Gripping GAAP Accounting policies, estimates and errors
4. Changes in Accounting Estimates (IAS 8.32 ± 40)
4.1 Overview Accounting estimates are
defined as:
Many elements in our financial statements (whether
x monetary amounts in financial
recognised or just disclosed) are not able to be measured statements that are subject to
precisely. In this regard, accounting policies could require x measurement uncertainty. IAS 8.5
an element to be measured at an amount that:
x can be directly observed (e.g. the measurement of land at cost can be directly observed
by way of the amount stated in the purchase contract), or
x cannot be directly observed (e.g. the measurement of plant at depreciated cost will
require us to estimate the depreciation). Please note:
Inventory cost formulae
If the measurement of an element cannot be directly observed, we
(e.g. first-in-first-out),
say it involves measurement uncertainty. In this case, to achieve
are not valuation techniques
the accounting policy objective (e.g. measurement at depreciated
used in developing accounting
cost), we develop an accounting estimate (e.g. depreciation). We
estimates but are accounting
do this using measurement techniques (e.g. the income approach
policies instead. See IAS 8.32 and .35
could be used to estimate fair value) and inputs (e.g. useful life,
residual value and depreciation method are used to estimate depreciation).
Thus, making estimates is an integral part of preparing financial statements and, if they are
based on reasonable judgements and assumptions, they will not undermine the reliability of
our financial statements (faithful representation).
Almost as often as estimates are made, we will decide that previous estimates are overestimated
or underestimated. These are not errors because estimates by their very nature will always need
to be adjusted as and when the circumstances relating to the original estimate change. See IAS 8.33-34
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Gripping GAAP Accounting policies, estimates and errors
If ever we find it difficult to distinguish between a change in estimate and a change in policy,
the change should rather be treated as a change in estimate (good news since a change in
estimate is a lot simpler to account for than a change in policy). IAS 8.35
4.2 How to adjust for a change in accounting estimate (IAS 8.32 - 38)
A change in estimate is applied prospectively (not
retrospectively). This means it will affect the profit or loss A change in accounting
estimate:
in the current and maybe also future periods, but will
never affect prior year profit or loss. For example: x is applied prospectively, thus
x a change to the expected credit loss allowance x affects current / current & future periods
(previously called a doubtful debt allowance) relating to trade receivables, will change the
credit loss expense recognised in that current year only; whereas
x a change to the useful life of a depreciable asset will affect the depreciation expense in
both the current and the future periods (i.e. until the asset is fully depreciated).
Although not specifically mentioned in IAS 8, there are two methods of making a change in
estimate: the cumulative catch-up method and the reallocation method. The amounts of the
change in estimate and the related disclosure will differ depending on which method is used.
Interesting fact: At first glance, it may seem that IAS 8 simply suggests the use of what we call the
reallocation method (e.g. see IFRIC 1.BC12-17). However, other standards specifically refer to the use
of what we refer to as the cumulative catch-up method (e.g. IAS 20.32 actually requires the use of
the cumulative catch-up method). Thus, clearly both methods are allowed and important.
When using the cumulative catch-up method, the adjustment made in the current year actually
includes the effect that we would otherwise have processed in prior years. This method ensures that
the FXUUHQW \HDU¶V closing balances in the statement of financial position will reflect the latest
estimates. The downside is that this method distorts the current year profits since the change in
estimate adjustment includes the effect on prior year balances (i.e. change in estimate adjustments
are always made prospectively, even when the cumulative catch-up method is used).
When using the reallocation method, no adjustment is made in the current year for the effect of the
change on prior years. Example: the opening carrying amount of plant (calculated in accordance with
the previous estimate) is simply reallocated over the remaining revised estimated useful life.
Thus, the reallocation method ensures that the impact of the change in estimate is spread evenly over
the future and therefore does not distort the current year profits. The downside is that no effort is
made to update the balances in the statement of financial position for the latest estimates.
These two approaches are best explained by way of examples.
Example 3: Change in estimated useful life:
Reallocation vs Cumulative catch-up method
Machinery was purchased on 1 January 20X7, on which date it had an estimated useful life
of 5 years and a nil residual value. The carrying amount on 31 December 20X8 was C300 000:
Cost (1/1/20X7) C500 000
Accumulated depreciation Being: (500 000 ± 0) / 5 yrs x 2 yrs (200 000)
Net carrying amount (31/12/20X8) 300 000
On the 1/1/20X9, the total economic useful life was re-estimated to be 4 years.
Required:
A. Assuming that the re-allocation method is used:
i) Show the journals assuming that the 20X9 depreciation journal had not yet been processed.
ii) Show all depreciation journals that would be processed in 20X9 assuming that the 20X9
depreciation journal had already been processed (i.e. before the change in estimate).
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Gripping GAAP Accounting policies, estimates and errors
Solution 3A: Change in estimated usHIXOOLIH WKHµUHDOORFDWLRQPHWKRG¶
Comment:
x Using the reallocation method, we do not consider the effect of the change in estimate on prior
years ± instead, we simply start with our opening carrying amount in the year of the change and
reallocate it over the remaining useful life.
x There is a change in estimated useful life:
the original estimate was that there were 3 remaining years (5 years ± 2 years), whereas
the revised estimate is that there are only 2 remaining years (4 years to 2 years).
W1 Calculations Was Is Difference
Reallocation method (a) (b) (b) – (a)
Cost Given 500 000
Accum. depr: 31/12/20X8 500 000 / 5 x 2 yrs (200 000)
Carrying amount: end 20X8 Put this in the µLV¶ 300 000 300 000 0 (c)
column as well j
Remaining useful life (5 ± 2yrs) (4 ± 2 yrs) 3 years 2 years
Depreciation ± 20X9 (300 000 / 3 years) (100 000) (150 000) (50 000) (d) More depr
(300 000 / 2 years)
Carrying amount: end 20X9 200 000 150 000 (50 000) (e) = (c) + (d)
i
Depreciation ± future Balancing (200 000) (150 000) 50 000 Less depr.
Carrying amount: future Residual value 0 0 0
j Notice that the carrying amount at 31 December 20X8 was C300 000.
i By the end of year 20X9, the carrying amount must be reduced to C150 000.
Thus, this means that depreciation of C150 000 must be journalised in 20X9 (300 000 ± 150 000):
C
Depreciation ± based on previous estimate 3HU: FROXPQµZDV¶ 100 000
Change in estimate Per : FROXPQµGLIIHUHQFH¶(e) 50 000
Total depreciation 150 000
i) Depreciation journals in 20X9: depreciation had not yet been processed
If the accountant realised that he needed to change the estimate before he had processed the 20X9
depreciation, the 20X9 depreciation journal would be:
Debit Credit
Depreciation (E) CA o/b: 300 000j± CA c/b: 150 000i 150 000
Machinery: accumulated depreciation (-A) 150 000
Depreciation using total useful life (TUL) of 4 yrs (new estimate)
ii) Depreciation journals in 20X9: depreciation had already been processed
If the accountant realised that he needed to change the estimate after he had already processed the
20X9 depreciation based on the old estimate, the 20X9 depreciation journals would be:
Debit Credit
Depreciation (E) (500 000 ± 0) / 5 yrs x 1 yr 100 000
Machinery: accumulated depreciation (-A) 100 000
Depreciation using total useful life (TUL) of 5 yrs (old estimate)
Depreciation (E) CA o/b: 300 000j ± CA c/b: 150 000i 50 000
± depreciation already processed: 100 000
Machinery: accumulated depreciation (-A) 50 000
Change in estimated depreciation: depreciation of 100 000 for 20X9
was already processed, based on a TUL of 5yrs (old estimate), but
the TUL since changed to 4 yrs. Using reallocation method, we must
get the opening CA of 300 000 down to a closing CA of 150 000
(W1), so we need to process an extra 50 000
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Gripping GAAP Accounting policies, estimates and errors
4.3 Disclosure of a change in accounting estimate (IAS 8.39 - 40)
The nature and amount of the change in estimate must
Disclosure of a change in
be disclosed, where the amounts to be disclosed are as accounting estimate
follows: includes:
x the effect on the current period; and x Brief description of ‘what’
x the effect on future periods, unless estimating the x Effect on each line item
future effect is impracticable, in which case this fact should be disclosed. See IAS 8.39-40
Example 4: Disclosure of a change in accounting estimate
Use the same information as that provided in example 3.
Required:
A. Disclose the change in estimate using the re-allocation method.
Solution 4A: Disclosure of a change in estimate: re-allocation
Company name
Notes to the financial statements (extracts)
For the year ended 31 December 20X9
20X9 20X8
3. Profit before tax Note C C
Profit before tax is stated after taking the following into account:
Depreciation 150 000 100 000
x original estimate 100 000 100 000
x change in estimate See Solution 3A: W1 5 50 000 0
Company name
Notes to the financial statements (extracts) continued ...
For the year ended 31 December 20X9
20X9 20X8
5. Change in estimate Note C C
The estimated economic useful life of machinery was changed from 5 years to 4 years.
The (increase)/ decrease in profits caused by the change is as follows:
x &XUUHQW\HDU¶VSURILWV 50 000
x Future profits: (50 000)
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