The preparation of financial statements often requires management to make estimates. Estimates involve judgements based on the latest available, reliable information. Some examples of estimates include determining an allowance for doubtful debts, provisions for slow moving or obsolete inventory, the useful lives of property, plant and equipment and intangible assets, fair values of financial assets and financial liabilities, recoverability of deferred tax assets, actuarial assumptions relating to defined benefit pension schemes, warranty provisions and impairment provisions.

The use of reasonable estimates is an essential part of the financial statements preparation and does not undermine their reliability. However, the degree of reliability of estimates can vary.

For example, estimates of the useful lives of property, plant and equipment tend to change infrequently, while estimates of inventory obsolescence or warranty obligations might change each year, or more frequently in response to consumer demand or manufacturing performance.

Distinction between change in accounting policies and accounting estimates

Changes in accounting estimates do not, by their nature, relate to prior periods and are not corrections of errors. Therefore, the accounting treatment for changes to accounting policies and estimates are different. However, IAS 8 only specifically defines ‘accounting policies’ and ‘change in accounting estimates’, and not ‘accounting estimate’ itself.

A change in accounting estimates 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. Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors”.

An entity might also consider the following questions when distinguishing between a change in accounting policy and an accounting estimate:

• What was the impetus for the change?
• Does the change arise as a result of new information, more experience or subsequent developments? Did the estimation model change, or just the inputs?
• Why and when did the inputs change? IFRS 13 states that a change in valuation technique or its application is a change in accounting estimate.
• Does the change relate to accounting that includes inherent uncertainty which is subject to estimation?
• Is the accounting result significantly different from the result before the change, and why?

IAS 8 provides specific guidance on certain changes. A change in the measurement basis (For example, a change from carrying assets at historical cost to carrying them at fair value) is a change in accounting policy and not a change in accounting estimate. In addition, IAS 16 notes that a change in depreciation method is a change in estimate and not a change in accounting policy.

Where it is still difficult to distinguish a change in accounting estimate from a change in accounting policy, the change is treated as a change in accounting estimate.

Applying changes in accounting estimates

An entity should recognize the effect of a change in accounting estimate prospectively (that is, from the date of change) by including it in profit or loss in:

• the period of the change, if the change affects that period only; or
• the period of the change and future periods, if the change affects both.

An example of a change in accounting estimate that would affect the current period profit and loss, and that would not affect future periods’ profit and loss, is a change in the allowance for doubtful debts.

A change in the estimate of the useful life of an item of property, plant and equipment would affect both the current and future periods, because the depreciation charge is affected for both current and future periods until the end of the useful life.

A change in estimate might affect both assets and liabilities, or relate to an equity item rather than affecting profit or loss. An entity recognizes such change by adjusting the carrying amount of the related assets and liabilities or the equity item in the period of the change.

The change in estimate would generally adjust the difference to profit or loss where the corresponding adjustments to an asset, a liability or an equity item are not equal.

Other scenarios on changes in accounting estimates Change in estimate affecting assets, liabilities and income statement An entity estimated a liability that was covered by insurance at C1 million, but subsequently revises that estimate to C1.5 million. Initially, it recognized a liability for C1 million and an asset for the reimbursement right of C1 million. Management revises the estimate of the liability to C1.5 million and increases the reimbursement right asset to C1.25 million, to equal the insurance recovery which is capped at C1.25 million. The increase in the estimate of the liability to C1.25 million gives rise to a corresponding increase in the estimate of the reimbursement right (Dr. Reimbursement right C0.25m, Cr. liability C0.25m). The remaining increase in the liability (C0.25m) is recognized in the income statement. Change in estimate affecting liabilities and other comprehensive income An entity revises an estimate of tax payable on foreign exchange differences recognized in other comprehensive income. The revision will affect tax liabilities on the balance sheet and the currency translation gains/losses in other comprehensive income. Change in estimate affecting assets and other comprehensive income an entity revises an estimate of the fair value of a property, plant and equipment item. The revision will affect the property, plant and equipment balance, with corresponding adjustment recognized in revaluation gains/losses in other comprehensive income.