What is an Accounting Estimate?
An accounting Estimate can be defined as a technique to measure items in accounting, which are harder to quantify. Since they cannot be accurately quantified, they are estimated on basis of judgment using intuition, and other knowledge derived from other past experiences.
Accounting estimates are mostly used by accountants for items that are harder to accurately predict. In this aspect, it is important for accountants to ensure that they are able to accurately predict these items in a proper manner, so that the financial figures disclosed in the Balance Sheet are accurate, and can be relied upon by the external stakeholders.
Role of Auditor in Accounting Estimates
During the year-end audit, the role of the auditor is to evaluate the reasonableness of the accounting estimates that are made by the management in the context of the financial statements. The accounting estimates that are made by accountants should be based on subjective, as well as objective factors. Given the fact that there are external factors involved in creating these estimates, it is challenging for management to establish stringent controls over these estimates. Therefore, it is imperative for auditors to ascertain that the basis used for gauging accounting estimates is accurate, with the required degree of professional skepticism involved.
Process for Creating Accounting Estimates
Regardless of the fact that the process for creating accounting estimates cannot always be formally applied, yet there are a couple of factors that accountants can utilize in order to ensure that they are able to create these estimates with relative ease. These processes are as follows:
- Identification of situations and scenarios for which accounting estimates are required
- Identification of new factors that might impact the accounting estimates
- Accumulating all relevant, sufficient, as well as reliable data that is based on the estimate
- Developing all assumptions that are representative of the management’s judgement of most used circumstances, as well as events – this mainly refers to the assumptions being stated and documented, so that there is proper basis as to why these assumptions were used in the first place.
- Determining the estimated amount that is based on the assumptions made earlier.
- Ensuring that the accounting estimate is prepared in conformity with the stated accounting principles, with proper disclosure duly stated.
Evaluation of Accounting Estimates
Once accounting estimates have been duly established by the accountants, it is of primitive importance to ensure that the following:
- Materiality – It is imperative to ensure that all accounting estimates are material to the financial statements that have been developed.
- Reasonableness of accounting estimates – It is important to ensure that all accounting estimates are considered to be reasonable in the given circumstances.
- Conformity and compliance – it is also rudimentary to make sure that the accounting estimates that have been established are in line with acceptable business practices, and accounting rules.
Importance of Accounting Estimates
Accounting estimates hold tantamount value from the perspective of external stakeholders, primarily because it directly impacts the decision-making power of the users of financial statements. There are several other reasons as to why accounting estimates are important, from the perspective of the company. These reasons are as follows:
- Increasing the accuracy of the financial statements – Accounting estimates greatly impact the accuracy of the financial statements, since all approximation is based on a combination of subjective, as well as objective factors.
- Investors make these decisions based on accounting estimates only – from an investors perspective, taking a glance at accounting estimates reveal the policies and practices adopted by accountants in terms of ensuring that the financial statements are prepared with due diligence, and proper accuracy.
- Accounting estimates might trigger the auditors – since accounting estimates need to be duly evaluated by auditors, it is important for companies to make sure that these estimates are prepared with higher accuracy. In case where auditors find red flags, it might eventually result in a qualified report, that will harness the reputation of the company.
Examples of Accounting Estimates
Some of the most common examples of accounting estimates are given below:
Accounts Receivable is considered one of the most common examples of accounting estimates. In this aspect, it is important for accountants to have a clear idea regarding the payment schedule that is followed by the buyers. Accurate estimation of accounts receivables is important because it is an asset on the financial statement, and hence, incorrectly depicting this asset might result in a skewed representation of accounts receivables.
Inventory estimation is also considered to be an important step when preparing financial statements at the year-end. Inventory is supposed to be recorded at a lower cost or net realizable value. Since inventory reconciliation is a very tedious task, it might not be humanly possible for accountants to make sure that all inventory-related items are included in the reconciliation process. Consequently, accountants are supposed to make estimates that can help extrapolate the closest and actual value of the inventory at hand.
Depreciation Method and useful life
Depreciation of fixed assets is a subjective decision made by accountants, based on the underlying assets, and the decisions involved. In this regard, it can be seen that depreciation is considered to be one of the most important areas that are covered by the company because it directly impacts the carrying value of the asset. Since there is subjectivity involved in writing down the assets, there is a need for accountants to make sure that they accurately prescribe a way to depreciate assets as closely as possible.
Goodwill is assumed to have an indefinite useful life. Factually, it can be seen that there is a need to conduct impairment reviews on a periodic basis so that an accurate estimate of the actual goodwill is possessed by the company.
Contingent Liability is also referred to as an accounting estimate used by companies. Contingent liabilities include several different factors that include revenue volatility, product commercialization, timings, and thresholds of the overall payment. This is an accounting estimate that is highly important, primarily because of reason that it needs to be disclosed on the financial statements of the company.
Companies that deal with warranty provisions are supposed to have a clear-cut idea regarding warranty-related costs. All warranty estimates need to be properly forecasted by companies in order to ensure that they are able to calculate costs and subsequently disclose them in the financial statements. This is considered a highly important part of accounting estimates because it tends to provide clarity to the stakeholders pertaining to the expenses incurred.
Pension and Other Post-Retirement Obligations
In order to accurately estimate pension and other post-retirement obligations, organizations need to make estimates pertaining to the discount rate, expected long-term return on plan assets, salary growth, and inflation and return rates as well as other rates.
Credit Losses Allowances
Credit Loss Allowance is defined as a change for credit losses as a prior period exchange rates. All credit loss allowances need to be estimated by companies so that they can be declared on the financial statements with proper accuracy.