Definition
Change in Accounting Estimate refers to an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. It often comes about due to changes in circumstances or newly obtained information. Such changes are reported in the period in which they occur and, if relevant, in future periods.
Key Takeaways
- A Change in Accounting Estimate is a modification made in the determination of the current or future periods’ earnings and assets based on new information.
- This change is natural and necessary as it reflects more accurate predictions due to changes in circumstances, new information, or more experience.
- A Change in Accounting Estimate doesn’t amend accounting figures retroactively. It only affects current and future financial statements, not past ones.
Importance
Change in Accounting Estimate is a crucial concept in finance as it reflects alterations made to previous approximations used for particular account values.
This is important as these changes directly impact the financial statements, which underpin decision-making processes for investors, creditors, and other stakeholders.
Since businesses and their environments are dynamic, estimates can change as more accurate data becomes available, resulting from changes in trends, policies, or economic conditions.
Hence, precise recognition, measurement, and reporting of a Change in Accounting Estimate is vital in maintaining truthful, transparent, and up-to-date financial reporting, aiding in more accurate financial planning, forecasting, and risk assessment.
Explanation
The purpose of a change in accounting estimate is to provide a more accurate reflection of a company’s financial position and performance. It involves adjusting the carrying amounts of assets or liabilities, or the amount of the periodic consumption of an asset. Any changes in the method of depreciation, amortization, or depletion for long-term assets under this principle are accounted for on a prospective basis.
This means that the change in the estimate is implemented in the current, as well as future accounting periods, and not retrospectively. The Change in Accounting Estimate is vital to improve the quality and relevance of the information provided in financial statements. It enhances the reliability of the financial statements by aligning the accounting estimates with the latest available information.
Usually, a company makes an estimate at the end of an accounting period, but as time progresses and new information is made available, the company might realize that its original estimate was not accurate, thus a ‘change in accounting estimate’ comes into action. It allows for adjusting the value of assets, liabilities or the determination of periodic expenses and income to mirror current market conditions or specific circumstances of the company. This is thus used for making financial statements more user-friendly and reflective of a company’s true financial condition.
Examples of Change in Accounting Estimate
**Depreciation of Assets**: An organization might estimate the lifespan of a piece of machinery to be 10 years, but after using it for a few years, they realize that it’s going to last 12 years. This change would mean they have to adjust the rate at which they’re depreciating this asset on their financial accounts.
**Bad Debt Provision**: A company may initially calculate an estimate for bad debt (debt considered uncollectible) as a certain percentage of their sales based on past experience. However, after observing a change in customers’ repayment behaviors or because of a change in the economic environment, the company may need to revise their estimate for bad debts. The new estimates will influence its provision for doubtful accounts and net income.
**Inventory Valuation**: A grocery store might estimate a certain percentage of their inventory will spoil and need to be thrown away each year. If the store implements a new system that allows them to reduce their spoilage, they’ll need to adjust their accounting estimate for shrinkage. As a result, the value of their inventory will change in their financial statements, affecting their cost of goods sold and gross profit margin.
FAQ: Change in Accounting Estimate
What is a Change in Accounting Estimate?
A change in accounting estimate refers to an adjustment of the carrying amount of an asset or liability, or the periodic consumption of an asset, which arises from the assessment of the present status and expected future benefits and obligations associated with assets and liabilities. These changes can occur due to new information or changes in circumstances.
What are some examples of Change in Accounting Estimate?
Examples of changes in accounting estimates are changes in the useful lives or residual values of depreciable assets, provisions for doubtful debts, warranty expenses, and changes in provision for taxation, etc.
How is a Change in Accounting Estimate accounted for?
Changes in accounting estimates are accounted for prospectively, which means that the effect of the change, if any, is recognised in the current and future periods affected by the change. In other words, previous financial statements are not restated.
What is the difference between a Change in Accounting Principle and a Change in Accounting Estimate?
A Change in Accounting Principle is when a company changes from one generally accepted accounting principle to another, while a Change in Accounting Estimate occurs when there are changes in the expected physical or economic conditions of a company. In other words, a Change in Accounting Principle impacts the method or procedure and a Change in Accounting Estimate impacts the estimates or assumptions used in the method or procedure.
Who is responsible for making a Change in Accounting Estimate?
The management of a company is responsible for making a Change in Accounting Estimate. This is part of their function of overseeing the financial activities and overall health of the company.
Related Entrepreneurship Terms
- Income Statement Impact
- Depreciation Method Change
- Amortization Period
- Useful Life Revision
- Asset Valuation Adjustment
Sources for More Information
- Investopedia: A reputable site providing a breadth of financial terms and explanations.
- Accounting Tools: This website is dedicated to explaining complex accounting terms and concepts.
- Financial Accounting Standards Board (FASB): Official site of the organization that sets accounting standards in the United States, it may provide the technical definition and treatment of the term.
- IAS Plus: A comprehensive site offered by Deloitte providing resources and news about international accounting standards.
