What it means
Financial statements are full of estimates. Nobody knows precisely how long a machine will last, which customers will fail to pay, how many products will come back under warranty, or what a pension scheme will cost.
Accounting requires a best estimate at each reporting date, and it requires the estimate to be revised when the facts change. The revision is a change in accounting estimate.
The rule is that the change is applied from the date it is made and going forward. If a machine bought for $1,000,000 was being depreciated over ten years and, after four years, is now expected to last only seven in total, the remaining carrying amount of $600,000 is written off over the remaining three years at $200,000 a year, instead of $100,000.
The depreciation of the first four years is not changed; the higher charge falls in years five to seven. If a receivables allowance of 3% is revised to 5% in the light of rising defaults, the extra 2% is charged in the year of the revision.
The rationale is that the earlier estimates were the best available at the time and the accounts of those periods were correctly stated; the new information changes the future, not the past. The alternative treatments are reserved for different situations.
A change in accounting principle (switching from one acceptable method to another, such as from FIFO to weighted average inventory costing) is applied retrospectively, with prior periods restated as if the new method had always been used, because the change is one of policy and comparability requires consistency. A correction of an error (a mistake in applying the rules, a miscalculation, a misuse of facts that were available) is also retrospective, because the prior accounts were wrong.
Distinguishing an estimate change from an error is sometimes contentious: if the earlier estimate ignored information that was available at the time, it may have been an error rather than a judgement, and the treatment and the disclosure differ. Disclosure is required for material changes: the nature of the change, its effect on the current period, and where practicable its expected effect on future periods.
Investors read these disclosures for what they reveal about management's judgement. A pattern of estimate changes that all improve current profit (longer asset lives, lower provisions, higher completion percentages) is a warning sign; changes that follow evidence in both directions are the ordinary business of accounting.
Some changes are hard to classify because they involve both a principle and an estimate; the standards treat a change in depreciation method as a change in estimate, since the method is a means of estimating the consumption of the asset. And a change in estimate that is so large it calls the previous estimate into question may prompt the auditor to ask whether the previous accounts were prepared with reasonable care.
In practice
Real-world examples.
Example
An airline extends the estimated life of its aircraft from 20 to 25 years after a maintenance review, reducing annual depreciation by $40 million prospectively.
Example
A contractor revises the estimated cost to complete a project upward by $2 million, reducing the profit recognised to date and future margins under the percentage-of-completion method.
Example
A retailer increases its inventory obsolescence allowance from 4% to 7% after a systems change reveals slow-moving lines, charging the difference in the current year.
Think of it
“A change in estimate updates assumptions going forward-not rewriting history, just adjusting the future.
Formula
Calculation
Prospective application: Remaining carrying amount (or obligation) is spread over the revised remaining period, or the revised provision is recognised, from the date of change; no restatement of prior periods
Revised annual depreciation = (Carrying amount at date of change minus Revised residual value) / Revised remaining useful life
Effect on current period = Charge under revised estimate minus Charge that would have arisen under the previous estimate
Worked example 1, useful life. A company bought a bottling line for $2,400,000 on 1 January of year 1, with an estimated life of 12 years and no residual value: depreciation $200,000 a year. At the start of year 5, after a technical review, management concludes the line will last 8 years in total and will have a residual value of $100,000.
- Carrying amount at start of year 5 = $2,400,000 minus (4 x $200,000) = $1,600,000
- Revised remaining life = 4 years; revised residual $100,000
- Revised annual depreciation = ($1,600,000 minus $100,000) / 4 = $375,000
- Effect on year 5 profit: $375,000 charged instead of $200,000, a reduction of $175,000; the same in years 6 to 8
- Years 1 to 4 are not restated. Disclosure: "During the year the estimated useful life of the bottling line was revised from 12 to 8 years and a residual value of $100,000 was introduced, increasing the depreciation charge by $175,000 in the current year and in each of the next three years."
Worked example 2, receivables allowance. A company has trade receivables of $8,000,000 and an allowance for expected credit losses of $240,000 (3%), based on historical loss rates. During the year, two customers in its largest sector fail, and an analysis of the sector's payment behaviour supports a loss rate of 5% on the $3,000,000 of receivables from that sector and 3% on the rest.
- Revised allowance = 5% x $3,000,000 + 3% x $5,000,000 = $150,000 + $150,000 = $300,000
- Increase = $60,000, charged to profit in the current year as an increase in the expected credit loss expense
- No restatement: the 3% rate was the best estimate when it was made
Worked example 3, warranty. A manufacturer provides for warranty at 2% of sales, based on five years of claims experience; the provision stands at $500,000. A design fault in a product line launched last year produces claims running at 6% on that line's $4,000,000 of sales. The provision for that line is revised to $240,000 (6%) from $80,000 (2%), an increase of $160,000 charged in the current year. The 2% rate on other lines is unchanged. A reader might ask whether last year's provision was an error; the answer is no if the fault was not known and could not reasonably have been known when the estimate was made, and yes if warranty claims data showing the problem was already available and ignored.Case study
Seen in the real world.
A listed telecoms company extended the estimated useful lives of its network equipment from 8 years to 12 years, disclosing the change as a change in accounting estimate that reduced the year's depreciation by $95 million and turned a small loss into a profit. The stated basis was a technical review concluding that the equipment would remain in service longer than originally assumed. Analysts noted that the change coincided with a profit target on which management bonuses depended, that competitors used 8 to 10 years, and that the company's own capital plan showed the equipment being replaced within 9 years.
The audit committee, prompted by the analysts and by the auditor's own concerns, commissioned an independent engineering review, which supported a life of 9 years. The company revised the estimate again the following year, disclosed the circumstances, and its chief financial officer left.
The regulator's subsequent guidance on estimate changes emphasised that a change must be supported by evidence about the assets, not by the desired result, and that the disclosure should allow readers to judge the basis. The episode illustrated that a change in estimate is prospective in its accounting and retrospective in its scrutiny.
Watch out
Common mistakes.
- Restating prior periods for a change in estimate. The treatment is prospective; only errors and changes in principle are applied retrospectively.
- Classifying an error as a change in estimate to avoid restatement, or a change in estimate as an error to move its effect out of current profit. The distinction depends on whether the information was available when the original figure was determined.
- Making estimate changes that consistently favour reported profit without evidence, which readers and regulators treat as earnings management.
Questions
People also ask.
What is the difference between a change in estimate and a change in accounting principle?
An estimate is a judgement about uncertain facts (a life, a rate, an amount); a principle is a method (FIFO versus average cost). Estimate changes are prospective; principle changes are retrospective.
Must a change in estimate be disclosed?
If material: the nature of the change, its effect on the current period, and its expected effect on future periods where practicable.
Is a change in depreciation method an estimate change or a principle change?
Under both IFRS and US GAAP it is treated as a change in estimate, because the method is a means of estimating how the asset's benefits are consumed.
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