Accounting policies often require entities to estimate amounts in financial statements because those amounts can’t be directly observed. The use of estimates is integral to the preparation of financial statements and doesn’t undermine their reliability (IAS 8.33). In fact, even estimates subject to a high degree of uncertainty may provide the most accurate representation of certain transactions or events.
Let’s dive in.
Definition of accounting estimates
Accounting estimates are monetary amounts in financial statements that are subject to measurement uncertainty. Developing these estimates involves using judgements or assumptions based on the most recent and reliable information available (IAS 8.5, 32). Examples of accounting estimates include:
- The value in use of a cash-generating unit (IAS 36).
- The variable portion of a transaction price (IFRS 15).
- The residual value of an item of PP&E (IAS 16).
- An allowance for expected credit losses (IFRS 9).
- The fair value of an investment property (IFRS 13).
- The expenditure necessary to settle a disputed obligation (IAS 37).
Estimates are developed using:
- Estimation techniques (e.g., measuring a loss allowance),
- Valuation techniques (e.g., measuring fair value), and
- Data inputs (e.g., a risk-free rate).
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Identifying changes in estimates
Entities often revise an accounting estimate because of changes in the circumstances on which the estimate was based. By their nature, changes in accounting estimates don’t relate to prior periods and aren’t corrections of errors. The distinction between errors and changes in estimates is discussed further here.
Changes in accounting estimates arise from:
- acquiring new information,
- recent developments, or
- experience.
IAS 8.34A explicitly states that changes in inputs or measurement techniques are treated as changes in accounting estimates unless they are corrections of prior period errors. Similarly, IFRS 13.66 states that a change in the valuation technique should be accounted for as a change in an estimate. In contrast, a change in the measurement basis is a change in an accounting policy, not an estimate.
If it’s 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 estimate (IAS 8.35). For example, a change in the depreciation method resulting from revised expectations about how an asset’s economic benefits will be consumed illustrates this distinction. The effect of the adjustment is therefore accounted for as a change in an estimate (IAS 16.BC33).
Example: Changing measurement techniques
To illustrate the difference between a change in an accounting estimate and a change in an accounting policy, consider Lux Estates. It owns an investment property and applies the fair value model under IAS 40. Since the acquisition date, the fair value of the property has been determined using the income approach, i.e. by discounting future cash inflows. However, because of ongoing inflation and rapid appreciation in real estate values, Lux Estates concludes that the market approach would provide a better measure of the fair value of the property. It therefore adopts a new fair value measurement technique based on benchmarking against transactions involving comparable properties.
In this instance:
- Lux Estates’ accounting policy is to measure the investment property at fair value under IAS 40.
- The fair value, which is a monetary amount subject to measurement uncertainty, is an accounting estimate used in applying that accounting policy.
- In determining the fair value of the investment property, Lux Estates uses judgements and assumptions, including the selection of the valuation technique and the determination of inputs such as discount rates and market prices from comparable transactions.
Changing from the income approach to the market approach represents a change in the measurement technique used to estimate fair value. Therefore, while the accounting policy (i.e., the fair value model) remains unchanged, the accounting estimate (i.e., the fair value measurement) changes. The effect of that change is accounted for prospectively.
Accounting for changes in estimates
When an accounting estimate changes, the effect is recognised prospectively. This means that it’s recognised in the period of the change and, where applicable, in future periods.
For example, an adjustment to a loss allowance for expected credit losses affects P/L in the current period only. Conversely, a revision of the estimated useful life of a depreciable asset affects depreciation expense in the current period and in each subsequent period over the asset’s remaining useful life (IAS 8.36-38).
Disclosure
Entities should disclose the nature and amount of any change in an accounting estimate that affects the current period or is expected to affect future periods. If the amount of the effect on future periods isn’t disclosed because estimating it is impracticable, that fact should be disclosed (IAS 8.39-40).
Entities are also required to disclose assumptions and other major sources of estimation uncertainty that carry a significant risk of resulting in material adjustments to the carrying amounts of assets and liabilities in the next financial year. Details of the nature and carrying amounts of those assets and liabilities should also be provided (IAS 8.31A / IAS 1.125).
Although certain other IFRS require disclosure of some of the assumptions that would otherwise be required under IAS 8.31A (e.g., impairment disclosures), all major sources of estimation uncertainty should be disclosed. Examples of disclosures that entities should consider providing are set out in IAS 8.31E / IAS 1.129 and include sensitivity analyses as well as explanations of changes made to previous assumptions concerning unresolved uncertainties.
The examples below illustrate the practical application of these requirements:
