Changes in accounting estimates occur when an entity, as a result of new information, is forced to make a new valuation of it’s estimated liabilities.
An accounting estimate is a calculation that a company performs on events that will occur in the future.
Due to it being an approximate calculation, this estimate may change as a result of new information that an entity receives over time.
Accounting estimates have the particularity they are exposed to different variables that prevent a company from knowing the exact amount that it should recognize in the financial statements.
For this reason, IAS 8 allows changes in accounting estimates to be recognized prospectively.
For example, an entity acquired a machine for 2,000,000, the entity’s management estimated useful life of 15 years.
However, after five years, based on the new information supplier provided, the company estimates the useful life should be 25 years instead of 15.
This economic fact is a change in an accounting estimate, as the change is the product of new information the entity received, information that the company did not have when calculating the initial estimate.
Changes in accounting estimates recognition
The accounting recognition of changes in accounting estimates is simple since it is unnecessary to affect previous accounting periods, unlike changes in accounting policies.
For example, an entity receives a demand by an employee in year one for wrongful termination.
The amount of claim can vary between 10,000 to 50,000 dollars.
The trial will take place in 3 years.
The entity considers that it is likely to pay a sum of $20,000 due to demand.
However, the lawyers set out that this amount may vary due to the evidence provided during the process.
At the end of year 2, the company’s attorneys believe the entity should increase its estimate from $20,000 to $32,000.
Because it is a change in an estimate, the entity should not affect the financial statements of year one but the current period’s financial statements.
Examples of changes in estimates
Example 1: An entity acquires a building for 500,000 with a useful life of 30 years; the company estimates that in the year 20, it will sell the building for 80,000.
That is, the asset’s residual value is 16% (80,000 / 500,000).
In year 15, due to the decrease in the real estate demand, the entity considers it will only be able to sell the asset for 60,000.
This means that the residual value went from 16% to 12 %. (60,000 / 500,000).
The immediate effect of this change is a variation in asset depreciation.
Before continuing with more examples, I leave you this article if you want to expand the information about the residual value of an asset.
Example 2: An entity leases a warehouse for five years to store perishable food; however, due to inventory characteristics, it is necessary to modify the warehouse interior so that the food remains in perfect condition.
Both the lessor and the lessee agree that once the lease agreement ends, it will be necessary to return the asset under the same conditions as those established in the agreement beginning.
The company estimates that it must incur 40,000 to leave the warehouse in the same conditions as the original asset delivered once five years have passed.
Besides, at the end of year 4, the company considers it necessary to increase its estimate due to the increase in the raw material price.
Therefore, the entity management believes it will have to disburse 60,000 instead of 40,000.
This example is a change in accounting estimate because it results from new information received by the company.
If you want more information about decommissioning costs, you can read the following article.
Example 3: An entity acquires inventory, with a trusted supplier, for 200,000 for 4 years without interest.
Although the agreement does not incorporate the recognition of interest payable to the supplier, the entity must recognize an implicit interest as a result of the inventory financing.
For this, the entity considers a rate of 10% reflects agreement expectations in relation with the present value.
Of this way, the entity must recognize an asset and a liability for ((1 + 10%) ^ -4) X 200,000 = 136,603
Each year, the entity must reverse the implicit interest against an expense until it reaches a liability corresponding to 200,000.
However, what is the effect if, at the end of year 2, the interest rate goes from 10% to 12%?
At the end of year 5, the liability of the agreement amounts to: 165,289 ((1 + 10%) ^ -2) X 200,000)
Based on the new information, the liability at the end of year 2 should be 159,439. ((1 + 12%) ^ -2) X 200,000)
Thus, the company must make an adjustment in the liability for 5,850
As we can see in the analyzed examples, all the changes produced are due to the effect of new information that has emerged, that is, information that the entity did not have at the time of making the first estimate.
Examples that do not represent changes in an accounting estimate
The following examples do not represent changes in accounting estimates:
An entity changes how it measures its inventories from FIFO to a weighted average.
An entity measures its property, plant, and equipment in the subsequent measurement at cost and decides to change the revaluation model.
An entity presents its statement of financial position classifying its assets and liabilities as current and non-current and decides to change a presentation based on the degree of liquidity.
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The difference between an accounting policy and an accounting estimate is that changes in estimates are recognized prospectively, while changes