Definition: A change in accounting estimate is an update to an approximation to a specific accounting treatment used in the past. A change usually only occurs when new information, subsequent developments, or improved judgments can be made that impact an accounting period.
What Does Change in Accounting Estimate Mean?
In other words, GAAP requires that accountants use their best judgment when recording events with no set values or time frames. In some cases, accountants must make estimations based on what they currently know and what they believe to be true. Unfortunately, sometimes estimates turn out to be wrong. When they do turn out incorrect, an adjustment or change of estimate must take place in the current period and future periods.
A good example of an estimate commonly made by accountants is useful life of an asset. Depreciation expense is based on how long an asset can be used to produce goods. A shorter useful life means depreciation will be recognized sooner.
Take a piece of machinery for example. When it is purchased, management determines that the useful life is 5 years based on previous experience with the brand and type of equipment. Two years later, the machine shows signs of deterioration and doesn’t appear to be able to last more than 3 years. Based on the new information that management and the accountants know, they should change the original accounting estimate of useful life from 5 years to 3 years.
Unfortunately, this is sometimes the case. It isn’t always clear how long an asset will last. Two identical pieces of machinery can have completely different useful lives based on how they are used and operated.
Changes in estimate should be done sparingly and as necessary. Keep in mind that estimate changes only affect the current year and future years. Prior years do not change based on the new estimate. A prior period adjustment must be used to change the prior periods.