Understand The Difference Between Change in Accounting Estimate Versus Change in Accounting Policies

Change in Accounting Estimate

Basics:

• Use of estimate is an integral process of the accounting process.
• Use 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 due to change 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 debts;

     · 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 amount of warranty expenses; and

     · Changes in the estimates of the future economic benefits of intangible assets as such goodwill.

Impact of Change in Accounting estimate affects:

• would generally involve no prior period recalculation and impact only the latest reporting period or
• the period of the change and future periods if the change affects both.

Example affecting latest reporting period

• a bad debt underprovided

Example affecting both latest reporting period and future period

• 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.

Illustration No.1 : Example affecting the latest reporting period:

Last year 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 has admitted to make good certain technical fault.

In the current year ended 31 st Dec 2005, the amount incurred to fix the technical fault was $800,000.

Solution:

Journal entry:

Debit: Provision for claim expenses $600,000

Debit: Claim expenses (Income Statement) $200,000

Credit: Bank account $800,000

Being under provision of claim expenses

Illustration No 2: Examples affecting the latest reporting period and future periods:

A machine bought in Year 2003 for $1,000,000 was depreciated on a straight line basis over 10 years.

In the current year 2005, management decided to change the useful life to 6 years only.

Its companys policy to charge a full year depreciation in the year of purchase.

Solution:

Refer below for working:

Debit: Depreciation Expenses $200,000

Credit : Accumulated Depreciation $200,000

Workings:

Cost of Machine $1,000,000

Accumulated Depreciation (2003-4) (200,000)

Net Book Value at 1 st Jan 2005 $800,000

Depreciation per year over the revised

remaining useful life of 4 years $200,000

Salient points to note:

The financial impact of a change in accounting estimate is on the earnings of the latest (current) reporting period or the latest reporting period and the future periods.

The nature and amount of a change in an accounting estimate that has a MATERIAL effect in the current period or which is expected to have a material effect in subsequent periods should be disclosed. And if it is impracticable to quantity the amount, this fact should be disclosed.