Acca f3 Financial Accounting (int) Study Text

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3: Accounting conventions   Part B  The qualitative characteristics of financial information and the fundamental bases of accounting 

5.5.3 Holding gains on inventories are included in profit 

Another criticism of historical cost depreciation is that it does not fully reflect the value of the asset 

consumed during the accounting year. 

During a period of high inflation the monetary value of inventory held may increase significantly while they 

are being processed. The conventions of historical cost accounting lead to the unrealised part of this 

holding gain (known as inventory appreciation) being included in profit for the year.

The following example is given to help your understanding of this difficult concept. Exam questions are 

only 1 or 2 marks and so would not be so detailed. 

Example: Holding gain 

This problem can be illustrated using a simple example. At the beginning of the year a company has 100 

units of inventory and no other assets. Its trading account for the year is shown below. 

TRADING ACCOUNT

Units

   $

Units

$

Opening inventory 

100

200 Sales (made 31 December)

100

500

Purchases (made 31 December)

100

400

 

 

 

200

600

 

 

Closing inventory  (FIFO basis)

100

400

 

 

100

200

 

 

Gross profit

    –

300

100

500

100

500

Apparently the company has made a gross profit of $300. But, at the beginning of the year the company 

owned 100 units of inventory and at the end of the year it owned 100 units of inventory and $100 (sales 

$500 less purchases $400). From this it would seem that a profit of $100 is more reasonable. The 

remaining $200 is inventory appreciation arising as the purchase price increased from $2 to $4.

The criticism can be overcome by using a 

capital maintenance concept based on physical units rather 

than money values. 

5.5.4 Profits (or losses) on holdings of net monetary items are not shown 

In periods of inflation the purchasing power, and thus the value, of money falls. It follows that an 

investment in money will have a lower real value at the end of a period of time than it did at the beginning. 

A loss has been incurred. Similarly, the real value of a monetary liability will reduce over a period of time 

and a gain will be made. 

5.5.5 The true effect of inflation on capital maintenance is not shown 

To a large extent this follows from the points already mentioned. It is a widely held principle that 

distributable profits should only be recognised after full allowance has been made for any erosion in the 

capital value of a business. In historical cost accounts, although capital is maintained in nominal money 

terms, it may not be in real terms. In other words, profits may be distributed to the detriment of the 

long-term viability of the business. This criticism may be made by those who advocate capital 

maintenance in physical terms. 

5.5.6 Comparisons over time are unrealistic 

This will tend to an exaggeration of growth. For example, if a company's profit in 1966 was $100,000 and 

in 1999 $500,000, a shareholder's initial reaction might be that the company had done rather well. If, 

however, it was then revealed that with $100,000 in 1966 he could buy exactly the same goods as with 

$500,000 in 1999, the apparent growth would seem less impressive. 

Exam focus 

point

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Part B  The qualitative characteristics of financial information and the fundamental bases of accounting

  3:  Accounting conventions

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6 IAS 8 Accounting policies, changes in accounting

estimates and errors 

IAS 8 Accounting policies, changes in accounting estimates and errors is an important standard. Here, you 

need to be able to understand the provisions and identify the appropriate accounting treatment in respect 

of

changes in accounting policies.

IAS 8 lays down the criteria for selecting and changing accounting policies and specifies the accounting 

treatment and disclosure of changes in accounting policies, changes in accounting estimates, and errors. 

6.1 Definitions 

The following definitions are given in the standard. 

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. 

Material: Omissions or misstatements of items are material if they could, individually or collectively, 

influence the economic decisions of users taken on the basis of the financial statements. 

Prior period errors are omissions from, and misstatements in, the entity's financial statements for one or 

more prior periods. 

Impracticable: Applying a requirement is impracticable when the entity cannot apply it after making every 

reasonable effort to do so. 

6.2 Changes in accounting policies 

The same accounting policies are usually adopted from period to period, to allow users to analyse trends 

over time in profit, cash flows and financial position. 

Changes in accounting policy will therefore be rare 

and should be made only if required. 

(a) By 

an 

standard or an interpretation (of a standard)

(b) 

If the change will result in a 

more appropriate presentation of events or transactions in the 

financial statements of the entity 

A change in accounting policy is a change in measurement, presentation or recognition of an item eg a 

business has written off all development expenditure in the past, but now decides to capitalise qualifying 

development expenditure in the statement of financial position. 

The standard highlights two types of event which do not constitute changes in accounting policy. 

(a) 

Adopting an accounting policy for a 

new type of transaction or event not dealt with previously by 

the entity. 

(b) Adopting 

a 

new accounting policy for a transaction or event which has not occurred in the past or 

which was not material. 

In the case of property, plant and equipment, if a policy of revaluation is adopted for the first time then this 

is treated, not as a change of accounting policy under IAS 8, but as a revaluation under IAS 16 Property,

plant and equipment (see 

Chapter 9

). The following paragraphs do not therefore apply to revaluations. 

A change in accounting policy should be applied retrospectively. Where an entity cannot determine the 

effect of applying the new policy to all prior periods, the new policy should be applied prospectively from 

the start of the earliest period practicable. 

Key terms 

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