What it means
Many numbers in a set of accounts are estimates, not exact measurements. Examples include the useful life of equipment, the residual (scrap) value of an asset, the allowance for doubtful debts, warranty provisions and the expected outcome of a lawsuit.
Estimates need revising as circumstances develop. A machine may turn out to last longer than expected, customers may pay more reliably than assumed, or a settlement figure may become clearer, and a good accountant adjusts the numbers when the evidence changes.
Under both IFRS and US GAAP the treatment is prospective. This means the company records the effect in the current period, and in future periods if they are affected, without going back to restate comparatives.
The reasoning is that a change in estimate is not an error. The earlier figure was a fair best guess at the time, and it would be misleading to rewrite history because things turned out differently.
It is important to separate a change in estimate from a correction of an error and from a change in accounting principle. A calculation mistake or the misuse of facts that existed at the time is an error and is corrected retrospectively, whereas switching from one accepted method to another is a change in principle.
Disclosure is expected when the effect is material. The notes normally describe the nature of the change and its impact on profit, so that readers can compare periods sensibly.
In practice
Real-world examples
Example 1
A retailer reviews its customer receivables and finds that bad debts have been far lower than its allowance of 5% suggested. It cuts the allowance to 3% going forward and records the release of the surplus in the current year's profit.
Example 2
A trucking company concludes from maintenance records that its vehicles last 8 years, not 6. It spreads the remaining carrying amount over the longer period, which lowers depreciation from the date of the review. The change is recorded in the same period as the review, and the finance director documents the evidence.
Example 3
A software business that offers a one-year warranty on its hardware finds that claims are running higher than expected. It increases its warranty provision and records the extra cost in the current period, with a note explaining why. The finance team reviews the claims data each quarter to keep the provision realistic.
Think of it
A change in estimate updates assumptions going forward-not rewriting history, just adjusting the future.
Formula
Calculation
Revised annual depreciation = (Carrying amount at date of change - Revised residual value) / Revised remaining useful life
A company bought a machine for $100,000 with a 10-year life and no residual value, so annual depreciation was $100,000 / 10 = $10,000. After 4 years the accumulated depreciation is $40,000, giving a carrying amount of $60,000. Management now expects the machine to last 8 more years. Revised annual depreciation = $60,000 / 8 = $7,500, so annual expense falls by $2,500 and profit rises by the same amount before tax, from the year of the change.Case study
Seen in the real world
Westbrook Aviation Services is an illustrative, fictional company that maintains regional aircraft. Its ground equipment was depreciated over 8 years, but the engineering team noticed that after 5 years most items were still performing as new.
The finance director took the evidence to the auditors and agreed to extend the useful life to 12 years for the equipment still in service. The remaining carrying amount of $240,000 was spread over 7 years instead of 3, reducing annual depreciation from $80,000 to about $34,300.
The illustrative notes explained the change and its effect, and no prior-year figures were restated. Investors noticed the profit uplift, but because the reasoning was documented and tied to maintenance records, they accepted it as a genuine update and not an attempt to flatter the results. The auditors reviewed the maintenance logs and agreed that the estimate was reasonable.
Watch out
Common mistakes
- Restating prior years for a change in estimate, when the correct treatment is to apply it prospectively.
- Using a change in estimate to smooth profits without any new evidence, which can look like earnings management.
- Confusing a change in estimate with an error correction, so that real mistakes are treated too lightly.
Questions
People also ask
Does a change in estimate need auditor approval?
Auditors do not approve it, but they will test whether the new estimate is reasonable and properly disclosed.
What if I cannot tell whether it is a change in estimate or principle?
Accounting standards say that when the distinction is unclear it is treated as a change in estimate, with the effect applied going forward.
How often should estimates be reviewed?
At least at each reporting date, and whenever there is a clear event such as a new technology, a change in usage or fresh data.
Watch