Accounting Estimates
Preparation of financial statements may involve the use of accounting estimates in determining the carrying amounts of assets & liabilities and the associated expense or income for the period where such amounts cannot be measured precisely.
Examples of accounting estimates include the following:
- Valuation of land where it is accounted for at revalued cost
- Impairment of non-current assets
- Useful lives of non-current assets
- Pattern of economic benefits expected to be received from non-current assets for calculating depreciation
- Impairment of receivables (bad debts)
- Pension Benefit obligations
- Provision for slow moving and obsolete inventory
Accounting Estimates involve management’s judgment of expected future benefits and obligations relating to assets and liabilities (and associated expense and income) based on information that best reflects the conditions and circumstances that exist at the reporting date. By its nature, estimates are subjective and may require frequent revisions in future. Revision of estimates must be distinguished correction of errors which occur because of not using information that was available at the time of preparation of financial statements.
Changes in Accounting Estimates
Estimates must be revised when new information becomes available which indicates a change in circumstances upon which the estimates were formed.
Changes in Accounting Estimates must be accounted for prospectively in the financial statements, i.e. the effects of the change must be incorporated in the accounting period in which the estimates are revised. Therefore, carrying amounts of assets and liabilities and any associated expense and gains are adjusted in the period of change in estimate.
Prospective application of changes in estimates prevents frequent revisions in prior period comparative figures which might cause unnecessary complications in respect of financial statement balances that are expected to be revised in future due to availability of new information or the experience of new events.
When it is hard to differentiate between a change in accounting policy and a change in accounting estimate, the change is accounted for prospectively.
Example
ABC LTD has depreciated a machine over its expected useful life of 5 years. The cost of machine was $100,000 and annual depreciation charge was therefore $25,000. No residual value is expected at the end of the machine’s useful life.
Three years later, the remaining useful life of the machine was estimated to be only 1 years.
ABC LTD should account for the change in estimate prospectively by allocating the net carrying amount of the asset over its remaining useful life. No adjustment is required to restate the depreciation charge in previous accounting periods.
Depreciation expense for the machine would therefore be as follows:
| Depreciation Expense | Accumulated Depreciation | Working | |
|---|---|---|---|
|
Year 1 |
20,000 |
20,000 |
(100,000/5) |
|
Year 2 |
20,000 |
40,000 |
(80,000/4) |
|
Year 3 |
30,000 |
70,000 |
(60,000/2) |
|
Year 4 |
30,000 |
100,000 |
(30,000/1) |
Although expected useful life of the machine has reduced at the end of third year, depreciation expense recorded in previous years is not affected. Instead, the depreciation expense is increased accordingly in years 3 and 4.