To outsiders, the world of accounting seems very cut and dry. College students enrolled in an introductory Financial Accounting class often remark on how nice it is to arrive at one correct answer. Then they take Advanced Financial Accounting. From there on, they realize estimating isn’t just for their actuarial counterparts. Indeed, quality estimation is a critical part of financial reporting and is an exercise undertaken routinely.
What is an estimate?
Not all financial statement items can be measured precisely. For these items, estimation is necessary. Accounting estimates are those which approximate a monetary amount in absence of precise values. Estimates are inherent in many accounting topics such as fair value, impairment, collectability, obsolescence, realizable value, and accrued expenses. Accounting estimates are for the unknowable. When we estimate something that is measurable as a shortcut, it is not an accounting estimate (for example, weighing a box of bolts to estimate on-hand quantity as opposed to individually counting them).
What makes a good estimate?
Making a good estimate isn’t always easy. In some cases estimates are too difficult, time consuming, or complex for mangers to make, and in those cases professionals such as actuaries, appraisers, and/or lawyers are often utilized. That said, managers and accounting professionals are charged with making estimates routinely and should make efforts to ensure their estimates are well crafted. A good estimate should:
- Use the best available information. Estimates are only as good as their inputs, and managers should think critically about what information to use. Relevant information should be current, accurate, and complete. Some estimates may even require a sensitivity analysis whereby a number of different scenarios are created and evaluated. Sometimes, good information can be hard to come by, and in those cases, seeking a professional’s assistance may be merited if the estimate is especially significant.
- Be unbiased. Financial statements are not valuable to users if the data within is colored by an overly optimistic or pessimistic viewpoint. Managers should attempt to recognize their own biases. They should look to make accurate estimates, not estimates that are part of a grander scheme or an attempt to paint the results in a certain way.
- Be conservative. This point is always fallback guidance and is cited often in GAAP. Simply said, when in doubt, err on the side of caution and go the more conservative route.
- Consider using a multiple-scenario approach. Some estimates involve complex variables. As these variables become more complex, it becomes more useful to use an approach whereby multiple scenarios are devised and then weighted based on likelihood of outcome (such as best case 10%, likely case 70%, and worst case 20%).
As with most accounting topics, managers should keep materiality (which is in itself an estimate) in mind. Sometimes, it might not be worth spending a lot of time on a given estimate if the results are likely to be immaterial. Managers are busy and should seek accuracy, but sometimes getting caught up in the weeds for a $100 difference isn’t a valuable use of time.
Review and adjustment
Sometimes our best estimates turn out to be pretty off base. That’s okay. Estimates are inherently an exercise in uncertainty, and we don’t always bat a thousand. If we always knew the end result, estimates wouldn’t be necessary in the first place.
We should, however, review our estimates regularly. How often? It depends. Certainly, estimates should be reviewed and evaluated at significant reporting dates such as fiscal year end or other required financial reporting dates. Auditors will review significant estimates as part of their procedures, and thus estimates should be up to date at that point. Otherwise, estimates should be reevaluated anytime new information that could affect the original assumptions becomes available. For example, if a customer of your company signals difficulty in paying its account, the allowance for doubtful accounts (an estimate) should be reviewed and likely adjusted. The review and evaluation of estimates should thus be regarded as an ongoing process, always open to change should relevant information emerge.
Change in accounting estimates: Financial statements
As new information is received, a change in an accounting estimate may be necessary. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and salvage values of depreciable assets, and warranty obligations. A change in an accounting estimate is accounted for in the period of change if the change affects that period only or in the period of change and future periods if the change affects both. A change in an accounting estimate is not accounted for by restating or retrospectively adjusting amounts reported in financial statements for prior periods. This is different from corrections of errors, which require restatement of the financial statements containing the error.
Estimating is a central component in much of GAAP. Highlighted below are a few common areas where estimates are required:
Determining the fair value of an asset is entirely an estimate based on a number of potential factors and assumptions. A manager may have the skills to evaluate fair values for most assets they encounter, but valuations for complex items such as buildings or assets acquired during acquisition are often left to professional appraisers. Fair values can change often and require ongoing evaluations.
If you do not collect all of your accounts, you likely utilize an allowance for doubtful accounts. The allowance is your estimate of accounts that are not likely to be collected. If information that specific accounts are not likely to be collected becomes known, the reserve should be reevaluated, particularly if the accounts in question are significant (yet another judgement call).
Generally, an inventory’s value is in its potential to be converted to cash when sold. Inventory can be recorded under a number of different methods, but if sale prices (net realizable values) are believed to be lower than carrying value, an impairment should be recognized. Expected prices are an estimate based on expected prices and potential demand. Slow-moving inventory should carry a reserve. Useless or unwanted inventory should have no carrying value unless it has some inherent scrap value.
Fixed Assets, Goodwilll, Intangibles, and Impairment
Fixed assets should be recorded at the lower of cost or market. Impairment or other fair value estimates judgments are used to evaluate market values. Carrying values for goodwill and intangibles should not exceed fair value when tested. These fair value estimates take into consideration a wide variety of factors such as expected future cash flows and market value. Goodwill is initially determined using an in-depth valuation of the fair values of other tangible and intangible assets held by an acquired entity.
Of course, over time, fixed assets are depreciated, reflecting their dwindling values. Depreciation methods and useful lives involve using estimates. Managers should avoid having long lists of assets that are fully depreciated but still in use. Residual (or scrap) values should be utilized to signal that some assets have inherent value that passing time won’t erase.
When claims are made against the company or are expected, a contingent liability is often recorded to house the expected payout. This liability is your estimate of expected settlement, which is often subject to the case’s merit, your company’s appetite for legal battle, the potential of other claimants, and a variety of other matters. Often, attorneys should be consulted to get the best information available to help make your estimates.
Sometimes managers know what their future costs will be as a result of a contract, agreement, invoices, etc. In addition, there are expenses that you know were incurred, but you aren’t quite sure how much the bill shows. Accruals should reflect your best estimate of the costs incurred.
Making estimates is an everyday occurrence for accounting managers. Many of these estimates are routine and unexciting but nevertheless important. Thus, managers should invest the time needed to make the best possible estimates and should always be on the lookout for new information that may alter their initial estimates. Remember, your financial statements are going to be useful only if you make reliable, quality estimates.