2.1 Hierarchy for selecting accounting policies

Where a section or standard does not specifically address a transaction, other event or condition, Section 10 permits but does not require an entity's management to refer to EU-adopted IFRS in the hierarchy established to determine how judgement is used in developing and applying an accounting policy. [FRS 102.10.6]. IAS 8's equivalent wording refers to any other standard setting body that uses a similar conceptual framework (to IFRS). [IAS 8.12]. This may result in different accounting policies being applied under FRS 102 for a particular transaction, event or condition compared to IFRS.

2.2 Key presentation and disclosure differences

IAS 8 requires disclosure of the impact of a new IFRS that is issued but not effective. [IAS 8.30]. Section 10 does not require disclosure of the impact on the financial statements of future periods of changes to FRS 102 that have been issued but are not yet effective. This would apply both to changes to individual sections of FRS 102 and changes to IFRSs which are being applied by a reporting entity under paragraphs 1.4, 1.5 and 1.7 or 11.2(b) and 11.2(c) of FRS 102 (for example IAS 33 – Earnings per Share).

IAS 1 – Presentation of Financial Statements – requires a third statement of financial position in such circumstances. [IAS 1.40A]. FRS 102 does not require a third statement of financial position as at the beginning of the preceding period to be presented whenever an accounting policy is applied retrospectively or a retrospective restatement or reclassification is made in the financial statements.

3.1 Terms used in Section 10

The following definitions are introduced: [FRS 102 Appendix I]

Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements.

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.

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: (a) was available when financial statements for those periods were authorised for issue; and (b) could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements.

Applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so.

3.2 Selection and application of accounting policies

The whole purpose of accounting standards is to specify the accounting policies and presentation and disclosure requirements that should be applied by an entity. Entities applying FRS 102 do not therefore have a free hand in selecting accounting policies. However, a reporting entity should select accounting policies to account for transactions, other events or conditions when financial reporting standards provide multiple choices or do not address accounting for such transactions, other events or conditions.

Accounting policies are defined as the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements. [FRS 102 Appendix I, 10.2]. This means that an accounting policy is not just a question of how to measure a transaction but also how items are classified and presented in the financial statements. For example, an entity makes an accounting policy choice as to whether to adopt a single statement of comprehensive income or adopt a two statement presentation. Similarly, an entity makes an accounting policy choice as to whether to present operating cash flows under the direct or indirect method.

The starting point of Section 10 is that if an FRS specifically addresses a transaction, other event or condition, an entity shall apply that FRS. However, the requirement need not be followed if the effect of doing so would not be material. [FRS 102.10.3]. See Chapter 4 at 3.2.3 for further details on materiality.

There will be circumstances where a particular event, transaction or other condition is not specifically addressed by an FRS. When this is the case, Section 10 sets out a hierarchy of guidance to use. The primary requirement of the hierarchy is that management should use its judgement in developing and applying an accounting policy that results in information that is: [FRS 102.10.4]

• relevant to the economic decision-making needs of users; and
• reliable in that the financial statements:
  • represent faithfully the financial position, financial performance and cash flows of the entity;
  • reflect the economic substance of transactions, other events and conditions, and not merely the legal form;
  • are neutral, i.e. free from bias;
  • are prudent; and
  • are complete in all material respects.

In support of the primary requirement that management should apply judgement in developing and applying appropriate accounting policies, Section 10 gives guidance on how management should apply this judgement. This guidance comes in two ‘strengths’ – certain things which management is required to consider and others which it may consider, as follows.

Management is required to refer to and consider the applicability of the following sources in descending order of authority:

• the requirements and guidance in an FRS dealing with similar and related issues;
• where an entity's financial statements are within the scope of a Statement of Recommended Practice (SORP), the requirements and guidance in that SORP dealing with similar and related issues; and
• the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses and the pervasive principles in Section 2 – Concepts and Pervasive Principles. [FRS 102.10.5].

Management may also consider the requirements and guidance in EU-adopted IFRS dealing with similar and related issues. However, entities should exercise caution in considering the guidance in EU-adopted IFRS dealing with similar issues as not all of the sections in FRS 102 are based on EU-adopted IFRS. In addition, Section 1 – Scope – requires certain entities to apply IAS 33 (as adopted in the EU), IFRS 8 – Operating Segments (as adopted in the EU) – or IFRS 6 – Exploration for and Evaluation of Mineral Resources (as adopted in the EU) – and therefore, where applicable, the accounting policies required by those standards should be followed. [FRS 102.10.6].

Section 10 does not state that an entity may refer to any GAAP other than EU-adopted IFRS. However, in our opinion, an entity would not be prevented from continuing with an accounting policy for a transaction that was applied under previously extant UK GAAP, where FRS 102 does not specifically address the matter, provided the policy was consistent with the guidance, definitions, criteria and concepts contained in the sources referred to by the hierarchy above.

The hierarchy implies that it is not possible to apply an accounting policy for a transaction using the criteria in Section 2 where the accounting for that transaction is specifically addressed by FRS 102 (since Section 2 can only be consulted in the absence of specific guidance). However, Section 3 – Financial Statement Presentation – states that there may be special circumstances where management concludes that compliance with FRS 102 would be so misleading that it would conflict with the objective of financial statements of entities as set out with Section 2. In such circumstances, an entity can depart from the specific requirements of FRS 102 by use of a true and fair override. [FRS 102.3.4]. See Chapter 6 at 9.2.2 for discussion of the use of the true and fair override.

The hierarchy in Section 10 does not refer to UK Company Law. The implication from Section 10 is that, where choice is available, an accounting policy should be selected on its merits based on the criteria in FRS 102 (relevance and reliability) rather than to comply with the law (e.g. The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/410) (the Regulations). Some accounting policy choices permitted or required by FRS 102, for example measuring certain financial liabilities at fair value through profit or loss, are not allowed by the Regulations. However, Section 3 requires an entity to make disclosures when it has departed from a requirement of applicable legislation. [FRS 102.3.5-6].

3.3 Consistency of accounting policies

An entity shall select and apply its accounting policies consistently for similar transactions, other events or obligations unless an FRS specifically requires or permits categorisation of items for which different policies may be appropriate. If an FRS requires or permits such categorisation, an appropriate accounting policy shall be selected and applied consistently to each category. [FRS 102.10.7].

There is no requirement in FRS 102 for each entity within a group to have consistent accounting policies in their separate or individual financial statements. Indeed, FRS 102 anticipates that this will not be the case by requiring consolidated financial statements to be adjusted where a member of the group uses accounting policies other than those adopted in the consolidated financial statements for like transactions and events. [FRS 102.9.17]. The Regulations also do not require each entity within a group to have consistent accounting policies. However, Section 10 requires an entity to select accounting policies that are both relevant to the economic decision-making needs of its users and reliable. [FRS 102.10.4]. Therefore, factors that one group entity would take into account in setting its accounting policies should normally also apply to other group entities.

3.4 Changes in accounting policies

An entity shall change an accounting policy only if the change: [FRS 102.10.8]

• is required by an FRS; or
• results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity's financial position, financial performance or cash flows.

This means that a change in accounting policy cannot be made on an arbitrary basis.

Reliability is defined as the quality of information that makes it free from material error and bias and represents faithfully that which it either purports to represent or could reasonably be expected to represent. [FRS 102.2.7]. Relevance is defined as the quality of information that allows it to influence the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations. [FRS 102.2.5].

If an FRS allows a choice of accounting treatment (including the measurement basis) for a specified transaction or other event or condition and an entity changes its previous choice, then that is a change in accounting policy. [FRS 102.10.10].

As noted at 3.2 above, an accounting policy is not restricted to measurement of a transaction but also includes how items are classified and presented in the financial statements. Therefore, changes in presentation, such as a decision to adopt a change from a single statement of comprehensive income approach to a two statement approach is a change in accounting policy. [FRS 102.5.3].

The following are stated specifically not to be changes in accounting policies: [FRS 102.10.9]

• the application of an accounting policy for transactions, other events and conditions that differ in substance from those previously occurring;
• the application of a new accounting policy for transactions, other events or conditions that did not occur previously or were not material; and
• a change to the cost model when a reliable measure of fair value is no longer available (or vice versa) for an asset that an FRS would otherwise require or permit to be measured at fair value.

3.5 Changes in accounting estimates

Estimates are a fundamental feature of financial reporting, reflecting the uncertainties inherent in business activities. The use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. [FRS 102.2.30]. FRS 102 does not define estimation techniques or accounting estimates. However, examples of estimates within FRS 102 include bad debt provisions, inventory obsolescence provisions, fair values of financial assets or liabilities and useful lives of depreciable assets.

Estimates will need revision as changes occur in the circumstances on which they are based or as a result of new information or more experience. Hence, a change in accounting estimate is an adjustment to the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from 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. [FRS 102.10.15]. Errors do not result from changes in circumstances or the availability of new information. See 3.6 below.

The distinction between an accounting policy and an accounting estimate is particularly important because a very different accounting treatment is applied when there are changes in accounting policies or accounting estimates. 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. [FRS 102.10.15].

By its nature, a change in an accounting estimate is not caused by a prior period event. Consequently, the effect of a change in accounting estimate is required to be recognised prospectively in profit or loss by including it in: [FRS 102.10.16]

• the period of the change, if the change affects that period only; or
• the period of the change and future periods, if the change affects both.

An example of a change in estimate which would affect the current period only is a change in an estimate of bad debts relating to receivables recognised in the previous period. An example of a change which would affect both current and future periods is a change in the estimated useful life of a depreciable asset.

Some changes in accounting estimates will give rise to changes in assets and liabilities, or relate to an item of equity. In those circumstances, the reporting entity adjusts the carrying amount of the related asset, liability or equity item in the period of the change. [FRS 102.10.17].

3.6 Corrections of prior period errors

Errors can arise in respect of the recognition, measurement, presentation or disclosure of elements of financial statements. Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud. [FRS 102.10.20].

FRS 102 states that information provided in financial statements should be reliable and in order to be reliable it should be free from material error. [FRS 102.2.7].

Prior period errors are omissions from, and misstatements in, an entity's financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that: [FRS 102.10.19]

• 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.

When it is discovered that material prior period errors have occurred, Section 10 requires that they be corrected in the first set of financial statements prepared after the discovery. The correction should be excluded from the statement of comprehensive income for the period in which the error is discovered. Rather, it is corrected retrospectively by adjusting prior periods. This is done by: [FRS 102.10.21]

• restating the comparative amounts for the prior period(s) presented in which the error occurred; or
• if the error occurred before the earliest period presented, restating the opening balances of assets, liabilities and equity for the earliest prior period presented.

This process corrects the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior year error had never occurred.

The same caution on the use of hindsight in applying a new accounting policy (see 3.4.2 above) applies to correction of prior period errors. As is the case for the retrospective application of a change in accounting policy, retrospective restatement for the correction of prior period material errors is not required to the extent that it is impracticable to determine the period-specific effects on comparative information for one or more periods presented. In that case, the entity restates the opening balances of assets, liabilities and equity for the earliest period for which retrospective statement is practicable (which may be the current period). [FRS 102.10.22]. As discussed at 3.4.2 above, IAS 8 contains additional guidance on impracticability.

3.7 Disclosure of a change in accounting policy, a change in accounting estimate and prior period errors

3.8 Amendments to Section 10 from the Triennial review 2017

The amendments to FRS 102 from the Triennial review 2017 are effective for periods beginning on or after 1 January 2019. Very few amendments were made to this section, the most substantive being to describe it as setting out ‘requirements’ rather than ‘guidance’,

4.1 Corrections of prior period errors and defective accounts

If a company's previous annual report and accounts did not comply with the Companies Act 2006 (for example due to an error), s454 of the Act allows the directors to revise any such reports and accounts (often referred to as the Defective Accounts regime). If an entity corrects errors by way of a prior year adjustment in its latest financial statements, the directors should always consider carefully whether to revise the earlier financial statements, although it is common practice not to do so.