Kestrel Industrial Ltd: three disputed items under a profit covenant
Kestrel Industrial Ltd prepares IFRS financial statements for the year ended 31 December 20X5. Profit before tax was £1.9m in 20X4 and is £2.6m in 20X5, and a bank covenant requires restated profit before tax of at least £1.75m in each year. Three items are disputed at the audit. (i) A £240,000 overhaul of the press line, carried out in November 20X4 and expensed in full, is now agreed to have extended the machine's life by four years and to have met the capitalisation criteria; the press returned to use on 1 December 20X4. (ii) From 1 January 20X5 depreciation of the forklift fleet changed from reducing balance at 25% to straight line over five years, reflecting a genuine shift in usage patterns. (iii) From 1 January 20X5 finished goods are valued on FIFO instead of weighted average, giving closing inventory £310,000 higher; the finance director calls this 'a refinement of an estimate' and points out that the 20X4 figures were signed off months ago. The 20X5 statements have not yet been approved.
1. Classify each of the three items under IAS 8 and justify the classification.
Read the worked answer
(i) Prior period error. The overhaul met the recognition criteria for property, plant and equipment and reliable information was available when the 20X4 statements were authorised. Expensing it was therefore an omission of an amount, not a new judgement made with hindsight. IAS 8 requires prior period errors to be corrected retrospectively.
(ii) Change in accounting estimate. The reducing-balance/straight-line choice is a measurement technique applied to an asset whose pattern of consumption has changed. IAS 8 treats a change in depreciation method as a change in estimate, applied prospectively from 1 January 20X5. No restatement of 20X4.
(iii) Change in accounting policy. IAS 2 requires the same cost formula for all inventories of a similar nature and use; switching from weighted average to FIFO replaces one cost formula with another. That is a policy change under IAS 8, not a refinement of an estimate - an estimate change adjusts the amount of an existing measurement, it does not swap the measurement basis. Retrospective application is required, subject to the impracticability exemption in IAS 8 where the cumulative effect cannot be determined (common for FIFO where historical layering data is missing).
2. Set out the adjustments and presentation for item (i), and state the effect of all three items on the covenant.
Read the worked answer
Restate 20X4 comparatives. Reverse the £240,000 expense and charge depreciation from 1 December 20X4 on a straight-line basis over the four-year extended life (£240,000 ÷ 4 = £60,000 a year): one month = £5,000.
- Restated 20X4 profit before tax = 1,900,000 + 240,000 − 5,000 = £2,135,000
- Carrying amount at 31 December 20X4 = £235,000
- 20X5 depreciation = £60,000, so restated 20X5 profit before tax = 2,600,000 + 60,000 = £2,660,000
- Opening retained earnings for 20X5 increase by £235,000; the 20X4 comparatives in the statement of profit or loss, statement of financial position and statement of changes in equity are restated. A third statement of financial position is not required because the error does not affect the opening position of the earliest period presented.
Covenant. Both restated figures clear the £1.75m threshold, so no breach arises on the corrected numbers. Item (ii) is prospective and affects only 20X5 onwards. Item (iii) raises opening retained earnings and 20X5 profit by the cumulative FIFO effect if retrospective application is practicable, which also helps the covenant.
3. The finance director argues that items (i) and (iii) should be handled prospectively because a restatement could alarm the bank. How should the auditor respond?
Read the worked answer
The classification depends on the nature of the item, not on its consequences. Motive is not part of the IAS 8 test, so the covenant cannot convert a prior period error into a change in estimate or a policy change into an estimate change.
That said, the commercial consequence is real and should be managed through disclosure rather than through misclassification: the restated comparatives, the nature of the error and the amount of the correction must be disclosed for each prior period presented, and the reason for the policy change must be given for item (iii).
If management refuses to adjust, the auditor quantifies the effect - £235,000 on 20X4 profit, £60,000 on 20X5 profit and £310,000 on inventory - and considers whether it is material. Against 20X4 profit before tax of £1.9m, the error is 12% and clearly material; a qualified or adverse opinion follows, and the bank covenant is in any case usually drafted on audited figures, so concealment is not a viable strategy.
One genuine forward-looking issue: if a covenant were expected to be breached, IAS 1 requires the related liability to be classified as current, which is a presentation consequence of the corrected numbers, not a reason to change them.