Accounting Estimate is a technique to measure those items in accounting that have no accurate quantification and are therefore estimated based on judgment and knowledge derived from experience. . They involve certain elements in the financial statements whose value cannot be determined using objective data.
However, those transactions are also necessary for maintaining proper details in the books of accounts for future reference. Thus, even though uncertainties and values must be determined using historical estimates and approximations, they should also be a part of financial reporting. A well-supported estimation will lead to a transparent and reliable financial statement.
The concept of accounting estimate deals with judgement or making approximations regarding some financial transactions in the books of accounts. The value of such element cannot be always fixed based of any particular data. They usually involve a lot of uncertainties and therefore some expertise, skill and knowledge is required to determine the value, which will always be an approximation.
Such inherent uncertainty arise due to differences in valuation, measurement or the method followed in the recognition process of revenues, liabilities, assets and various expenses. Such cases require significant accounting estimates.
This also leads to the fact that there is a certain level of subjectivity in the process because the management and accountants require a very good level of skill, expertise and knowledge to make the assumption. Thus, there is an obvious situation where there will be differences in the value assumed for such items which will be based on the information available from various sources.
Such estimates are also subject to changes over time due to change in economic and accounting policies, revision in assumptions and new information coming in. It is extremely necessary for companies to record and take these changes into consideration so that they are clearly reflected in the financial statements and reports.
Typically the note to the financial statements contain the details of the basis of assumptions and estimates and the methods followed of the same. Such disclosures are necessary to maintain transparency and accountability. Therefore the management should use their best available judgement for the critical accounting estimates.
Here are the top 8 list of significant accounting estimates examples –
Accounts Receivables are one of the most common examples. As we see below, Ligand considers receivables past due based on contractual payment terms of 30 to 90 days.
Ligand valued inventory based on FIFO and is stated at lower of cost or market value. Obsolete inventory is accessed periodically, and inventory write-downs are done to their net realizable value.
Ligand uses the straight-line method for depreciation method and considers the useful life in three to ten years.
Goodwill has an indefinite useful life. A goodwill impairment review is done annually to assess any changes in goodwill.
Contingent liabilities for Ligand were $4.97 million. Contingent liabilities are again subjective critical accounting estimates. Many inputs are considered here, including revenue volatility, the probability of commercialization of the product, timings, thresholds, etc.
Companies that provide warranties have to establish warranty-related costs. Ford forecasts these warranty and field service action obligations using a patterned estimation model, as described below.
To estimate the Pension Cost and other post-retirement obligations, companies have to estimate the discount rate, expected long-term return on the plan assets, salary growth, inflation, retirement rates, mortality rates, etc.
The credit loss is the change in the provision for credit losses at prior period exchange rates. For analysis purposes, Ford management splits the provision for credit losses into net charge-offs and the change in the allowance for credit losses.
Let us try to understand the concept with the help of a suitable example.
Let’s say that a company perceives that it will incur some bad debts during a particular period. But, it has no idea how many bad debts it will incur during the period. The question is how much provision the company should create to be able to deal with the bad debts? Can the company deliberately calculate the bad debts in quantifiable measures?
The answer is the bad debts the company is about to incur can’t be measured in numbers. The accountant, who would be creating the provisions for the bad debts, needs to depend on his judgment and expertise to conclude. And then, he would create a provision entirely from his experience and years of training.
This particular measurement through which few items in accounting are quantified is called accounting estimates.
Significant accounting estimates may not seem very significant, but actually, it is a great way to prove the company's worth to the investors.
But why is this so very important?
Because in this case, the accountants need to put in more effort.
When there’s no quantifying opportunity for the accountants, they need to look for more information. They gather many data points, use their experience, see the historical data, and then value the items on the list since the actual amount for the particular items is unknown.
We will talk about a couple of items to make things clear.
Since the accountant can’t just debit or credit any account without the precise amount, accounting estimates need to be done to get an estimate of the same account. For example, let’s say that depreciation would be debited for machinery the company has just bought. Without the precise amount, the accountant wouldn’t be able to put it on the debit side.
To pass that journal entry, the accountant needs to estimate an approximate amount, and then she can pass the entry.
It is a big question. When an auditor looks at the financial statements and accounting entries, they have one question: Do the entries/items have evidence to support them?
In the case of all other accounting entries, the company can produce evidence.
But in the case of items where the accountants have used an accounting estimate, the company can’t have any physical evidence.
That’s why for the auditors, the list of accounting estimates aren’t very convincing. Things like management bias, subjective assumptions, or errors in judgment may affect the estimates.
When an auditor is looking at the accounting statements and the accounting entries, he should be very careful and ensure that the amounts estimated based on accounting estimates are free from bias, errors, and wrong assumptions.
As an investor, you should take the same approach.
If you’re new to investing, you may need to educate yourself in the fundamentals and advanced accounting to discover errors in accounting estimates.
But for the investors who have many years of experience would be able to judge the entries quite well. Yes, like auditors, these investors wouldn’t have all the information. But if they know the fundamentals of accounting; they would be able to judge the basics like –
These questions may seem a bit advanced for an investor, but an actual story lies between the lines. Suppose an investor wants to invest a decent amount in the company. In that case, it makes sense to look at the financial statements and the accounting entries with diligence, meticulousness, and closer examination.
And there lies the importance of correctness and accuracy in disclosing the financial statements of the company.
The above are two different financial concepts that are commonly used while preparing financial statements for a company. However, it is necessary to understand the basic differences between the two. Let us point out the same, as given below:
Thus, both are important and relevant in the financial world and should be used to maintain consistency, transparency and provide a clear view of the financial condition of the business.
This article has been the guide to Accounting Estimates and their definition. Here we discuss the list of accounting estimates along with examples and explanations. You may also have a look at the below-recommended articles on accounting.
