Changes in Accounting Estimates
Accounting estimates are approximate values assigned by a company’s management to different accounting variables. Whenever a company changes such estimates, it is required to reflect the change only in current and future periods, but not in past periods.
Accounting elements are either definite, such as invoice price of a fixed asset, cost of freight, cost of insurance, an employee’s base salary, a building’s rent, interest expense on a fixed-rate loan, etc., or variable, such as useful life of a fixed asset, potential doubtful debts expense, potential warranty expense, potential damages payable under a law suit, etc. Accounting information is reliable when it is definite, but in many cases definite information become available only with the passage of time. In many situations, a company is required to strike a balance between relevance and reliability. The management is required to apply its best judgment to particular circumstances to arrive at an expected value.
Under IFRS, IAS 8 provides guidance on how to make accounting estimates and how to account for any change in such estimates over a period. It requires companies to reflect changes in estimates prospectively.
Examples of changes in estimate include:
- Change in useful life and salvage value of a fixed asset or intangible asset
- Change in provision for bad debts
- Change in provision for obsolescence of inventories
- Change in defined benefit obligation
Example: Prospective Application
CAE, Inc. is an airline that owns an XYZ aircraft that it bought in 2006 for $300 million. At the time of recognition of the aircraft as a fixed asset, i.e. on 1 January 2006, the company estimated its useful life to be 15 years and expected it to fetch $50 million at the end of its useful life.
The company uses straight-line depreciation method for the aircraft.
Regulatory changes introduced in November 2013 barred the company from flying this aircraft after the end of 2015. The company cannot fly it on any alternate route either. The management is forced to sell it and acquire an upgrade aircraft by end of 2015. It revised the useful life of the aircraft down to 10 years and increased its salvage value to $90 million.
Illustrate how the company will account for the developments in financial year ending 31 December 2014.
From 2006 to 2013, the company must have recorded yearly depreciation expense of $16.67 million [= ($300 million - $50 million) ÷ 15].
By end of 2013, the aircraft served 8 years of its 15-year useful life. Its book value at the end of 2013 comes out to be $166.6 [= $300 million - $16.67 million × 8].
The regulatory changes forced the company to reduce useful life down to 10 years. It means the remaining useful life as at 1 January 2014 was 2 years.
Depreciation expense for 2014 = ($166.6 million – $90 million) ÷ 2 = $38.32 million
Please note that the change in estimate is reflected only in periods subsequent to the change. It doesn’t affect any of the historical depreciation expense or book values.
Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork