the financial position, financial performance and cash flow; reflect the economic substance of transaction, not only the legal form; and are free from bias Are complete in all material aspects Directive 5 provides guidance on which standards to apply. Where no guidance is available, a very strict hierarchy must be followed to determine a specific accounting policy. While considering the above key principles, the following hierarchy is used to determine which standard or guidance to follow: January 2014 Page 8

9 1 st equirements of Standards of GAP or Interpretations dealing with similar / related issues 2 nd The Framework for the Preparation and Presentation of Financial Statements (definitions, recognition criteria and measurement criteria) 3 rd Pronouncements of the International Public Sector Accounting Standards Board (IPSAS) 4 th The International Accounting Standards Board (IASB) 5 th The International Financial eporting Interpretations Committee (IFIC) or the former Standing Interpretations Committee of the IASB 6 th Accounting Practices Board (APB) Figure 1 When an entity uses pronouncements of, for example other standard-setting bodies, it should ensure that it is not in conflict with similar standards of GAP or the Framework. For example an entity is not allowed to use IAS 20 on Government Grants issued by the IASB to development its accounting policy for revenue from non-exchange transactions as the standard is in conflict with the existing standard, GAP 23 on evenue from Non-exchange Transactions. 4.3 Consistent application of accounting policies Users of financial statements should be able to compare the current period presented to previous periods. It is therefore crucial that the accounting policies are consistent from period to period. Accounting policies must also be applied consistently for similar transactions. The only exception is if a standard of GAP specifically requires or permits items to be split into categories and a separate accounting policy is applicable for each category. January 2014 Page 9

10 Example 2: Accounting policies for different categories of inventory Different categories of inventory may be accounted for using different accounting policies, for example: Finished goods first-in-first-out method aw materials weighted average method GAP 17 on Property, Plant and Equipment is another excellent example. Each class of property, plant and equipment must be categorised and a different accounting policy may be applicable for each class of property, plant and equipment. Categories vs. Classes Categories are predetermined in the standards of GAP and are fixed, for example categories of financial instruments, whilst classes are determined by management. The standards may provide examples of different classes, but it is up to management to decide which classes will be used in the financial statements. An example is items of property, plant and equipment, where a class may be office furniture, computer equipment, etc. The following is an extract from the accounting policy for property, plant and equipment found in the annual financial statements of a public entity (only for illustration purposes): Example 3: Accounting policy extract Property, plant and equipment Class of property, plant and equipment Model Depreciation method Useful life Plant and machinery Cost Straight line over useful life Office equipment Cost Straight line over useful life Motor vehicles Cost 20 % diminishing balance method IT equipment Cost Straight line over useful life 7 years 5 years 5 years 3 years Land evaluation Not depreciable Indefinite Buildings evaluation Straight line over useful life 20 years The residual value and useful life of each asset are reviewed at each financial periodend. As illustrated in the above extract, each class of property, plant and equipment has its own accounting model and depreciation method, in other words, accounting policy for recognition and measurement. January 2014 Page 10

11 Note that according to GAP 3, the initial application of a policy to revalue assets in accordance with GAP 17 on Property, Plant and Equipment, GAP 31 on Intangible Assets and GAP 103 on Heritage Assets, should be dealt with as a revaluation in accordance with GAP 17, GAP 31 and GAP 103. GAP 3 will not be used. 4.4 Subsequent change in accounting policies After the initial accounting policy has been set, using a specific standard or judgement where no specific standard exists, GAP 3 will be applied. The accounting policy must ensure the quality and reliability of all information presented in the financial statements as envisaged by the qualitative characteristics of financial reporting in the Framework for the Preparation and Presentation of Financial Statements. These are: Understandability elevance Materiality eliability Faithful presentation Neutrality Prudence Completeness Comparability Figure 2 Therefore, an accounting policy will change in accordance with GAP 3 when it no longer conforms to the above characteristics. It will be necessary to change an accounting policy only if: A change is required by a standard of GAP; or A change in the current accounting policy will result in more reliable and relevant information about the impact of transactions and events on the entity s financial statements. The above two prerequisites are the only reasons when a change in accounting policy can be justified. A change in the accounting treatment, recognition or measurement of a transaction, event or condition will be a change in accounting policy. January 2014 Page 11

12 An entity should not consistently keep changing its accounting policies as this will negatively impact the comparability of the entity s results from one period to another. It will also limit the ability of the user of the financial statements to establish trends in an entity s financial position, financial performance and cash flows. Apart from these reasons it is also a costly and time consuming exercise. Example 4: What may constitute a change in accounting policy An entity accounts for its property, plant and equipment on the cost basis, but decides to adopt the revaluation method in accounting for these items due to a decision on how it will manage the assets. An entity that previously accounted for its investments in joint ventures using the equity method decides to rather adopt the proportionate method, as management is of the view that this method provides more relevant information about the effects of the transactions. A change from one basis of accounting to another basis of accounting is a change in accounting policy, therefore if a department moves from the modified cash basis to the accrual basis of accounting, it will be a change in accounting policy and GAP 3 should be applied. 4.5 Instances that will not result in a change in accounting policy Certain events or transactions do not qualify as a change in accounting policy, namely: Application of an accounting policy for transactions or events that differ in substance from those previously occurring Another existing accounting policy will be used applicable to the specific type of transaction or substance of the transaction Application of a new accounting policy for transactions or events that did not occur preciously or that were immaterial This would represent a new accounting policy being applied to a new type of transaction or event Figure 3 January 2014 Page 12

13 Example 5: Application of an accounting policy to a transaction that differs in substance from the previous transaction An entity leases equipment which, after taking substance over form into account, qualifies as an operating lease. The lease contract expires and management decides to change the contract with the lessor. After considering the substance of the new lease contract, the lease now qualifies as a finance lease. The transaction is consequently different in substance, from the previous transaction and the accounting policy for finance leases will now be applied. This will not result in a change in accounting policy. Example 6: Application of a new accounting policy An entity acquires a building in the current period which qualifies as an investment property. The entity previously never had investment property. Other land and buildings owned by the entity, qualifies as owner-occupied property, and therefore the accounting policy for property, plant and equipment is used. No accounting policy existed for investment property; therefore this situation qualifies as an adoption of a new accounting policy, not a change in accounting policy. Example 7: A transaction that was previously regarded as immaterial In the prior financial periods an entity had very low levels of borrowings; as a result the entity did not separately disclose its borrowing costs as they were insignificant in relation to other expense items. During the current financial year the entity raised a significant amount of finance in order to undertake a specific project. As a direct result the borrowing cost incurred by the entity increased to the extent that it now represents a material amount. The entity now adopts a policy whereby borrowing costs are capitalised to the cost of the qualifying asset. The adoption of this accounting policy will qualify as a new accounting policy and will therefore not be treated as a change in accounting policy. 4.6 Applying changes in accounting policies GAP 3 outlines the following important aspects: Guidance on change in accounting policy exists in the specific standard Account for change on initial application of standard in accordance with the transitional provisions of that standard No specific guidance exists on change in accounting policy Account for the change in accordance with GAP 3 etrospective adjustment of change in accounting policy Voluntary change in accounting policy Account for the change in accordance with GAP 3 etrospective adjustment of voluntary change in accounting policy Figure 4 January 2014 Page 13

14 A voluntary change in accounting policy will occur when the entity has applied an accounting policy from other standard-setters in the absence of a standard of GAP for a specific transaction or event and that standard has been amended. Therefore the entity applied the hierarchy provided in GAP 3, see figure 2 for detail. If a standard is not yet effective, but the effective date has been determined by the Minister of Finance, i.e. it has been issued and approved, an entity may want to early adopt the specific standard. This decision will not be a voluntary change in accounting policy. The change in accounting policy will be accounted for in accordance with the transitional provisions of that particular standard. The main objective of retrospective application is to adjust the financial statements as if the entity had always been applying the accounting policy as in the current year. Therefore, the change must be reflected not only in the current period, but also in the comparative periods' figures shown in the statement of financial position, statement of financial performance, statement of changes in net assets, cash flow statement and notes to the financial statements. Example 8: Change in accounting policy An example of an entity s statement of financial position (2008 has only been included for illustrative purposes): Extract from Statement of Financial Position Current Assets Note Cash and cash equivalents 4 9,000 5,000 2,500 Deposits ,500 1,000 Accounts receivable 6 8,400 5,700 4,800 In the above example the retrospective adjustment will be applied to Accounts receivable. The first step in applying retrospective adjustment is to start from the earliest year presented, thus, 2009 s opening balance (thus the closing balance for 2008). After adjusting 2009 s opening balance, the next step will be to adjust 2009 and then the current year. For each year presented the period specific adjustment must be made and the cumulative effect in each year s closing balance must be accounted for. January 2014 Page 14

15 The steps discussed in the above example can be illustrated as follows: 2009 Opening balance adjusted Apply in 2009 movement Closing balance adjusted 2010 Opening balance adjusted Apply in current year Figure 5 Example 8: Change in accounting policy (cont.) Let s further consider the example of Accounts receivable : Closing balance in ,800 Plus: movement in Equals: closing balance in ,700 Plus: movement in ,700 Equals: closing balance in ,400 As can be seen from above, the closing balance of the previous period affects the opening balance of the current period, i.e. it has a cumulative effect, and the closing balance for 2008 plus movements in 2009 equals the opening balance for Consequently if you are applying a change in accounting policy retrospectively, the opening balance for the earliest period presented, which is the closing balance for the period before that, i.e must be adjusted with the cumulative effect on all prior periods (2008 and back) and then every other opening and closing balance thereafter must be adjusted with the cumulative effect, i.e and In addition to adjusting the opening and closing balances with the cumulative effect, the period specific adjustments, i.e. movement for the period, must also be adjusted, which will be the effect on the surplus or deficit or assets or liabilities. emember that an adjustment to prior periods affecting surplus or deficit will always be made to accumulated surplus or deficit. This is best illustrated by showing the journal entries. efer to the example below. January 2014 Page 15

16 Example 8: Change in accounting policy (cont.) If we take the same information as in Example 8 above and assume the following: Previously shown: Should be: Closing balance in ,800 5, Plus: movement in , Equals: closing balance in ,700 6, Plus: movement in ,700 2,500 Equals: closing balance in ,400 8,500 Adjustment: The journal entries to adjust the accounts receivable balance will be as follows: 2009 Debit Credit Accounts receivable 200 Accumulated surplus/deficit (opening balance) Adjust the opening balance for Debit Credit Accounts receivable 100 evenue (against surplus/deficit) 100 Account for the movement in Debit Credit Accounts receivable 2,500 evenue (against surplus/deficit) 2,500 Account for movement in 2010 As can be seen, any adjustments that affect surplus or deficit should be made against accumulated surplus or deficit (see first journal entry in 2010). In 2010, the total movement for the period is journalised as it is the current reporting period. January 2014 Page 16

17 The diagram below summarises the application of a change in accounting policy: Specific transitional provisions contained in relevant GAP Standard? YES Apply specific transitional provisions NO Apply change retrospectively Does the standard require retrospective application? NO YES Apply change prospectively Practicable? Impracticable? Adjust opening balance of each affected component of net assets for earliest period presented Adjust comparative amounts disclosed for each prior period presented as if the new policy had always applied Impracticable to determine period-specific effect Impracticable to determine cumulative effect of changes Apply new accounting policy to carrying amount of assets and liabilities as at the beginning of the earliest period for which the retrospective application is possible Make a corresponding adjustment to the opening balance of each of the affected components of net assets Adjust comparative information to apply new accounting policy prospectively from the earliest date possible Figure 6 January 2014 Page 17

18 4.7 Disclosure Disclosure relating to accounting policies is divided into three basic groups: Would have an effect or may have an effect on current period and prior periods No effect on current period and prior period periods Initial adoption of a Standard of GAP Voluntary change in accounting policy New Standard of GAP that has been issued but not effective yet Figure 7 Below are examples illustrating the disclosure required relating to accounting policies for the three basic groups as indicated above (refer to the standard for detail): Illustrative example A - initial adoption of a Standard of GAP Extract from Notes to the Financial Statements 1) New standards Standards effective and adopted in the current period In the current period the entity has adopted the following standards that are effective for the current period: GAP x Insert nature of new standard or change, for example, the standard prescribes the accounting treatment, recognition measurement and disclosure requirements for employee benefits. Insert impact of standard adopted, for example, the adoption of the standard has had no material impact on the results of the entity, but has resulted in increased disclosure. Insert reference to the note where the effect is disclosed, if the adoption of the standard had an impact of the results of the entity, for example, refer to note x for the effect on the current and prior periods on initial adoption of the standard. January 2014 Page 18

19 The effect on the current and prior periods are disclosed below: Statement of Financial Position 20x1 20x0 Asset XX XX Liability XX XX Statement of Financial Performance evenue XX XX Expense XX XX Statement of Changes in Net Assets Opening accumulated surplus/deficit Illustrative example B - voluntary change in accounting policy Extract from Notes to the Financial Statements 1) Change in accounting policy Insert nature of change, for example, the entity has changed its accounting policy on xxx with regards to the measurement of xxx as management is of the view that it will provide reliable and more relevant information; the reason being xxx. The effect on the current and prior period is shown below. The effect on the current and prior period are disclosed below: Statement of Financial Position 20x1 XX 20x0 Asset XX XX Liability XX XX Statement of Financial Performance evenue XX XX Expense XX XX January 2014 Page 19

20 Illustrative example C - standards of GAP issued, but not yet effective Extract from Notes to the Financial Statements 1) New standards Standards issued, but not yet effective The entity has not early adopted the following standards of GAP for which an effective date has been determined and/or has not yet applied the following standards of GAP due to the fact that the Minister of Finance has not yet determined the effective dates thereof: GAP x Insert nature of impending change, for example, the standard prescribes the accounting treatment, recognition measurement and disclosure requirements for financial instruments. Insert possible impact on the entity s financial statements on application of the standard once it will be adopted initially, for example, the adoption of the standard will result in financial instruments to be recognised, measured and disclosed differently than currently required. The standard has been approved by the Accounting Standards Board, but its effective date has not yet been determined by the Minister of Finance. The entity expects to adopt the standard once an effective date has been determined. O The effective date of the standard is for financial periods beginning on or after xxx. The entity expects to adopt the standard in the xxx financial period. A change in accounting policy must be disclosed in the period the change occurred. The financial statements for subsequent periods need not repeat the required disclosure relating to changes in accounting policies. 4.8 Illustrative examples Example D change in accounting policy (retrospective application) An entity decided to change its accounting policy for valuing inventory from weighted average to first-in-first-out (FIFO) according to GAP 3. Management is of the opinion that changing to the FIFO method will provide more reliable information for users of financial statements. The entity kept full history of all inventory purchased and issued to other departments and sales to the public, therefore, it is able to determine the effect of the change in accounting policy on prior periods. January 2014 Page 20

21 The change was made at the end of the 2010 financial period (31 March 2010). The effect of the change in accounting policy on the two comparative periods presented (only for illustration purposes) was determined and the value of inventories on the different bases is as follows: 30 June 2010 Inventory closing balance - Weighted average method 4,750 Inventory closing balance - FIFO method 4,900 Surplus from operating activities using FIFO method 101, June 2009 Inventory closing balance - Weighted average method 3,500 Inventory closing balance - FIFO method 3,800 Surplus from operating activities using Weighted average method 90, June 2008 Inventory closing balance - Weighted average method 2,100 Inventory closing balance - FIFO method 2,300 Surplus from operating activities using Weighted average method 88, June 2007 Inventory closing balance - Weighted average method 1,900 Inventory closing balance - FIFO method 2,150 Surplus from operating activities using Weighted average method 81,600 Opening accumulated surplus/deficit 250,000 Note that inventory was first purchased in 2007 Extract from Statement of Financial Performance estated Note Surplus for the period 1 101,050 90,600 88,350 Note that the applicable expense line item will (90, ) (88, ) January 2014 Page 21

22 also be affected, for this example, only the effect on surplus has been shown Notes on the calculation of the adjustments to be made to the applicable expense line item and ultimately surplus: 2008: Surplus for the period (previously reported in 2008) Deduct difference between weighted average and FIFO opening balance of inventory in 2008 Add difference between weighted average and FIFO closing balance of inventory in ,400 1,900 2,150 (250) 1 2,100 2, Opening balance of inventory increased due to change from weighted average to FIFO, the effect on surplus will be a decrease 2 Closing balance of inventory increased due to change from weighted average to FIFO, the effect on surplus will be an increase 2009: Surplus for the period (previously reported in 2009) Deduct difference between weighted average and FIFO opening balance of inventory in 2009 Deduct difference between weighted average and FIFO closing balance of inventory in ,500 2,100 2,300 (200) 1 3,500 3, Opening balance of inventory increased due to change from weighted average to FIFO, the effect on surplus will be a decrease 2 Closing balance of inventory increased due to change from weighted average to FIFO, the effect on surplus will be an increase In order to know what the effect on surplus will be due to an increase or decrease in inventory, one needs to understand how the amount for the expense line item in the statement of financial performance is calculated. The following formula is used: Opening balance (inventory) + purchases closing balance (inventory) = cost of sales (the expense line item in the statement of financial performance) Therefore an increase in the closing balance of inventory will increase the surplus, or reduce the deficit, as the amount for the expense will be lower. January 2014 Page 22

23 Similarly, a decrease in the closing balance of inventory will decrease the surplus, or increase the deficit, as the amount for the expense will be higher. The opposite will be happen for an increase or decrease in the opening balance of inventory. Extract from Statement of Financial Position estated Current assets Note Inventory 4,900 3,800 2,300 (closing balance using the FIFO method) Extract from Statement of Changes in Net assets estated Opening accumulated surpluses as previously reported Change in accounting policy with respect to the measurement of inventory Opening accumulated surpluses as restated Note ,500 (420,000+90,500) (3,800-3,500) 420,000 (331,600+88,400) 200 (2,300-2,100) 331,600 (250,000+81,600) 250 (2,150-1,900) 510, , ,850 Surplus for the period 101,200 90,600 88,350 Closing accumulated surpluses 612, , ,200 Extract from Notes to the Financial Statements Change in accounting policy Management decided to voluntarily change the method of valuation of inventory during the period from weighted average cost to first-in-first-out method as the latter method provides a more reliable estimate of the valuation of inventory. The change in accounting policy was applied retrospectively and the corresponding comparative figures were restated. January 2014 Page 23

24 The effect of the individual line items on the financial statements is as follows: Increase / (Decrease) in cost of sales 150 (100) 50 Increase / (Decrease) in surplus for the period (150) 100 (50) Increase inventory opening balance Increase in inventory closing balance Increase in accumulated surplus (250) 150 (50) Illustrative example E change in accounting policy (retrospective application) A public entity owned land previously recognised at cost. The entity decided in 2010 to change the accounting policy to revalue the land as it will provide a more reliable value for the land at year end. After various attempts, management could not obtain enough information to establish the revaluation amounts for the previous periods. Therefore, retrospective application is impracticable. The following information applies: 31 March 2009 Land at cost 100,000 Land at revaluation 500,000 The difference in the cost as previously measured and the revaluation is 400, 000. The application of the new accounting policy should be applied in the earliest period possible, which is the beginning of 2010 financial period. According to GAP 17 Property, Plant and equipment the increase in the value of land carried at revaluation will be recognised in the statement of changes in net assets. Therefore, in the 2010 financial period, a revaluation reserve of 400, 000 will be created on 1 April No retrospective adjustments will be done in the previous period as it is not practicable. Extract from Notes to the Financial Statements Change in accounting policy From the start of 2010, the entity changed its accounting policy for land from the cost model to the revaluation model. Management takes the view that this policy provides more reliable and relevant information, because it is based on up-to-date values. The policy has been applied prospectively from the start of 2010, as it was not practicable to estimate the effects of applying the policy either retrospectively or prospectively from any earlier date. The adoption of the new policy has no effect on prior periods. The effect on the current period is to increase the carrying amount of property, plant and equipment at the beginning of the period by 400, 000 and to create a revaluation reserve at the beginning of the period of 400, 000. January 2014 Page 24

25 5. ACCOUNTING ESTIMATES The use of accounting estimates is an essential part in the preparation of financial statements. They arise as a result of uncertainties inherent in delivering goods, services and conducting trading activities. The use of estimates does not undermine the reliability of the information presented as the estimate should be made using the latest available and most reliable information. As and when the information on which the estimate is based changes, it also becomes necessary to revise the previous estimate. By nature, the revision of an estimate does not have an effect on prior periods and is therefore not a correction of a prior period error. A revision of an accounting estimate won t be seen to be a correction of an error provided the estimate was based on the latest and most reliable information available at the time that the estimate was made. An example of a change in accounting estimate will be the reassessment of the prior period impairment loss based on new information available in the current financial period. The diagram below illustrates the distinction between a change in accounting estimate and correction of an error: When the estimate was originally made, was it based on information that was only available at that point in time? YES NO YES Was the information used reliable and accurate? NO Is the change in estimate as a result of information that can reasonably be expected to have been available at the time when the estimate was made? Change in accounting estimate, apply prospectively Consider error, apply retrospectively YES NO Change in accounting estimate, apply prospectively Figure 8 Other examples of estimations, especially at period end, can include: Estimation of the amount of inventory to be written off due to obsolescence (GAP 12 on Inventory); The fair value of accounts receivable and accounts payable (GAP 104 on Financial Instruments); Useful lives and residual values of property, plant and equipment (GAP 17 on Property, Plant and Equipment); January 2014 Page 25

26 Estimation of the amount for provisions such as provision for rehabilitation of landfill sites (GAP 19 on Provisions, Contingent Liabilities and Contingent Assets); The percentage of completion for construction contracts (GAP 11 on Construction Contracts). Most standards of GAP requiring estimations lay out certain conditions on how and when estimates need to be reviewed. For example, according to GAP 31 on Intangible Assets, the value of an intangible asset with an indefinite useful life, must be reviewed in every financial period for possible impairment. To review the balance, estimates are necessary to evaluate if impairment occurred. These estimates will be made every period and reviewed in subsequent periods for possible changes based on conditions and other relevant factors that exist at the date of subsequent review. evision of estimates will also in most instances be made at the same time in each period, for example management can decide to have a policy to review useful lives and residual values of property, plant and equipment at the end of each financial period. The revision will then take place for each period at the end of the financial period. emember that a change in a measurement basis is not a change in accounting estimate. This is rather a change in accounting policy as in the previous section. A change in accounting estimate results from a change in the underlying, e.g. assumptions/judgements used to determine the amount. If the measurement basis for buildings changes from cost to revaluation, this represents a change in accounting policy. Where the useful life for buildings changes from 20 years to 15 years, this will represent a change in accounting estimate. A change in the depreciation method from, for example, the straight-line method to the reducing balance method, will also represent a change in accounting estimate as the change in the method of depreciation is often rooted in a change in an asset s estimated future cash flows. 5.1 Applying a change in an accounting estimate A change in accounting estimate will be accounted for in the current period and in the future periods if it affects the future periods. The effect of the change in estimate would be accounted for in surplus or deficit or against the asset or liability, where applicable, in the specific period in which the change occurs. The other side of the accounting entry will be the applicable asset or liability in the period of change. January 2014 Page 26

27 An example of a change in an accounting estimate affecting only the current financial period: Allowance for impairment 1 : 1, 000 Allowance for impairment: Change in estimate: 1, 500 1, 000 Change in estimate: Effect 2008 financial period 500 Effect 2009 financial period 1 Allowance for impairment is the same as provision for bad debt Allowance for impairment: 1, 200 Change in estimate: 300 Effect 2010 financial period Figure 9 The illustration above demonstrates how a change in estimate only affects the current period in which the specific event or transaction occurred. The journal entries for the above will be as follows: 2008 Debit Credit Impairment loss on debtors (statement of financial performance) Allowance for impairment (statement of financial position) 1,000 1, Debit Credit Impairment loss on debtors (statement of financial performance) Allowance for impairment (statement of financial position) Debit Credit Impairment loss on debtors (statement of financial performance) Allowance for impairment (statement of financial position) January 2014 Page 27

28 Note that the amounts for the change in estimate in this example only refers to the change in the underlying information on which the estimate was based; therefore it does not include changes due to amounts reversed and/or amounts written off. Note that the change in the amount for the provision recognised is not accounted for retrospectively, i.e. the balance for 2008 for example is not restated in the 2009 financial period due to the change in estimate, only the 2009 balance will be adjusted in the 2009 financial period and the corresponding expense debited or credited with the increase or decrease in the provision, therefore prospectively. An example of a situation where the change in accounting estimate will affect future periods as well is illustrated as follows: Cost price of IT equipment at the beginning of 2008: 60, 000 Useful life at acquisition: 6 years Depreciation per year: 10, 000 Carrying amount end of 2008: 50, 000 Carrying amount end of 2009: 40, 000 emaining useful life end of 2009: 4 years 1Management decided to change the remaining useful life to 1 year as they are planning on replacing the asset end of Figure 10 Carrying amount end of 2010: 30, 000 New estimate of useful life end of 2010: 1 year 1 Therefore change in estimate from 4 years to 2 years at the beginning of 2010 Effect on future periods: Depreciation for 2 years: 2010: 20, : 20, 000 Therefore an adjustment of 10, 000 must be made in 2010 for the increase in depreciation From the second illustration it is clear that the change in accounting estimate in 2010 had an effect on the carrying amount in the future period, i.e A change in accounting estimate will always be made at the beginning of the period and the depreciation for that period onwards will be based on the revised estimate, i.e. over the remaining useful life. Change in estimate was made at the end of 2010, therefore the effect will be calculated based on the carrying amount at the end of 2009 (beginning of 2010) divided by the revised remaining useful life (remaining useful life at the end of 2010 plus one year). January 2014 Page 28

29 The calculation will be as follows: Depreciation for ,000 / 6 10,000 Depreciation for ,000 / 6 10,000 Carrying amount end of ,000 20,000 40,000 emaining useful life assessed to be 2 years and not 4 years at the beginning of 2010 New depreciation for ,000 / 2 20,000 The depreciation for 2010 based on original estimate 60,000 / 6 10,000 Change in estimate 20,000 10,000 10,000 The journal entries for the above will be as follows: 2008 Debit Credit Depreciation (statement of financial performance) Accumulated depreciation (statement of financial position) 10,000 10, Debit Credit Depreciation (statement of financial performance) Accumulated depreciation (statement of financial position) 10,000 10, Debit Credit Depreciation (statement of financial performance) Accumulated depreciation (statement of financial position) 20,000 20, Debit Credit Depreciation 20,000 January 2014 Page 29

30 (statement of financial performance) Accumulated depreciation (statement of financial position) 20,000 The following will be disclosed in the financial statements: Extract from Notes to the Financial Statements Change in accounting estimate The useful life of IT equipment was estimated in 2008 to be 6 years. At the beginning of the current period management has revised their estimate from 4 years to 2 years. The effect of this revision has increased the depreciation charge for the current and the future period by 10, Disclosure Below is an illustration of disclosure required relating to a change in accounting estimates (refer to the standard for detail). Extract from Notes to the Financial Statements Change in accounting estimate Insert the nature and amount of the change in accounting estimate for current and future periods (if applicable), for example, the entity has reassessed the useful lives and residual values of property, plant and equipment which resulted in certain infrastructure assets remaining useful lives to change from x to x years on average. The effect of the change in accounting estimate has resulted in an increase in depreciation amounting to x for the current period. The effect on future periods could not reasonably be determined (only if the effect on future periods cannot reasonably be determined should this be disclosed). 5.3 Illustrative examples A change in accounting estimate must be disclosed in the period that the change occurred. The financial statements for subsequent periods need not repeat the above disclosure. Further take note that GAP 1 - Presentation of Financial Statements also requires disclosure on key sources of estimation uncertainty, i.e. the natures of the assumption or other estimation uncertainty used in determining estimates as part of the accounting policies or in the relevant note (refer to the accounting guideline on GAP 1 for detail). Illustrative example F change in an accounting estimate prospective application The management of a public entity realised, during their annual assessment of useful lives and residual values, in the beginning of 2010 financial period that the pattern of service potential derived from depreciable assets has changed from that in previous periods. These depreciable assets are currently depreciated using the straight line method over a useful life of 10 years. As a result, management decided to change the remaining useful life of the depreciable assets to 5 years. January 2014 Page 30

31 The following information regarding the depreciable assets is available: Carrying amount at the beginning of the 2010 financial period 80,000 Original cost price (purchased beginning of 2008) 100,000 Depreciation per year 10,000 Changing the remaining useful life of the asset from 8 to 5 years, will affect the current period, i.e. 2010, as well as future periods in the following way: Depreciation for 2010 period based on 5 years remaining useful life (80,000 / 5) 16,000 Carrying amount at the end of ,000 Depreciation for future periods 16,000 The 2010 financial statements will reflect the new depreciation expense. No adjustment will be made to prior periods as this represents a change in accounting estimate which is applied prospectively. Extract from Notes to the Financial Statements Change in accounting estimate Depreciable assets original remaining useful life of 8 years has been changed to 5 years in the beginning of the current period to reflect the actual pattern of service potential derived from the assets. The effect on the current and future periods will be an increase in the depreciation charge of 6, 000 in the current period and an equal decrease in the depreciation charge of 6, 000 over the next 4 periods. January 2014 Page 31

32 6. EOS Prior period errors are 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 could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements. Errors can be made in any of the 4 elements of financial statements illustrated below in prior periods. Errors in the current period can be corrected before the financial statements are issued; therefore they are not relevant in this case. It is important to keep in mind that an omission or misstatement is an error only if the information was available at the time the particular transaction or event occurred, but not used at all, or used incorrectly. Figure 11 Financial statements do not comply with GAP when: material errors exist; or immaterial errors exist, which were made intentionally to achieve a specific presentation of the entity s financial position, performance and cash flow situation. In determining whether or not an error is material; management should assess the error in the context of the affected entity s financial statements. January 2014 Page 32

33 Example 9: Examples of what may constitute an error omission of amounts from the financial statements e.g. revenue or expenditure items are not included in the financial statements; calculation errors e.g. incorrect casting of a note; or incorrect application of an accounting policy. 6.1 Correction of errors All errors must be corrected in the financial statements of the entity. etrospective application will be applied for all errors discovered in subsequent periods. These errors will be corrected by: estating the comparative amounts for the prior period(s) presented in which the error occurred; or If the error occurred before the earliest period presented, restate the opening balances of the earliest period s assets, liabilities and net assets. The diagram below summarises the correction of an error: January 2014 Page 33

34 Error Current period Prior period Correct financial statements prior to authorisation for issue Material Immaterial etrospective restatement Do not adjust financial statements Impracticable Practicable Impracticable to determine period-specific effect Impracticable to determine cumulative effect of changes Correct financial statements prior to authorisation for issue estate opening balances of assets, liabilities and net assets for the earliest period for which retrospective restatement is practicable (this may be the current period) estate comparative information to correct the error prospectively from the earliest date possible Figure Disclosure The disclosure of a prior period error is very similar to the disclosure required for a change in accounting policy as both will result in retrospective adjustment of financial figures, unless impracticable. efer to the disclosure section of change in accounting policy for an example. The only difference is that there will be no disclosure in the current period column as is the case with a change in accounting policy. The results from the correction of an error must be disclosed in the period in which the financial statements were restated. The financial statements for subsequent periods need not repeat the required disclosure. 6.3 Illustrative examples Illustrative example G errors retrospective restatement A municipality discovered in 2010 that the revenue from property rates recognised in the prior period has been incorrectly calculated and recognised. An amount of 6,200,000 was not recognised as revenue due to an error in the calculation. January 2014 Page 34

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