Understanding Changes in Accounting Estimates: Accounting and Disclosure Requirements

In the realm of financial reporting, precision is often sought, but many elements in financial statements cannot be measured with absolute exactness due to the inherent uncertainties in business activities. Instead, they rely on estimates, which are judgements based on the latest available, reliable information. Indian Accounting Standard (Ind AS) 8, "Accounting Policies, Changes in Accounting Estimates and Errors," prescribes the criteria for the accounting treatment and disclosure of these changes, aiming to enhance the relevance, reliability, and comparability of an entity's financial statements.

What is a Change in Accounting Estimate?

A change in accounting estimate is defined as an adjustment to the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset. This adjustment arises from an assessment of the present status, expected future benefits, and obligations associated with assets and liabilities. Crucially, changes in accounting estimates are a result of new information or new developments and, accordingly, are not corrections of errors.

Examples of items that frequently require estimation include:

• Bad debts

• Inventory obsolescence

• The fair value of financial assets or financial liabilities

• The useful lives of, or expected pattern of consumption of future economic benefits from, depreciable assets

• Warranty obligations

The use of reasonable estimates is an essential part of preparing financial statements and does not diminish their reliability.

Distinguishing Changes in Estimates from Accounting Policies and Errors

It is vital to differentiate changes in accounting estimates from changes in accounting policies and the correction of errors:

• Not a Correction of an Error: A revision of an estimate does not relate to prior periods and is not the correction of an error. Accounting estimates are, by their nature, approximations that may require revision as new information becomes available. For instance, a gain or loss recognised from a contingency outcome is not the correction of an error.

• Not a Change in Accounting Policy: A change in the measurement basis applied is considered a change in an accounting policy, not a change in an accounting estimate. However, if it is difficult to distinguish between a change in an accounting policy and a change in an accounting estimate, the change is treated as a change in an accounting estimate.

Estimates may need revision due to changes in underlying circumstances, new information, or more experience.

Accounting Treatment: Prospective Recognition

The effect of a change in an accounting estimate is generally recognised prospectively. This means the change is applied to transactions, other events, and conditions from the date the estimate is changed. The recognition method involves including the effect in profit or loss:

• If the change affects only the current period: It is recognised in the period of the change [36(a)]. For example, a change in the estimate of bad debts only impacts the current period's profit or loss.

• If the change affects both the current and future periods: It is recognised in the period of the change and future periods [36(b)]. For instance, a change in the estimated useful life of a depreciable asset affects depreciation expense for the current period and for each future period during the asset's remaining useful life.

In both scenarios, the effect of the change relating to the current period is recognised as income or expense in the current period, and any effect on future periods is recognised as income or expense in those future periods.

Furthermore, to the extent that a change in an accounting estimate leads to changes in assets and liabilities, or relates to an item of equity, it is recognised by adjusting the carrying amount of the related asset, liability, or equity item in the period of the change.

Disclosure Requirements

Entities are required to disclose specific information regarding changes in accounting estimates to provide transparency to financial statement users. An entity must disclose the following:

• The nature of the change in an accounting estimate that impacts the current period or is expected to impact future periods.

• The amount of the change.

However, if it is impracticable to estimate the effect on future periods, the entity is not required to disclose that amount. In such cases, the entity must disclose the fact that the amount of the effect in future periods is not disclosed due to impracticability.

In summary, Ind AS 8 provides a clear framework for handling changes in accounting estimates, ensuring that financial statements remain relevant and reliable while maintaining comparability over time. The emphasis on prospective application and comprehensive disclosure helps users understand the financial impact of these revisions.