Everyone believes accounting is all numbers and mathematical calculations, that it should be pretty straightforward and logical. Is it really though? Not quite. In the accounting world, not everything is simply numbers and black or white. There’s a concept called accounting estimates that involves anything that can be considered to be in a gray area. What exactly is accounting estimates? That’s what we will explain in this article.
What Are Accounting Estimates?
Accounting estimates are amounts in the financial statements or used to produce financial statements that are subject to uncertainty in their measurements. Estimation is a part of everyone’s day-to-day life. Same in accounting, there are areas that are difficult to perfectly quantify, which requires the management of a company or an accountant to use professional judgment, past experience or knowledge to determine certain accounting items.
Example of Accounting Estimates
When mentioning accounting estimates, we tend to think about complicated topics right away. However, we can find accounting estimates included in some very standard accounts. Let’s go through the most popular ones.
- Depreciation and expected useful life: The majority of companies have assets that need to be depreciated every year. The depreciation rate and the expected useful life are examples of accounting estimates made by management.
- Inventory: A company’s inventory is valued at the lowest of cost and realizable value. The method used to value inventory requires management’s estimation.
- Allowance for bad debts from account receivables: Bad debts can be part of any company, no matter the type of business. Management needs to estimate the portion of bad debts from account receivables in order to reflect accurately the level of accounts receivable.
- Goodwill: There is no finite useful life for goodwill but it needs to be evaluated every year for impairment. This requires management’s estimation on whether an impairment is needed or not.
- Contingent liability: Lawsuits, damage claims, product warranties are just a few examples of contingent liability. A contingent liability is created by the potential occurrence of a future event that will make a company liable to other parties. This requires estimation since no one can predict the future but if the event is more likely than not to happen, an estimated amount of the outcome needs to be recorded in the financial statements.
- Employee benefits and pension obligations: Similarly to contingent liability where it’s highly dependent on future events, employee benefits and pension obligations are also dependent on future events and therefore require complex calculations involving various estimations.
The examples above are just a few of the most popular accounting estimates. There can be many more types of accounting estimates depending on the company or the industry. Remember that as soon as an amount cannot be accurately quantified, then most likely an accounting estimate is involved.
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Importance of Accounting Estimates
One might wonder why companies make use of accounting estimates since it’s not 100% accurate. Why not wait until we are certain about the monetary amount and then record transactions? That’s because accounting estimates help paint a more accurate picture of a company’s financial situation. Even if it’s an estimation, including amounts based on estimates will only help the readers of financial statements better understand what’s going on within a company than not including these uncertain amounts. Accounting estimates can always be revised in light of new information to increase the accuracy of the monetary amount previously recorded.
Accounting standards will guide accountants on methodologies to record transactions but ultimately, some information cannot be dictated. Taking the simple example of depreciation, we all know that it’s the right thing to do to depreciate assets to reflect their usage over time and there are accounting standards stating various accepted depreciation methods but no standards will be able to determine the expected useful life of an asset nor the right depreciation rate. That’s when accounting estimates come into play and play a key role. Management will use historical data, market comparatives or professional judgment and experience to determine the right depreciation rate and expected useful life of an asset in order to get the depreciation expense to be reflected in the financial statements.
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Risks of Accounting Estimates
Accounting estimates can be subject to errors or management bias to improve the looks of their bookkeeping records.
For auditors, accounting estimates are difficult to audit since there is no tangible evidence that the amounts recorded are close to reflecting reality. When making accounting estimates, the management of a company needs to ensure they keep all documentation on how they arrived at the estimated amounts, whether it’s historical data, complex calculations or industry practice so that the auditors can follow the logic behind the estimations.
Accounting estimates are also risky for investors since an error in judgment or a management bias could wrongfully show a healthy financial situation. Investors need to be alert when reading financial statements and understand the areas that require management’s estimates in order to ask the right questions and perform an accurate analysis. For example, is the company recording less depreciation than the norm to improve its results or is the company understating its bad debts allowance to present a better balance sheet? Understanding how accounting estimates work and where they are used can only help an investor in making smart investment decisions.
Accounting Estimates: Final Thoughts
When a business faces uncertain events or circumstances that need to be disclosed in the financial statements, management will make estimations of the impact and quantify the monetary amount using their professional judgment. That’s the purpose of accounting estimates, they are part of every company and should be considered as a good addition as it helps ensure the financial situation of a company is reflected as accurately as possible, including uncertain events.
