What is Accounting Estimates?
Accounting Estimate is technique to measure those items in accounting that have no accurate way of quantification and are therefore estimated on the basis of judgement and knowledge derived from past experience.
Let’s say that a company perceives that it will incur some bad debts during a particular period. But, it has no idea how much 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., 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 –
#1 – Accounts Receivables
Accounts ReceivablesAccounts ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet. is 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. value. Obsolete inventory is accessed periodically, and write-downs of inventory are done to its 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..
source: Ligand SEC Filings
#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. and considers the useful life in the range of 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. has an indefinite useful life. Goodwill impairment review is done annually to access any changes in goodwill.
source: Ligand SEC Filings
#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. is again a subjective accounting estimate. Many inputs are considered here, including revenue volatility, the probability of commercialization of product, timings, thresholds, etc. Contingent Liabilities for Ligand was $4.97 million.
source: Ligand SEC Filings
#6 – Warranty Estimates
Companies that provide warranty 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 make an estimate regarding is the discount rate, expected long-term return on the plan assets, salary grown, inflation, retirement rates, mortality rates, and many others.
#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 worth of the company 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 they value the items on the list since the actual amount for the particular items is not known.
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. at the end of every year. That’s why it’s the accountant’s job to find out 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. If a machine is purchased, how a company would know how long it will serve the company? 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.
Since the accountant can’t just debit or credit any account without the precise amount, accounting estimates need to done to get an estimate of the same account. Taking an 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 be able 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?
This 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. , they have one question in mind – do the entries/items have evidence behind them to support?
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.
That’s why when an auditor would be looking at the accounting statements and the accounting entries, he should be very careful and should ensure that the amounts that are 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 be able 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., 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 was right? (as an investor, you can look at similar companies and compare)
- Whether the provision for bad debts is 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 in between the lines. If an investor wants to invest a decent amount in the company, it makes sense to look at the financial statements and the accounting entries with diligence, meticulousness, and with a 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. of the company.
Accounting Estimates Video
This article has been the guide to Accounting Estimates and its definition. Here we discuss the list of accounting estimates along with examples and explanations. You may also have a look at these below-recommended articles on accounting.