Accounting Standard 5 (AS 5) deals with the classification and disclosure of specific items in the Statement of Profit and Loss.
The purpose of AS 5 is to suggest such a classification and disclosure in order to bring uniformity in the preparation and presentation of statement of net profit or loss across enterprises.
This enables the enterprises to compare their financial statements over time as well as draw comparison of their financial statements with other enterprises.
Thus, the statement of net profit or loss requires:
- Disclosure of certain items within profit or loss from ordinary activities
- Classification and disclosure of extraordinary and prior period items
- Accounting treatment and disclosure for changes in the accounting estimates
- Disclosure of changes in the accounting policies
Scope of Accounting Standard 5
AS 5 should be put into use by an enterprise in:
- Presenting profit or loss from ordinary activities,
- Representing extraordinary items and prior period items in the statement of P&L
- Considering changes in the accounting estimates
- Disclosure of changes in accounting policies
This standard pertains to the disclosure of specific items of net profit or loss for the given period. Such disclosures are made apart from any other disclosures required by other accounting standards.
This standard does not pertain to tax implications of:
- extraordinary items,
- prior period items,
- changes in accounting estimates and
- the changes in accounting policies for which necessary adjustments would be required depending on specific conditions
Profit or Loss From Ordinary Activities
What Are Ordinary Activities?
These are the activities that a business entity undertakes in the ordinary course of its business. It also includes related activities that a business entity assumes:
- To grow activities undertaken in the ordinary course of business
- That result from activities undertaken in the ordinary course of business
- To support activities undertaken in the ordinary course of business
Disclosure of Certain Items of Ordinary Activities
The nature and amount of items of income and expense within profit or loss from ordinary activities must be disclosed separately.
This must be done if the size, nature or incidence of such activities is such that their disclosure is important. It is important in terms of describing the performance of the enterprise for the given period.
Disclosure To Be Made in Notes
The items of income and expense within profit or loss from ordinary items may not be extraordinary in nature.
But the nature and amount of such items may be important for the users of the financial statements in order to evaluate the financial position and performance of a business entity. And to make future projections with regards to the same.
Thus, business entities choose to declare details with regards to such items as notes to financial statements.
Examples of Such Items of Ordinary Activities
There are certain situations that may lead to separate disclosure of items of income and expense within profit or loss from ordinary activities. These are as follows:
- Write down of inventories to net realizable value and reversal of such write downs
- Restructuring of activities of an enterprise and reversal of any provisions for costs of restructuring
- Disposal of items of fixed assets
- Litigation settlements
- Disposal of long term investments
- Legislative changes with retrospective application
- Other reversals of provisions
What Are Extraordinary Items?
Extraordinary items are income or expenses that result from events or transactions that are separate from ordinary activities of an enterprise. In other words, these incomes or expenses are not anticipated to occur repetitively.
Disclosure of Extraordinary Items
Extraordinary items must be declared in the statement of profit or loss as a part of net profit or loss for the given period.
Business entities must separately declare the nature as well as the amount of every extraordinary item in the profit and loss statement.
Further, it should be done in such a way that its implication on the current profit and loss is clearly understood.
When an Activity is Considered Extraordinary?
Typically, all the items of income and expense that establish net profit or loss of a business entity for a given period result in the course of its ordinary activities. Thus, it’s only in few circumstances that an event or a transaction leads to an extraordinary item.
The business entity needs to establish if a particular event or transaction is different from the ordinary activities of the business entity. This is established by the nature of the event or the transaction with regards to the business undertaken ordinarily by the business entity. And not by the frequency of such activities.
Accordingly, a particular event or a transaction may be an extraordinary activity for one business entity and not the other. This is because of the different ordinary activities of different business entities.
For instance, losses incurred due to earthquake may count as an extraordinary item for many business entities. But it is not so for an insurance company as such companies ensure the risk of losses due to earthquakes and disburse claims for the same to the policyholders.
Prior Period Items
What Are Prior Period Items?
Prior period items include income and expenses which occur in the current period due to certain errors and omissions while preparing financial statements of one or more prior periods.
Disclosure of Prior Period Items
The nature and the relevant amount of prior period items should be declared separately in the profit and loss statement. Further it should be done in such a way that their implications on the current period’s profit and loss can be clearly understood.
Are Adjustments A Part of Prior Period Items?
As mentioned above, prior period items include income or expenses that occur in the current period due to errors or omissions while preparing financial statements of one or more prior periods. These do not encompass other adjustments so demanded by situations which are no doubt related to the prior periods but are established in the current period. For instance, arrears outstanding to workers due to revision of wages with retrospective effect during the current period.
Reasons Due To Which Errors Arise
Errors while preparing the financial statements of one or more prior periods may be found in the current period. Such errors may be an outcome of some mathematical mistakes, mistakes in the application of accounting policies, misinterpretation, oversight etc.
Difference Between Prior Period Items and Accounting Estimates
Prior period items are typically not repetitive in nature and can be differentiated from changes in the accounting estimates. When it comes to accounting estimates, they are approximations that may need to be corrected on the availability of additional information.
How To Disclose Prior Period Items?
Prior period items are typically considered while calculating the profit or loss for the current period. Another way is to show such items in profit or loss statements after establishing the current period’s net profit or loss. In both circumstances the purpose is to suggest the implications of such items on the current period’s profit or loss.
Changes in Accounting Estimates
How To Measure Accounting Estimates?
Many items that form part of financial statements cannot be measured accurately and hence are estimated figures. This is because of the uncertainties deep rooted in the business activities. Estimation requires judgement based on the current information available to a business entity.
Further, a business entity may have to provide estimates with regards to bad debts, useful life of depreciable assets, inventory obsolescence etc. Accordingly, using rational estimates forms an important part of preparing financial statements. Thus, such estimates do not hamper the reliability of such statements.
When Are Accounting Estimates Altered?
Business entities would have to alter such estimates if there are any changes in respect of the situations on which such estimates are based. Or due to additional information, greater experience or any other future developments. Further, a revised estimate does not bring about any adjustment within the definitions of extraordinary or prior period items.
When It Gets Difficult To Differentiate Between change in the accounting policy and a change in the estimate
In certain situations, it becomes challenging to differentiate between change in the accounting policy and a change in the estimate. In such circumstances, business entities are required to treat the change as a change in the accounting estimate after making proper disclosure with regards to the same.
In What Period Change In Accounting Estimate Should Be Shown?
The impact of change in the accounting estimate should form part of the calculation of the net profit or loss in:
- The period of change if the change impacts the period only or
- Period of change and future periods if such a change impacts both
How To Show Change In Accounting Estimate in Current as well as Future Periods?
There can be situations where a change in the accounting estimate may impact either only the current period or both current and future periods. For instance, any change in the estimation of the amount of bad debts is shown immediately and thus impacts only the current period.
But, a change in the estimated useful life of the depreciable asset impacts both the amount of depreciation in the current period as well as the depreciation amount in each period during the remaining useful life of the asset.
Now, in both situations, the impact of change with regards to the current period is shown as income or expense in the current period. Whereas, the impact of change on the future periods is recognized in the future periods.
Classification of Impact of Change in Accounting Estimate
Business entity should use the same classification for classifying the impact of change in the accounting estimate in the profit and loss statement as used previously for recognizing such an estimate.
When To Classify The Impact of Change in Accounting Estimate as Ordinary Item and Extraordinary Item
Business entities should include the impact of change in the accounting estimate in the profit and loss from ordinary activities. This happens if such an impact was previously included in the same component of the profit or loss.
Similarly, changes in the accounting estimate should form part of an extraordinary item if it was included in extraordinary item previously. This is so done in order to compare the financial statements of different periods.
Disclosure of Change in the Accounting Estimate Having a Significant Impact
Change in the accounting estimate that has significant impact in the current period or is anticipated to have a significant impact in the future periods must be declared.
Further, if it’s not practical to quantify the change in the accounting estimate, the same should be disclosed in the financial statement.
Changes in Accounting Policies
Use of Same Accounting Policies Over Time
The users of financial statements of business entities should be able to compare its financial statements over time. This is to understand the trends and performance of the business entity and its cash flows.
Thus, business entities must use the same accounting policies for similar transactions in every period.
When Should Business Entity Change An Accounting Policy
Business entity should make changes in the accounting policy only if such a change:
- is required by the statute
- is required to comply with an accounting standard
- Would help in presenting financial statements appropriately
Benefit of Adopting
Business entities can present transactions in a better way if new accounting policies lead to more relevant information about the performance, financial position and cash flows of business entity.
Changes That Cannot Be Taken As Change in Accounting Policies
There are certain changes which cannot be taken as changes in accounting policies. These include:
- choosing accounting policies for transactions that vary in substance, vis-a-vis the transactions that occurred previously
- Choosing new accounting policies for transactions which did not take place previously or were insignificant
Changes in Accounting Polices Having a Material and Immaterial Impact
Changes in accounting polices having a significant impact must be declared in the financial statements. Further, the effect of and the adjustments arising from such changes which are significant in nature must be declared in the financial statements in the period in which such changes take place.
This is done to show the impact of such changes during the given period. In cases where the impact of such a change cannot be determined, the fact with regards to the same should also be declared.
Further, changes made in accounting policies not having significant impact on the financial statements for the current period but are anticipated to have significant impact in the future periods must be declared in the period in which such changes are adopted.
Change In Accounting Policies After Choosing an Accounting Standard
Any change in the accounting policy that takes place after an enterprise chooses an accounting standard must also be accounted for. This should be done according to the provisions mentioned in such an accounting standard.