You've encountered many instances during your study of accounting in which it's necessary to make estimates of uncertain future events. Depreciation, for example, entails estimates not only of the useful lives of depreciable assets, but their anticipated residual values as well. Anticipating uncollectible accounts receivable, predicting warranty expenses, amortizing intangible assets, and making actuarial assumptions for pension benefits are but a few of the accounting tasks that require estimates.
Accordingly, estimates are an inherent aspect of accounting. Unfortunately, though, estimates routinely turn out to be wrong. No matter how carefully known facts are considered and forecasts are prepared, new information and experience frequently force the revision of estimates. Of course, if the original estimate was based on erroneous information or calculations or was not made in good faith, the revision of that estimate constitutes the correction of an error.
Revisions are viewed as a natural consequence of making estimates.
Changes in accounting estimates a change in an estimate when new information comes to light. are accounted for prospectively. When a company revises a previous estimate, prior financial statements are not revised. Instead, the company merely incorporates the new estimate in any related accounting determinations from then on. So, it usually will affect some aspects of both the balance sheet and the income statement in the current period and future periods. A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period.
A change in estimate is reflected in the financial statements of the current period and future periods.
When Owens-Corning Fiberglass revised estimates of the useful lives of some of its depreciable assets, the change was disclosed in its annual report as shown in Graphic 20-5.
Change in Estimate—Owens-Corning Fiberglass Corporation
Real World Financials
Note 6: Depreciation of Plant and Equipment (in part)
… the Company completed a review of its fixed asset lives. The Company determined that as a result of actions taken to increase its preventative maintenance and programs initiated with its equipment suppliers to increase the quality of their products, actual lives for certain asset categories were generally longer than the useful lives for depreciation purposes. Therefore, the Company extended the estimated useful lives of certain categories of plant and equipment, effective … The effect of this change in estimate reduced depreciation expense for the year ended …, by $14 million and increased income before cumulative effect of accounting change by $8 million ($.19 per share).
An example of another change in estimate is provided in Illustration 20-2.
Change in Accounting Estimate
Universal Semiconductors estimates bad debt expense as 2% of credit sales. After a review during 2011, Universal determined that 3% of credit sales is a more realistic estimate of its collection experience. Credit sales in 2011 are $300 million. The effective income tax rate is 40%.
Neither bad debt expense nor the allowance for uncollectible accounts reported in prior years is restated. No account balances are adjusted. The cumulative effect of the estimate change is not reported in current income. Rather, in 2011 and later years, the adjusting entry to record bad debt expense simply will reflect the new percentage. In 2011, the entry would be:
The after-tax effect of the change in estimate is $1.8 million [$300 million × (3% − 2%) = $3 million, less 40% of $3 million]. Assuming 100 million outstanding shares of common stock, the effect is described in a disclosure note to the financial statements as follows:
Note A: Accounts Receivable
In 2011, the company revised the percentage used to estimate bad debts. The change provides a better indication of collection experience. The effect of the change was to decrease 2011 net income by $1.8 million, or $.018 per share.
Changing Depreciation, Amortization, and Depletion Methods
When a company acquires an asset that will provide benefits for several years, it allocates the cost of the asset over the asset's useful life. If the asset is a building, equipment, or other tangible asset, the allocation process is called depreciation. It's referred to as amortization if an intangible asset or depletion if a natural resource. In each case, estimates are essential to the allocation process. How long will benefits accrue? What will be the value of the asset when its use is discontinued? Will the benefits be realized evenly over the asset's life or will they be higher in some years than in others?
The choice of depreciation method and application reflects these estimates. Likewise, when a company changes the way it depreciates an asset in midstream, the change would be made to reflect a change in (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company's knowledge about those benefits. For instance, suppose Universal Semiconductors originally chose an accelerated depreciation method because it expected greater benefits in the earlier years of an asset's life. Then, two years later, when it became apparent that remaining benefits would be realized approximately evenly over the remaining useful life, Universal Semiconductor switched to straight-line depreciation. Even though the company is changing its depreciation method, it is doing so to reflect changes in its estimates of future benefits. As a result, we report a change in depreciation method as a change in estimate, rather than as a change in accounting principle.
An exception to retrospective application of a change in accounting principle is a change in the method of depreciation (or amortization or depletion).
For this reason, a company reports a change in depreciation method (say to straight-line) prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from then on. The undepreciated cost remaining at the time of the change would be depreciated straight-line over the remaining useful life. Illustration 20-3 on the next page provides an example.
Companies report a change in depreciation prospectively.
Is a change in depreciation method a change in accounting principle, or is it a change in estimate? As we've seen, it's both. Even though it's considered to reflect a change in estimate and is accounted for as such, a change to a new depreciation method requires the company to justify the new method as being preferable to the previous method, just as for any other change in principle. A disclosure note should justify that the change is preferable and describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported.
In practice, the situation arises infrequently. Most companies changing depreciation methods do not apply the change to existing assets, but instead to assets placed in service after that date. In those cases, of course, the new method is simply applied prospectively (see Graphic 20-6).
A company must justify any change in principle as preferable to the previous method.
Change in Depreciation Method for Newly Acquired Assets—Rohm and Haas Company
Real World Financials
Note 12: Land, Buildings, and Equipment, Net (in part)
… the company changed its method of depreciation for newly acquired buildings and equipment to the straight-line method. The change had no cumulative effect on prior years' earnings but did increase [current year] net earnings by $9 million, or $.14 per share …
Change in depreciation methods
The $24 million depreciable cost not yet depreciated is spread over the asset's remaining three years.
Universal Semiconductors switched from the SYD depreciation method to straight-line depreciation in 2011. The change affects its precision equipment purchased at the beginning of 2009 at a cost of $63 million. The machinery has an expected useful life of five years and an estimated residual value of $3 million.
The depreciation prior to the change is as follows ($ in millions):
A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. So, Universal Semiconductors reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from 2011 on. The undepreciated cost remaining at the time of the change is depreciated straight-line over the remaining useful life.
Sometimes, it's not easy to distinguish between a change in principle and a change in estimate. For example, if a company begins to capitalize rather than expense the cost of tools because their benefits beyond one year become apparent, the change could be construed as either a change in principle or a change in the estimated life of the asset. When the distinction is not possible, the change should be treated as a change in estimate. This treatment also is appropriate when both a change in principle and a change in estimate occur simultaneously.
When it’s not possible to distinguish between a change in principle and a change in estimate, the change should be treated as a change in estimate.