Prior Period Errors Problem
PQR Ltd is in the business of manufacturing electronics items and supplying them across the globe. While preparing the financial statements for the year ended 31st March 2023, PQR Limited has observed an issue in the previous year financial statements (i.e. 31st March 2022) which are as follows:
i) PQR Ltd. has obtained a term loan of Rs.50 crores for the complete renovation and modernization of its factory in May 2020.
ii) A machinery costing Rs.35 crores was acquired under the modernization scheme and installation was completed in June 2021.
iii) Management of PQR Ltd considers the 12 months period as substantial period of time to get the asset ready for its intended use.
iv) Therefore, entity has capitalized the interest cost for the period May 2020 to March 2021 in machinery account as per Ind AS 23.
v) However, entity has also capitalized the interest cost of whole financial year 2021-2022 in the cost of machinery since management opined that term loan is for special purpose and its finance cost should be capitalized to the related asset during the whole tenure of loan.
Considering the prior period error, the management intends to restate the comparative amounts for the prior period presented (i.e., as at 31st March 2022) by de-recognizing the finance cost from machinery and recognizing the finance cost in the profit or loss for the period July 2021 to March 2022.
Would this reclassification of finance cost in the comparative amounts will be considered as correction of an error under Ind AS 8? Would PQR Ltd. need to present a third balance sheet?
SOLUTION
As per Para 22 of Ind AS 23,
"An entity shall cease capitalising borrowing costs when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete." In the given case, finance cost till June 2021 should be capitalized in machinery and thereafter the entity shall cease capitalizing borrowing cost since substantially all the activities necessary to prepare the qualifying asset are completed. Therefore, finance cost for the period July 2021 to March 2022 shall be recognized in profit or loss as per Ind AS 23.
PARA 7 OF IND-AS 23- BORROWING COST
Depending on the circumstances, any of the following may be qualifying assets:
(a) inventories;
(b) manufacturing plants;
(c) power generation facilities;
(d) intangible assets;
(e) investment properties;
(f) bearer plants.
Financial assets, and inventories that are manufactured, or otherwise produced, over a short period of time, are not qualifying assets. Assets that are ready for their intended use or sale when acquired are not qualifying assets.
PARA 12 OF IND-AS 23- BORROWING COST
To the extent that an entity borrows funds specifically for the purpose of obtaining a qualifying asset, the entity shall determine the amount of borrowing costs eligible for capitalisation as the actual borrowing costs incurred on that borrowing during the period less any investment income on the temporary investment of those borrowings.
PARA 22 OF IND-AS 23- BORROWING COST
An entity shall cease capitalising borrowing costs when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.
PARA 23 OF IND-AS 23- BORROWING COST
An asset is normally ready for its intended use or sale when the physical construction of the asset is complete even though routine administrative work might still continue. If minor modifications, such as the decoration of a property to the purchaser's or user's specification, are all that are outstanding, this indicates that substantially all the activities are complete.
PARA 24 OF IND-AS 23- BORROWING COST
When an entity completes the construction of a qualifying asset in parts and each part is capable of being used while construction continues on other parts, the entity shall cease capitalising borrowing costs when it completes substantially all the activities necessary to prepare that part for its intended use or sale.
PARA 25 OF IND-AS 23- BORROWING COST
A business park comprising several buildings, each of which can be used individually, is an example of a qualifying asset for which each part is capable of being usable while construction continues on other parts. An example of a qualifying asset that needs to be complete before any part can be used is an industrial plant involving several processes which are carried out in sequence at different parts of the plant within the same site, such as a steel mill.
Para 5 of Ind AS 8
It defines prior period errors as "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:
(a) was available when financial statements for those periods were approved 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.
Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud."
PARA 5 OF INDS AS 8
The following terms are used in this Standard with the meanings specified:
- 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.
- Material Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor.
- 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:
(a) was available when financial statements for those periods were approved 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.
Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud. Retrospective application is applying a new accounting policy to transactions, other events and conditions as if that policy had always been applied. Retrospective restatement is correcting the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior period error had never occurred.
In the given case, capitalizing the borrowing cost after the cessation is a misstatement in the financial statements as this information was available at the time of approval of those financial statements. Therefore, it will be classified as prior period errors due to application of incorrect accounting policy and contravention with the requirement of Para 22 of Ind AS 23 as stated above.
A per Para 5 of Ind AS 8, the term "Material" used in this Standard shall have the same meaning as assigned to it in paragraph 7 of Ind AS 1.
Para 7 of Ind AS 1 defined the term 'Material' as follows
"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."
In the given case, finance cost is not recognized in the profit or loss instead capitalized in the value of machinery in the year 2021-2022, therefore profit for the period is overstated which could reasonably be expected to influence decisions of the users of financial statements.
Hence, this will be classified as material prior period error.
Para 42 of Ind AS 8 states "Subject to paragraph 43, an entity shall correct material prior period errors retrospectively in the first set of financial statements approved for issue after their discovery by:
(a) restating the comparative amounts for the prior period(s) presented in which the error occurred; or
(b) 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."
In accordance with Para 42 of Ind AS 8, in the financial statements for the year ended 31st March 2023, the comparative amounts for the year ended 31st March 2022 would be restated to reflect the correct recognition.
PARA 42 OF IND AS 8
Subject to paragraph 43, an entity shall correct material prior period errors retrospectively in the first set of financial statements approved for issue after their discovery by:
(a) restating the comparative amounts for the prior period(s) presented in which the error occurred; or
(b) 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.
PARA 43 OF IND(AS) 8
A prior period error shall be corrected by retrospective restatement except to the extent that it is impracticable to determine either the period-specific effects or the cumulative effect of the error.
Para 40A of IND AS 1 states
"An entity shall present a third balance sheet as at the beginning of the preceding period in addition to the minimum comparative financial statements required in paragraph 38A if:
(a) it applies an accounting policy retrospectively, makes a retrospective restatement of items in its financial statements or reclassifies items in its financial statements; and
(b) the retrospective application, retrospective restatement or the reclassification has a material effect on the information in the balance sheet at the beginning of the preceding period."
PARA 38A OF IND(AS) 1- PRESENTATION OF FINANCIAL STATEMENTS
An entity shall present, as a minimum, two balance sheets, two statements of profit and loss, two statements of cash flows and two statements of changes in equity, and related notes.
PARA 42A
An entity shall present a third balance sheet as at the beginning of the preceding period in addition to the minimum comparative financial statements required in paragraph 38A if:
(a) it applies an accounting policy retrospectively, makes a retrospective restatement of items in its financial statements or reclassifies items in its financial statements; and
(b) the retrospective application, retrospective restatement or the reclassification has a material effect on the information in the balance sheet at the beginning of the preceding period.
In the given case, the retrospective restatement has no effect on the information in the balance sheet at the beginning of the preceding period (i.e., 1st April 2021). Therefore, PQR Ltd. is not required to present a third balance sheet.
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