Change in Accounting Estimate

What is Change in Accounting Estimate?

A change in accounting estimate occurs when there is the appearance of new information, which replaces the current data based on which the company had taken an earlier decision, resulting in two things – changing the carrying amount of an existing asset or liability and alteration of subsequent accounting for recognition of future assets and liabilities.

Examples of Change in Accounting Estimate

While accounting for the transactions, we need to take into consideration the number of estimates or use our prudence or judgment. In some cases, these estimates can prove to be inappropriate, as the basis on which we had taken our assumption has changed. To keep our books align with the subsequent changes, it warrants for change in accounting estimateAccounting EstimateAccounting estimates refer to the technique of calculating unquantifiable items in business with no accuracy of date, record or expense. It is based on experience, judgement and knowledge and helps in the overall view of the total balance and cost incurred.read more.

In the following situation, we use our prudence.

This is not an exhaustive list, and it would expand depending upon the sector in which the business is involved.

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Numerical Example

ACE Inc, bought a chemical plant amounting to $400 mn on January 1, 2016. At the time of recognition of the plant as a fixed asset, the company estimated its useful life to be ten years and salvage value $80 mn.

The company used the Straight Line MethodStraight Line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more for depreciating the assets.

On January 1, 2019, the company ought to know that the salvage value of the plant has decreased to $60 mn and life to 8 years, due to new technology being introduced in the market.

Calculation

• From 2016 to 2018, the company would have recorded depreciation of $32 mn per annum, {(400-80)/10}.
• The book value as on January 1, 2019, would be $336 mn. ($400-$32-$32).
• Due to new technology in the market,
• Now the revised depreciation would be $35 mn {(336-60)}/8}.

Please note that the change in estimate affects subsequent periods only and not the historical book values.

Change in Accounting Policy and Estimate is Not the Same

A change in accounting policyAccounting PolicyAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level.read more governs how the financial information would be calculated, wherein a change in accounting estimate is a change in the valuation of financial information.

The best example of a change in accounting policy is the inventory valuationInventory Valuation Inventory Valuation Methods refers to the methodology (LIFO, FIFO, or a weighted average) used to value the company's inventories, which has an impact on the cost of goods sold as well as ending inventory, and thus has a financial impact on the company's bottom-line numbers and cash flow situation.read more. The company is using First in, First Out (FIFO) inventory(FIFO) InventoryUnder the FIFO method of accounting inventory valuation, the goods that are purchased first are the first to be removed from the inventory account. As a result, leftover inventory at books is valued at the most recent price paid for the most recent stock of inventory. As a result, the inventory asset on the balance sheet is recorded at the most recent cost.read more method as the valuation of the stock. Due to the requirement of the law, now the company has to use Last In, First Out (LIFO) methodLast In, First Out (LIFO) MethodLIFO (Last In First Out) is one accounting method for inventory valuation on the balance sheet. LIFO accounting means inventory acquired at last would be used up or sold first.read more as the stock valuation.

In the accounting estimate, the company was using the Straight Line Method to depreciate the asset, and it has estimated salvage value of the assetSalvage Value Of The AssetSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000.read more as $3,000. But due to changes in the market scenario, now the company can fetch only $1,000 of its asset.

Due to this, the depreciable value would alter, resulting in a change in accounting estimate. In case the company would have changed the Straight Line Method to Written Down ValueWritten Down ValueThe Written Down Value method is a depreciation technique that applies a constant rate of depreciation to the net book value of assets each year, resulting in more depreciation expenses recognized in the early years of the asset's life and less depreciation recognized in the later years of the asset's life.read more, then it would be classified as a change in accounting policy.

Is a Change in Accounting Estimate Equivalent to Error?

An error is one that happens unintentionally, and change in estimates would not fall under this category.

Estimates are based on certain assumptions and theories, and when it changes according to the scenario, then we need to alter the basis. It does not tantamount to error or omission.

Once an error is identified, we need to assess the appropriate means to rectify the error.

There are three things to be considered when we identify the omission in the financial statements –

• Determining if the error exists and it is not changed in accounting estimate or principle
• Assessing the materiality of the error, keeping in mind the revenue or turnover of the company;
• Reporting an error in the previously issued financial statements;

So, there is a thin line of difference between error and change in estimate. It would involve the judgment and experience of the management involved.

Internal Controls on Changes in Accounting Estimates

Financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more risks related to changes in accounting estimates must be adequately mitigated by the proper internal controls placed by the management.

Management should understand the significant assumptions and methods used and ensure that unnecessary changes are timely identified by the controls to prevent harm to the interests of stakeholders.

A company should try the following to ensure stringent control on change in the accounting estimates.

• Communication flow should be proper and flawless.
• A qualified person should be handed this task for alteration, whenever required.
• A comparison between pre and post-change of the estimate should be listed out, which would help the stakeholders to make informed decisions.

How Should an Investor Look at Estimates?

An investor needs to ensure that the financial position of the company is free from bias, errors, and wrong assumptions.

He should be able to ask the following questions while deciding to invest in the company –

• Whether the rate of depreciationRate Of DepreciationThe depreciation rate is the percent rate at which an asset depreciates during its estimated useful life. It can also be defined as the percentage of a company's long-term investment in an asset that the firm claims as a tax-deductible expense throughout the asset's useful life.read more, if taken more than the permissible limit of the law, is in line with the usage of the assets?
• Is the provision of bad debtsProvision Of Bad DebtsA bad debt provision refers to the reserve made by a company to set aside an amount computed as a specific percentage of overall doubtful or bad debts that has to be written off in the next year.read more inflated or deflated to temper with the profits of the company?
• Is the useful life of the fixed asset proper?

Though it may seem difficult for an investor to deep-dive in such type of questions, the actual position of the company lies in this pothole only.

Disclosure of Change in Accounting Estimates

The entity should disclose the following in the financial statements-

• Nature and amount of change in an accounting estimate that has an effect in the current period or has an impact in the future periods
• If it is impracticable to determine the effect in future periods, then proper disclosure should be provided in the notes to accounts.

Conclusion

There are different and less stringent compliances when it comes to change in accounting estimate over the change in principle. The latter needs to be changed retrospectively, whereas the former to be prospective.

In some cases, one can find that the change in accounting principle may lead to a change in accounting estimate. In such cases, reporting and disclosure requirements of both variation in principle and estimate should be followed.

Recommended Articles

This has been a guide to Change in Accounting Estimate. Here we discuss Examples, Internal controls, and disclosure of Change in Accounting Estimate. We also discuss how investors look at estimates. You can learn more about financing from the following articles –

• Percent Change in Excel
• Obligation of Asset Retirement
• Prudence Concept