Responsibility for selection of the depreciation methods used in financial reporting rests with:

Financial statements and the ratios derived from them may be significantly impacted by a company’s selected depreciation method and accompanying assumptions and estimates.

Companies should review the estimates used periodically to ensure that they remain reasonable.

The Effect of the Choice of Depreciation Method and Assumptions on Depreciation Expense, Financial Statements, and Financial Ratios

The choice of depreciation method will affect the amounts that are reported on the financial statements, including the amounts for reported assets and operating and net income. Several financial ratios will be affected because of this. Among others, the fixed asset turnover, total asset turnover, operating profit margin, operating return on assets, and return on assets will be affected.

In some countries, the same depreciation method is not used for financial reporting and tax purposes. As a result, pre-tax income on the income statement and taxable income on the tax return are likely to differ. The amount of tax expense computed based on pre-tax income and the amount of taxes actually owed based on taxable income may, therefore, be different.

For example, a company may use the straight-line method of depreciation for financial reporting and an accelerated depreciation method for tax purposes.  In such an instance, the company’s financial statements will report lower depreciation expense and higher pre-tax income in the first year, compared with the amount of depreciation expense and taxable income in its tax reporting. The tax expense that is calculated based on the financial statements’ pre-tax income will be higher than taxes payable based on taxable income. The difference between the two amounts is a deferred tax liability. This deferred tax liability will be reduced as the difference reverses, i.e., when the depreciation for financial reporting becomes higher than the depreciation for tax purposes, and the income tax is paid.

Significant estimates are required for calculating depreciation expenses. These include the useful life of an asset and the expected residual value at the end of that useful life. A longer useful life and a higher expected residual value will decrease the amount of annual depreciation expense relative to a shorter useful life and lower expected residual value.

Question 1

Companies A and B purchase a similar machine at the same time and at the same cost. In reporting this acquisition, company A uses the straight-line method of depreciation, while company B uses the double declining balance method. Other than the choice of depreciation method, both companies use similar estimates and assumptions.

Assuming that the machine is the only long-lived asset that both companies report on their financial statements, which of the following statements is the most accurate?

1. Company A and B will have the same tax expense.
2. Company A will have a higher pre-tax income in the first year, than company B.
3. Company A will have a higher depreciation expense in the first year than company B.

Solution

The correct answer is C.

Company A will have a higher pre-tax income in the first year than company B because of its lower depreciation expense under the straight-line method of depreciation.

A is incorrect because company A will have a lower depreciation expense.

B is incorrect because company A will have a higher tax expense in the first year due to its higher pre-tax income.

Question 2

How would an increase in the estimated residual value of an asset affect a company’s net income?

1. It has no effect.
2. It would increase net income.
3. It would decrease net income.

Solution

The correct answer is B.

Increasing the residual value would decrease the annual depreciation expense of the asset. Decreasing the depreciation expense of the asset would therefore increase net income.

• IAS 8(2003) supersedes SIC-2 Consistency - Capitalisation of Borrowing Costs
• IAS 8(2003) supersedes SIC-18 Consistency - Alternative Methods.

• Disclosure initiative – Principles of disclosure
• Disclosure initiative — Changes in accounting policies and estimates

• 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 liability, or related expense, resulting from reassessing the expected future benefits and obligations associated with that asset or liability.
• International Financial Reporting Standardsare standards and interpretations adopted by the International Accounting Standards Board (IASB). They comprise:
  • International Financial Reporting Standards (IFRSs)
  • International Accounting Standards (IASs)
  • Interpretations developed by the International Financial Reporting Interpretations Committee (IFRIC) or the former Standing Interpretations Committee (SIC) and approved by the IASB.
• Materiality. Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entity.*
• 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 was available and could reasonably be expected to have been obtained and taken into account in preparing those statements. Such errors result from mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud.

* Clarified by Definition of Material (Amendments to IAS 1 and IAS 8), effective 1 January 2020.

When a Standard or an Interpretation specifically applies to a transaction, other event or condition, the accounting policy or policies applied to that item must be determined by applying the Standard or Interpretation and considering any relevant Implementation Guidance issued by the IASB for the Standard or Interpretation. [IAS 8.7]

In the absence of a Standard or an Interpretation that specifically applies to a transaction, other event or condition, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. [IAS 8.10]. In making that judgement, management must refer to, and consider the applicability of, the following sources in descending order:

• the requirements and guidance in IASB standards and interpretations dealing with similar and related issues; and
• the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework. [IAS 8.11]

Management may also consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards, other accounting literature and accepted industry practices, to the extent that these do not conflict with the sources in paragraph 11. [IAS 8.12]

An entity shall select and apply its accounting policies consistently for similar transactions, other events and conditions, unless a Standard or an Interpretation specifically requires or permits categorisation of items for which different policies may be appropriate. If a Standard or an Interpretation requires or permits such categorisation, an appropriate accounting policy shall be selected and applied consistently to each category. [IAS 8.13]

An entity is permitted to change an accounting policy only if the change:

• is required by a standard or interpretation; 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. [IAS 8.14]

Note that changes in accounting policies do not include applying an accounting policy to a kind of transaction or event that did not occur previously or were immaterial. [IAS 8.16]

If a change in accounting policy is required by a new IASB standard or interpretation, the change is accounted for as required by that new pronouncement or, if the new pronouncement does not include specific transition provisions, then the change in accounting policy is applied retrospectively. [IAS 8.19]

Retrospective application means adjusting the opening balance of each affected component of equity for the earliest prior period presented and the other comparative amounts disclosed for each prior period presented as if the new accounting policy had always been applied. [IAS 8.22]

• However, if it is impracticable to determine either the period-specific effects or the cumulative effect of the change for one or more prior periods presented, the 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. [IAS 8.24]
• Also, if it is impracticable to determine the cumulative effect, at the beginning of the current period, of applying a new accounting policy to all prior periods, the entity shall adjust the comparative information to apply the new accounting policy prospectively from the earliest date practicable. [IAS 8.25]

Disclosures relating to changes in accounting policy caused by a new standard or interpretation include: [IAS 8.28]

• the title of the standard or interpretation causing the change
• the nature of the change in accounting policy
• a description of the transitional provisions, including those that might have an effect on future periods
• for the current period and each prior period presented, to the extent practicable, the amount of the adjustment:
  • for each financial statement line item affected, and
  • for basic and diluted earnings per share (only if the entity is applying IAS 33)
• the amount of the adjustment relating to periods before those presented, to the extent practicable
• if retrospective application is impracticable, an explanation and description of how the change in accounting policy was applied.

Financial statements of subsequent periods need not repeat these disclosures.

Disclosures relating to voluntary changes in accounting policy include: [IAS 8.29]

• the nature of the change in accounting policy
• the reasons why applying the new accounting policy provides reliable and more relevant information
• for the current period and each prior period presented, to the extent practicable, the amount of the adjustment:
  • for each financial statement line item affected, and
  • for basic and diluted earnings per share (only if the entity is applying IAS 33)
• the amount of the adjustment relating to periods before those presented, to the extent practicable
• if retrospective application is impracticable, an explanation and description of how the change in accounting policy was applied.

Financial statements of subsequent periods need not repeat these disclosures.

If an entity has not applied a new standard or interpretation that has been issued but is not yet effective, the entity must disclose that fact and any and known or reasonably estimable information relevant to assessing the possible impact that the new pronouncement will have in the year it is applied. [IAS 8.30]

The effect of a change in an accounting estimate shall be recognised prospectively by including it in profit or loss in: [IAS 8.36]

• 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.

However, 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, it is recognised by adjusting the carrying amount of the related asset, liability, or equity item in the period of the change. [IAS 8.37]

Disclose:

• the nature and amount of a change in an accounting estimate that has an effect in the current period or is expected to have an effect in future periods
• if the amount of the effect in future periods is not disclosed because estimating it is impracticable, an entity shall disclose that fact. [IAS 8.39-40]

The general principle in IAS 8 is that an entity must correct all material prior period errors retrospectively in the first set of financial statements authorised for issue after their discovery by: [IAS 8.42]

• 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.

However, if it is impracticable to determine the period-specific effects of an error on comparative information for one or more prior periods presented, the entity must 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). [IAS 8.44]

Further, if it is impracticable to determine the cumulative effect, at the beginning of the current period, of an error on all prior periods, the entity must restate the comparative information to correct the error prospectively from the earliest date practicable. [IAS 8.45]

Disclosures relating to prior period errors include: [IAS 8.49]

• the nature of the prior period error
• for each prior period presented, to the extent practicable, the amount of the correction:
  • for each financial statement line item affected, and
  • for basic and diluted earnings per share (only if the entity is applying IAS 33)
• the amount of the correction at the beginning of the earliest prior period presented
• if retrospective restatement is impracticable, an explanation and description of how the error has been corrected.

Financial statements of subsequent periods need not repeat these disclosures.

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