 Hello and welcome to this session. This is Professor Farhad in which we will discuss accounting changes. We have three types of accounting changes and those are change in accounting principle which we already discussed in the prior session. We have change in accounting estimate. In this session we will focus on change in accounting estimate. Now what is a change in accounting estimate? Well, companies do estimates all the time. Bet that expense. When you compute bet that expense, it's an estimate. You don't know what the future bet that expense will be but you'll have to book a number today. And when you book that number, you make an estimate when you book that number. Same for warranty expense. If you sell a product and a warranty comes with that product, you have to estimate that warranty expense. Therefore, that's another accounting estimate. Period benefit by the third cost. You will have the third cost. Well, what's gonna happen? You're gonna have to spread that the third cost over period benefited. How many periods? That's an estimate. Income tax expense. You don't know actually what your income will be by the end of the year but you can estimate your income tax expense. When you write down inventory, inventory obsolescence, that's also an estimate. And also depreciation expense which we will discuss a little bit more in details later. So in this session, we'll focus on number two. And the third type of accounting changes are change in reporting entity which we will discuss in the next session. So when we have a change, accounting change, there are three approaches for reporting the change. Currently, retrospectively, which is this is what we looked at when we looked at changes in accounting principle and prospectively. Prospectively are used when we have a change in estimate. Now what is prospectively? Well, it means we're gonna make the change in this period only. It could be affecting only this period only. We'll make the change in this period. Or it's gonna affect this period and future period. That's fine. So the change is affecting this year and future years. Simply put, when we have a change in estimate, we don't go back and change prior periods. It's not retrospective. Which is, think about it, it's easier. Why it's easier? Because you don't have to worry about going back and restating or computing the changes and booking the changes into beginning retained earning as we did for changes in accounting principle when we did retrospectively. So in a sense, if this is easy for you to remember, prospectively, it's easy. Easy in a sense that you don't have to go back and change prior period relative to retrospective where it's a little bit more challenging. And in the real world, retrospectively, is very, very challenging. Because sometimes you don't have the record. You don't know what you did in prior years and you have to go back and kind of rebuild your financial statements. Now the best way to illustrate prospectively, which is change in estimate, is to actually look at an example. Before we do so, I would like to remind you, most likely you are a student or a CPA candidate. Either or I would suggest you go a step further. Go to farhatlectures.com. The reason you are watching because you are looking for some help and guess what? I can help you. I have resources such as lectures, multiple choice through false exercises that's gonna help you do better on your exam, on your CPA exam and your accounting courses. If you have not connected with me only then, please do so. Like this recording, it doesn't cost you anything. If you're watching, it's helping you like it. Share it with other, connect with me on Instagram, Facebook, Twitter and Reddit. So let's take a look at this example. Adam Company purchased for half a million a building that it originally estimated to have a useful life of 10 years. So that's the original estimate and no salvage value. Adam recorded depreciation for four years using the straight line basis. And on January 1st, year five, Adam revises the estimate of the useful life to be 14. So simply put, they extended the original life by four years. Well, what do we have to do under those circumstances? The first thing you have to do is to find out what is your book value as of the date of the change in estimate. Well, here's what happened. At the beginning of the fifth year, here's where we stand. The building has a cost of half a million and we took four years of depreciation. Well, it's half a million minus zero salvage value divided by 10. So every year we were taking 50,000 of depreciation, 50,000 times four years. We already booked 200,000 of depreciation expense. That means our accumulated depreciation for that account is 200,000. Therefore, the book value for this building is 300,000. Now we need to know what's gonna happen going forward. Well, we changed the life. We changed the life of the asset. We extended its life. Well, under those circumstances, here's what we have to do. We have to take the book value, which is 300,000, and divide the book value of the asset by the remaining service life. Well, what is the remaining service life? Now we're gonna have to go from year five, the beginning of year five, to all the way to year 14. Well, if we do this computation, it means we have 10 years to go. Six years from the original life and four additional years by extending the life of the asset. Well, 300,000 divided by 10. Now our depreciation expense, rather than 50,000, our new depreciation expense will be 30,000. So notice what happened. Our depreciation expense went down by $20,000, and that could be a significant number, depending how large is the company. That could be a significant number. Now, can companies do changes in estimate for depreciation? And the answer, obviously, as you saw, is a yes. However, you have to be very careful. Those changes have to be made in good faith. A good case to show you how companies could change estimate in bad faith is waste management. U.S. government, United States District Court for the Northern District of Illinois versus waste management. So let's take a look at this case just to show you what happened. This action concerns a massive financial fraud motivated by greed and a desire to preserve professional and social status. The defendant were the high ranking officer of waste management. So what did they do? What type of scheme they went in? They concealed the operating realities of the company by making or authorizing false and misleading statements about the company's financial performance to the investors as well as to the public. And by doing so, what did they do? They manipulated the company's financial result to meet predetermined earnings target. So what did they do? What did they do? Well, let's look at the amount first. The company admitted its profit has been overstated by $1.7 billion. Now, this was not for one year. It was a period of time over several years. So what did they do? Well, the scheme was simple. They improperly eliminated or deferred current period expenses in order to inflate earnings. For example, they avoided depreciation expenses by extending the estimated useful life of the company's asset garbage trucks. Well, at the same time making unsupported increases to the salvage value. So what they did, they changed the salvage value. They extended the life of the asset. And what happened as a result? Well, they overstated their profit by $1.7 billion. So they made other supported changes in depreciation estimates. Again, you can do depreciation estimate, but not the waste management method. And I hope this case will illustrate the concept that yes, change in estimates are allowable. That's okay, as long as they are made in good faith. And if you're interested, you can Google the case and read more about it. When we talk about estimate, we have to be aware of one single rule. Just make sure we're aware of it. It's called the change in estimate affected by a change in principle. So sometimes the change in estimate and the change in principle are so much interrelated. What do we have to do? How do we treat that change? Let's talk about a specific example to illustrate this point. Change in depreciation method. No, notice, this is a method. It sounds like FIFO and LIFO, right? Like accounting principle. Let's assume we went from the straight line method of depreciation to the double declining balance from one depreciation method to the other, okay? Is based on changes in estimate about future benefit from the long-lived asset. Now, why would we go from the straight line to the double declining balance or from the double declining balance to the straight line? Because we believe the asset is benefiting different periods differently. So for example, if we go from the straight line to the double declining balance, it means the asset is benefiting us more now rather than future period because we take more depreciation under double declining balance. So notice, the reason we switch is because it has to do with the life of the asset, the long-lived asset. Because when we compute depreciation expense, we have to take into account its life, its residual value, and the method is the third component. But life is an estimate. The residual value is an estimate. And the method is an accounting method, but this method is basically so related to the life of the asset. Therefore, it's really based on an estimate rather than an actual accounting figure. So it's not possible to separate the effect of the accounting principle change from the estimate, from the life of the asset. Therefore, any situation where you have something like this and depreciation is a good example, we consider the change as a change in estimate, not change in accounting principle. And that's why depreciation is a change going from one depreciation method to the other as a change in estimate, not change in accounting principle. So companies account for a change in depreciation method as a change in an estimate affected by a change in accounting principle because they are so interrelated. What else do we have to know about estimates is when it comes to disclosure, what do we have to disclose or not disclose? Well, here are the rules. You don't have to disclose changes in accounting estimate made as a part of a normal operation. What do we mean by normal operation? Well, we have to estimate that expense. We have to estimate warranty expense to run the business on a day-to-day basis. As long as those estimates are immaterial, they're not major, we don't have to disclose them unless they are material. Now, again, material itself, materiality itself, it's a judgment, it's an estimate. But generally speaking, you don't have to disclose them as long as they're not considered material now. And now obviously the company will have to also define what's materiality for them. Is it 3%, 5%, 10%, they will have a policy. So simply put, we don't have to worry about those because those estimates, they're constantly being made by the company. You don't want to fill your notes with explanation about those estimates. However, you have to disclose estimates that could affect several periods. By its nature, once it affects several period, you would say, well, it's material. Like what? The service life of depreciable assets. If you change the service life of depreciable asset, it's gonna affect many periods. So you want to kind of tell the users, here's what's gonna happen now, here's how it's affecting the future. So you have to disclose the effect on income from continuing operation and any effect on earnings per share because those amount are important for the current period. Because of the changes, this is what happened to our EPS. And you have to tell them that this change could affect several period and talk about it a little bit more. Now you could always disclose to be on the safe side, but those are the rules for disclosure when it comes to accounting estimate. What should you do now? Go to farhatlectures.com and work some multiple choice through false questions that's gonna reinforce this concept. So you are prepared whether you are an accounting students to understand it better or you are preparing for your CPA or professional exam. Good luck, study hard, invest in yourself, invest in your career. The CPA is worth it and stay safe.