Change in accounting estimates (IAS 8 32 – 39) is an accounting rule which is easily explained in a few captions of bullet points, as follows.
- Use of estimates is an integral process of the accounting process.
- Use of estimates is in line with matching concept and conservatism concept
- Use of estimate is needed due to the inherent uncertainties in business activities
- There is a need to revise the estimate due to changes in circumstances on which the estimate was based or as a result of new information, more experience or subsequent developments.
Examples of changes in accounting estimates include:
- Changes in the estimate of the collectibility of trade debtors;
- Changes in the estimate of useful lives or depreciation methods of depreciable assets;
- Changes in the estimates of provision for stock obsolescence;
- Changes in the estimates of the amount of warranty expenses; and
- Changes in the estimates of the period an entity may enjoy the future economic benefits of intangible assets as such customer relationships, a customer database, a well trained technical workforce, and goodwill.
Impact of a change in accounting estimate affects:
- would generally involve no prior period recalculation and impact only the current reporting period, or
- the current period and future periods of the change in the estimate if the change affects both.
An example of a change in an accounting estimate affecting latest reporting period is a bad trade debtor under-provided
An example of a change in an accounting estimate affecting both the current reporting period and the future period(s) of the change in the estimate is a change in the estimate of the useful life of a fixed asset where the effect is applied prospectively by allocating the carrying amount of the fixed asset over the current and future periods during the remaining useful life of the asset.
Example affecting the latest reporting period
In 2004, Company ABC has provided for claim expenses of €600,000 in respect of an installation work done for a customer. However, due to negligence, the company had to agree to improve/repair a certain technical fault.
In the current year ended 31 st Dec 2005, the amount incurred to fix the technical fault was €800,000.
The provision was understated at the end of 2004, the underprovision of €200,000 will be recorded as a claim expense in profit or loss in 2005.
Examples affecting the current reporting period and future periods
A machine bought in 2003 for €1,000,000 is depreciated on a straight line basis over 10 years. Its company’s policy to charge a full year depreciation in the year of purchase.
In the current year 2005, management came to the conclusion that the useful life should have been 6 years.
The machine was depreciated for two tears, 2003 and 2004. The net book value as at 1 January 2005 was €800,000 (€1,000,000 -/- €100,000 (depreciation 2003) -/- €100,000 (depreciation 2004)). The revised (remaining) useful life as at 1 January 2005 is changed from 8 years (of 10 years 2 years are consumed) to 4 years (of 6 years 2 years are consumed). The change in estimate is not retrospectively adjusted in 2003 and 2004.
The depreciation in 2005 is €200,000 (net book value €800,000 / 4 years).