Accounting Estimates

Accounting Estimates
Accounting Finance

Accounting Estimates

What are Accounting Estimates?

Accounting estimates are monetary amounts in the financial statements which are estimated by the companies. These estimates are helpful when the actual figures are not available easily. These are essential for the completeness of the financial statements. Accounting estimates should be reasonable enough to capture the realistic picture, without being biased towards optimism or pessimism. These are backed by some documentation which becomes a reference for the entities in later years. Accounting estimates are used for estimating the value of inventory, useful life, depreciation method and scrap value of an asset, probable loss in case of default by credit customers, contingent claims on the company, probable warranty expense, and the list goes on and on.

As per recently amended IAS 8 Accounting Policies, Changes in accounting estimates and errors, accounting estimates are monetary amounts in the financial statements which are estimated by the companies in preparing those financial statements when the actual monetary amounts cannot be observed directly; and estimation and presentation of such figures are essential for the completeness of those financial statements.

Tips for Accounting Estimates

Some of the best-known tips for computing the accounting estimates are as follows:

  • The accounting estimate should be reason enough to capture the realistic picture of the financial transaction. For example, the average life of people around the world is 72 years approximately. The retirement allowed by a corporate has to be somewhere after 50 years.
  • An estimate should never appear to be as too optimistic (retirement year of 40 years) or even too pessimistic (retirement year of 70 years).
  • The estimate made by you should make sense and should be consistent with other related information. For example, if the salary basis considered for calculating the gratuity expense is assumed to increase by 5%, you have to make the same estimate for calculating the expense for compensated absences.
  • Whatever assumption you make, there has to be a backup paper or documentation. This should form the basis of your estimation. You cannot estimate something abruptly or illogically. Prefer to write notes below the accounting estimate worksheet. Reference of such note should be provided in all related working papers. Documentation should be as detailed as possible since such work papers will help the clients to refer back after few years.
  • There should be a maker checker system for accounting estimates so that errors in formulae are corrected at right time. Thus, timely review of estimates is essential.
  • The past estimates should be compared with actual figures later on so that future estimates can be revised accordingly. A large variance in the estimate versus actual scenario calls for an investigation at the management level. Thus, a periodical review of estimates is also necessary.
  • Wherever required, estimates should be made with the help of experts in the field. You can provide reference to the name of the expert, in providing the expense in books. The signed report provided by the expert becomes documentation. However, beware to provide the correct set of data to the expert.
  • The accounting estimates should be consistent with the accounting policy for which the estimate has been made.

Examples of Accounting Estimates

There are a varied set of examples for accounting estimates. However, the calculation may change from one expert to another and at different points in time.

  • Inventory

Big corporates producing a different set of products have huge quantities of inventory at the end of the year. It is difficult to identify which inventory is the latest and which is the oldest. Thus, estimating the value of inventory is a tough task. Generally, inventory is valued using LIFO, FIFO, or WAM. LIFO (Last in first out) – it assumes that the latest inventory has been consumed and the left-out inventory is old inventory. FIFO (First in First out) – it assumes the oldest inventory has been consumed and the left-out inventory is the latest one. WAM (Weight Average Method) – assumes that the inventory should be valued at average prices. According to each type of valuation, a provision for obsolete inventory is required.

  • Depreciation

Expense can be revenue or capital in nature. Capital expenses are incurred for the long-term use of the business and are not intended for immediate sale. Using the assets acquired, the entity can generate revenue. The revenue is credited to the profit and loss account and the asset is capitalized in the balance sheet. So as per the matching principle, some portion of the capital expenditure needs to be expensed out on a systematic basis. The systematic basis helps to match the utilization of the asset vis-à-vis the revenue generated. The systematic basis can be a straight-line method, declining balance method, double-declining balance method, machine hours utilization method, etc.

  • Useful Lives

The assets acquired by an entity need to have lived until which the assets can be utilized. The life here needs an estimation. Estimation of useful lives has a close nexus with the depreciation method selected by an entity.

  • Scrap Value or Residual Value

Over the period of time, the asset gets completely utilized by the entity until such asset is ready to be scrapped now. However, at the time of estimating the depreciation expense, the scrap value needs to be estimated in advance. Scrap value is the minimum sale value at the end of the tenure of the asset.

  • Impairment

Fixed Assets are recorded at historical costs. If the company follows the revaluation method, it can revalue its fixed assets to represent a rise in the value of fixed assets. On the other hand, the cost model assumes no change in prices over the years. However, under both methods, a check for impairment is essential. Goodwill is an intangible asset that measures the inbuilt value of the company. Over the period of time, the goodwill may reduce due to many factors. Thus, impairment helps in reducing the asset value to a realistic level.

  • Accounts Receivable

This is another area where the estimates are helpful. Once the goods are sold to customers on credit, many corporates provide a credit period within which they can expect the realization of cash flows from customers. The period of credit to be provided is a call of the management. However, it may happen that few categories of customers may pay beyond the credit period. Longer time taken by customers presents a doubt in the creditworthiness of the customer. Thus, as per the conservatism principle, entities are required to make provisions for doubtful debts. This provision requires estimation. The estimate can be 5% (say) for accounts receivables due after 15 days from the due date.

  • Fair Value

This term is widely used in international accounting standards. Fair values at estimates at a certain point in time and may change as per change in circumstance or situations or factors. As per the revaluation model used by few entities, fair value is taken as the base for recognizing the assets. Goodwill is also valued on the basis of fair value. 

  • Legal

A big-sized entity has to face many issues. Some of which may require the company to pay for claims. Such claims are called contingent liabilities, which depend on the probability of occurrence. The entity needs to disclose the fact of such a claim on the company. Accounting standards require providing an estimation of the outflow in case the contingency is triggered against the company.

  • Warranties

Many companies sell their products with warranties say 3 years. However, at the time of sale of a product, it is unaware of the expectation of the warranty. It may or may not arise. So a rough estimate is made on the basis of past experiences. The matching principle and conservatism principle, asks for recognizing the warranty expense in the year of the sale itself. Thus, estimation is essential. Technical expertise may be used for such estimation.

Features and Importance of Accounting Estimates

Features:

  • The accounting estimates are required by the accounting policies.
  • These are based on multiple factors.
  • This is just an estimation which may or may not significantly deviate from the actual figures.
  • The estimates are normally consistent with other assumptions.
  • It is within the parameters set by accounting principles.

Importance:

Imagine a situation wherein the employees of your company are to retire at the age of 60 years. Your company is obliged to pay gratuity (kind of monetary gift at the time of reliving). Gratuity is a symbol of honesty and loyalty to the employer. The employee has served for years (say 20 years) with a good performance. His performance is linked to increasing sales each year and other improvements in the company over these 20 years. What if the gratuity expense, hits the P&L account in the year of retirement? It would show a devasted picture of profitability in the last year and the readers of the financial statement may get worried by observing reduced net profits. Thus, the gratuity expense should have hit the P&L every year. This is where estimation comes into play. We have discussed a number of examples above to discuss the situations wherein estimates are useful.

Leave your thought here

Hey, wait!

Before you go, let us offer you a 10% discount coupon for your purchase.