Change in Accounting Estimate (Examples) | Internal Controls and Disclosure

What is a change in an accounting estimate?

A change in an accounting estimate occurs when there is the emergence of new information, which replaces existing data on the basis of which the company made a previous decision, which led to two things – a change in the carrying amount of an existing asset or liability and a subsequent change. Accounting for the recognition of future assets and liabilities.

Examples of a change in an accounting estimate

While calculating coefficients, we need to take into account the number of estimates or use our caution or judgment. In some cases, these estimates may be inappropriate, as the basis on which we have taken our assumption has changed. To keep our books in line with subsequent changes, it warrants the change in the accounting estimate.

In the following case, we use our caution.

  • bad debt reserve
  • Save obsolete inventory
  • Change in the useful life of depreciable assets
  • Change in liability arising from warranty obligations
  • Estimated lifetime of goodwill
  • The discretion involved in assessing the criterion of potential liability
  • Post-retirement commitments say pension, bonus.

This is not an exhaustive list, and will expand depending on the sector in which the business is involved.

Digital example

ICE purchased a chemical plant for $400 million on January 1, 2016. At the time the plant was recognized as a fixed asset, the company estimated its useful life of 10 years and salvage value of $80 million.

The company used the straight line method to depreciate the assets.

On January 1, 2019, the company must learn that the salvage value of the plant has been reduced to $60 million and its lifespan has been reduced to 8 years, due to the new technology being introduced into the market.

Calculation

  • From 2016 to 2018, the company would have reported depreciation of $32 million annually, {(400-80)/10}.
  • The book value as at January 1, 2019, will be $336 million. ($400 – $32 – $32).
  • Because of the new technology in the market,
  • Now the adjusted depreciation would be $35 million {(336-60)}/8}.

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

Change in accounting policy and estimate is not the same

A change in accounting policy governs how financial information is calculated, where a change in an accounting estimate is a change in the evaluation of financial information.

The best example of a change in accounting policy is the valuation of inventory. The company uses the first in, first out (FIFO) inventory method as an inventory valuation. Due to the requirements of the law, the company is now required to use the Last In, First Out (LIFO) method as the stock valuation.

In the accounting estimate, the company was using the straight line method to depreciate the asset, and estimated the salvage value of the asset at $3,000. But due to changes in the market scenario, the company can now bring in only $1,000 of its assets.

As a result, the depreciable value may change, which leads to a change in the accounting estimate. If a company changes the straight line method to a written low value, it will be classified as a change in accounting policy.

Is a change in an accounting estimate equivalent to an error?

An error is an error that occurs inadvertently, and a change in estimates would not fall into this category.

Estimates are based on certain assumptions and theories, and when they change according to the scenario, we need to change the basis. It does not amount to error or omission.

Once the error has been identified, we need to evaluate the appropriate means to correct the error.

There are three things to consider when defining an omission in the financial statements –

  • Determine whether an error exists and has not changed in an accounting estimate or principle
  • assess the relative importance of the error, taking into account the company’s revenue or turnover;
  • reporting an error in previously issued financial statements;

Therefore, there is a fine difference between error and change in estimate. It will include the judgment and experience of the concerned department.

Internal controls over changes in accounting estimates

Financial statement risks related to changes in accounting estimates must be appropriately mitigated by appropriate internal controls established by management.

Management must understand the important assumptions and techniques used and ensure that unnecessary changes are identified in a timely manner by controls to prevent harm to stakeholder interests.

The company shall attempt the following to ensure strict control over the change in accounting estimates.

  • The flow of communications must be adequate and free from defects.
  • This task should be handed over to a qualified person to change, whenever required.
  • A comparison between before and after the change should be included in the estimate, which helps stakeholders to make informed decisions.

How should an investor view estimates?

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

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

  • Whether the rate of depreciation, if taken up more than the limit permitted by law, is in line with the use of assets?
  • Is the provision of bad debts exaggerated or hollowed out in proportion to the company’s earnings?
  • Is the useful life of the fixed asset appropriate?

Although it may seem difficult for an investor to delve into this type of question, the actual position of the company lies only in this hole.

Disclosure of a change in accounting estimates

The entity must disclose the following in the financial statements-

  • The nature and amount of the change in an accounting estimate that has an effect in the current period or has an effect in future periods
  • If it is impracticable to determine the effect in future periods, appropriate disclosure should be made in the notes to the accounts.

Conclusion

There is a different and less strict compliance when it comes to a change in an accounting estimate over a change in principle. The latter needs to be changed retrospectively, while the former must be prospective.

In some cases, one can find that a change in the accounting principle may lead to a change in the accounting estimate. In such cases, reporting and disclosure requirements for both the difference in principle and discretion must be followed.

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