What are Accounting Estimates?

Illustration

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 debtsProvisions For The Bad DebtsA bad debt provision refers to the reserve made by a company to set aside an amount computed as a specific percentage of overall doubtful or bad debts that has to be written off in the next year.read more, 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.

Examples of Accounting Estimates

Here are the top 8 list of Accounting estimates examples –

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Accounting Estimates (wallstreetmojo.com)

#1 – Accounts Receivables

Accounts ReceivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more 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.

source: Ligand SEC Filings

#2 – Inventory

Ligand valued inventory based on FIFO and is stated at lower of cost or marketLower Of Cost Or MarketLower of cost or market (LCM) is the conservative way through which the inventories are reported in the books of accounts. It states that the inventory at the end of the reporting period is to be recorded at the original cost or the current market price, whichever is lower.read more value. Obsolete inventory is accessed periodically, and inventory write-downs are done to their net realizable valueNet Realizable ValueNet Realizable Value is a value at which the asset may be sold in the market by the company after deducting the expected cost of selling the asset in the market. It is a crucial metric for determining the value of a company’s ending inventory or receivables.read more.

#3 – Depreciation Method and Useful Life

Ligand uses the straight-line method for depreciation Straight-line Method For Depreciation Straight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more method and considers the useful life in three to ten years.

source: Ligand SEC Filings

#4 – Goodwill

GoodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company’s net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company’s net identifiable assets from the total purchase price.read more has an indefinite useful life. A goodwill impairment review is done annually to assess any changes in goodwill.

#5 – Contingent Liabilities

Contingent liabilitiesContingent LiabilitiesContingent Liabilities are the potential liabilities of the company that may arise at some future date as a result of a contingent event that is beyond the company’s control. read more for Ligand were $4.97 million. Contingent liabilities are again a subjective accounting estimate. Many inputs are considered here, including revenue volatility, the probability of commercialization of the product, timings, thresholds, etc.

#6 – Warranty Estimates

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.

# 7 – Pension and Other Post Retirement Obligations

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.

#8 – Credit Losses Allowances

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.

source: Ford SEC Filings

Why is accounting estimates important?

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.

  • Depreciation: How would one understand how much depreciation a company should incur for machinery or a plant? Yes, one can use the accounting method; but there’s no accurate information about how much should be the written down valueWritten Down ValueThe Written Down Value method is a depreciation technique that applies a constant rate of depreciation to the net book value of assets each year, resulting in more depreciation expenses recognized in the early years of the asset’s life and less depreciation recognized in the later years of the asset’s life.read more at the end of every year. That’s why it’s the accountant’s job to determine how much percentage of depreciation should be incurred by the company by looking at the life expectancy of the plant or machinery and then by seeing the usefulness and necessity of the machinery for the business.The useful life of fixed assets: It’s difficult to say how long fixed assets will serve a company. How would a company know how long it will serve the company if a machine is purchased? Well, there’s no possible quantifiable method. The accountant needs to use an accounting estimate to figure out the useful life of fixed assets. The accountant needs to look at past data points, look at the similar machinery in similar companies, and finally use their knowledge and expertise to figure out an estimate of the useful life of fixed assets.

Purpose

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.

How does an auditor look at accounting estimates?

It is a big question. When an auditor looks at the financial statements and accounting entriesAccounting EntriesAccounting Entry is a summary of all the business transactions in the accounting books, including the debit & credit entry. It has 3 major types, i.e., Transaction Entry, Adjusting Entry, & Closing Entry. read more, 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 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 statementsAccounting StatementsAn accounting statement or account statement refers to a document that summarizes the financial details of an account during a given period. An example of an accounting statement is a bank account statement. A bank account statement reflects the source and amount of every transaction within a selected period. Different accounting statements serve other purposes, but they all act as written proof that helps resolve disputes.read more 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 auditorsAuditorsAn auditor is a professional appointed by an enterprise for an independent analysis of their accounting records and financial statements. An auditor issues a report about the accuracy and reliability of financial statements based on the country’s local operating laws.read more, 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 –

  • Whether the percentage of depreciation taken is right? (as an investor, you can look at similar companies and compare)Is the provision for bad debts right? (You can see what that company did in the previous years and also how similar companies in the same industry respond to bad debts)How many years of useful life has that company estimated for its fixed assets? (find out the past data points and how the company has used the same previously)

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 statementsFinancial StatementsFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more of the company.

Accounting Estimates Video

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.

  • Accounting Ethics ExamplesAccounting Treatment for Contingent AssetAccounting Interview Questions and AnswersFinance vs. Accounting – Top Differences