Understanding Estimates/Accounting estimates?
The accounting process often presents certain scenarios where an amount or item in the financial statements cannot be measured with precision. Accounting estimates, therefore, are an approximation of a value that is to be debited or credited on items for which a precise means of measurement is not available. In financial statements, the carrying amounts of assets, liabilities, income, or expenses for the period where such amounts cannot be measured with precision, are determined using accounting estimates.
1 What are accounting estimates?
2 Why do we need accounting estimates?
3 Examples of accounting estimates?
4 Best Practices
5 Accounting Principles vs Accounting Estimates
6 Conclusion
Why do we need accounting estimates? Why do we need precise values?
- In the absence of a precise value, an accountant cannot debit or credit any amount of arbitrary value. There is a need to establish a set of principles or accounting policies to arrive at an estimate. Therefore, accounting estimates serve the purpose of providing accountants with a reasonable estimate so that an amount can be entered on the debit or credit side of the journal.
- The process of arriving at estimates involves collecting and analyzing relevant data. This means that the method of estimation can also be used in other domains. For example, if a company wants to understand how much depreciation it should incur for machinery, an accountant would be able to use this data and estimate its year-end value.
Examples of Accounting Estimates
In real-world situations, precise means of measurements are often not available, and hence, most values require approximations. Let us have a look at some of these examples listed below and an exhaustive list ( but not all inclusive)shown in the chart that are included in the financial statements
- Estimating the useful life, impairment and revalued amounts of non-current assets
- Bad debts
- Revenues, such as freight revenue
- Receivables, such as allowance for loan losses and uncollectible receivables
- Accruals and inventory estimates
- Financial instruments, such as the valuation of securities
- Estimating depreciation of a plant or machinery
Examples of Accounting Estimates Chart ( Source: aicpa.org)
| Examples of Accounting Estimates | |
|---|---|
| Receivables: Uncollectible receivables Allowance for loan losses Uncollectible pledges | Revenues: Airline passenger revenue Subscription income Freight and cargo revenue Dues income Losses on sales contracts |
| Inventories: Where future selling prices Future costs are involved Obsolete inventory Net realizable value of inventories Losses on purchase commitments | Contracts: Revenue to be earned Costs to be incurred Percent of completion |
| Financial Instruments: Valuation of securities Sales of Securities with Puts and calls | Leases: Initial direct costs Executory costs Residual values |
| Productive facilities, and intangibles: Useful lives and residual values Depreciation and amortization methods Recoverability of costs Recoverable reserves | Litigation: Probability of loss Amount of loss |
| Accruals: Property and casualty insurance company loss reserves Compensation in stock option plans and deferred plans Warranty claims Taxes on real and personal property Renegotiation refunds Actuarial assumptions in pension costs | Rates: The annual effective tax rate in interim reporting Imputed interest rates on receivables and payables Gross profit rates under program method of accounting |
| Others: Losses and net realizable value on disposal of segment or restructuring of a business Fair values in nonmonetary Exchanges. | Others: Interim period costs in interim reporting Current values in personal financial statements |
Best Practices
The International Accounting Standards Board (IASB) is the international body that sets accounting standards. It is an independent body of the IFRS foundation and is responsible for developing and publishing the IFRS standards for accounting.
When we talk of best practices in making accounting estimates, having sound knowledge of the International Financial Reporting Standards (IFRS) is a prerequisite. These standards set common rules that enable financial statements across the world to be consistent, transparent, and comparable.
Some best practices for accounting estimates may include:
- Making sure that the estimates and also the assumptions underlying the estimates are reasonable. An estimate that is too optimistic or too pessimistic might need to be reconsidered. It is also best to keep a record of the reasoning behind the assumptions.
- Having a proper process or framework to enable regular reviews of estimates so that they are comparable to actual amounts. Large variations, when compared to past estimates, may also be a concern unless there is a known reason for these variations.
- In certain cases, involving third-party specialists may also be worth considering.
Accounting Principles vs Accounting Estimates
The process of making an accounting estimate is not arbitrary. Rather, it is governed by a set of guidelines and principles known as accounting principles. The term accounting policies is also often used, although the definitions may seem overlapping and ambiguous. The International Accounting Standard 8 (IAS 8) has defined accounting policies as specific principles, bases, conventions, rules, and practices applied by an entity while preparing and presenting financial statements.
It is important to make a distinction between accounting principles and accounting estimates because any change in accounting principles is a change in how financial information is calculated and is generally applied retrospectively. On the other hand, a change in accounting estimates is a change in the actual financial information and is applied prospectively.
Summarising the differences for accounting estimates vs accounting principles:
| Accounting Estimates | Accounting Principles |
|---|---|
| An approximation of a value that is to be debited or credited on items for which a precise means of measurement is not available | Specific principles, bases, conventions, rules, and practices applied by an entity while preparing and presenting financial statements |
| Accounting estimates are a change in actual financial information | Accounting principles changes refer to changes in how financial information is calculated |
| Applied prospectively | Applied retrospectively |
| Example: depreciation values, Receivables | Example: changes in revenue recording, or asset valuation |
Conclusion
The process of making accounting estimates requires not only data collection but also training and experience. Since it can be subjective in nature, an experienced accountant would know which data to emphasize and when to re-estimate. Estimates are based on information that is most reflective of the situation at the time of estimation. The process is somewhat both art and science since it requires both scientific analyses and intuitive judgment. Check out this detailed guide to bookkeeping for entrepreneurs for an in-depth understanding.
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