Accounting Estimates – This is an important concept to understand if you are an investor and is keen to understand the nitty-gritty of the Accounting concepts.

Learning and understanding this particular concept will help you get into the minds of the accountants and you would be able to find out why something is measured in a specific way.

In this article, we will understand this topic in detail with Accounting Estimates example.

Let’s get started.

What are Accounting Estimates?

You may have known accounting as a way to represent the accounts. Most of these accounts can be measured through quantitative measures. And every accountant can follow the fundamental rules of accounting, apply basic maths, and find out the amount in quantifiable terms.

But what if the accountants are unable to measure the items in quantifiable measures?

What would be the alternatives then?

Let’s illustrate an accounting Estimate example here.

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 measure?

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 debts, needs to depend on his own judgment and expertise to come to a conclusion.

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.

If you are new to accounting, do have a look at this basic tutorial on Accounting

Examples of Accounting Estimates

Here are the top 8 list of Accounting estimates –

#1 – Accounts Receivables

Accounts Receivables is one of the most common examples of Accounting Estimates. 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 on the basis of FIFO and is stated at lower of cost or market value. Obsolete inventory is accessed periodically and write downs of inventory is done to its net realizable value.

source: Ligand SEC Filings

#3 – Depreciation Method and Useful Life

This is another common example of accounting estimates. Ligand uses straight-line method for depreciation and considers the useful life in the range of three to ten years.

source: Ligand SEC Filings

#4 – Goodwill

Goodwill 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 liabilities is again a subjective accounting estimate. There are many inputs that 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

Warranty is another very common accounting estimates example. Companies that provide warranty have to establish warranty related costs. Ford forecasts these warranty and field service action obligation using a patterned estimation model as described below.

source: Ford SEC Filings

# 7 – Pension and Other Post Retirement Obligations

In order 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.

source: Ford SEC Filings

#8 – Credit Losses Allowances

The credit loss is the change in the provision for credit losses at prior period exchange rates. For analysis purposes, Fod 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 this is so very important?

Because in the case of the accounting estimates; the accountants need to put in more efforts.

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 are not known.

We will talk about a couple of items to make things clear.

• Depreciation: How one would understand how much depreciation a company should incur for a machinery or a plant? Yes, one can use the accounting method; but there’s no accurate information how much should be the written down value 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 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 of accounting estimate

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 accounting estimate 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 entries, 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 accounting estimate, the company can’t have any physical evidence.

That’s why for the auditors, the accounting estimates isn’t very convincing. Things like management bias, subjective assumptions, or errors in judgment may affect the accounting 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 estimate.

But for the investors who have many years of experience would be able to judge the entries quite well. Yes, like auditors 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 their 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 actual story lies in between the lines. If an investor wants to invest a decent amount into 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 statements of the company.

Recommended Readings

This has been the guide to Accounting Estimates, examples of accounting estimates and list of accounting estimates. You may also have a look at these below-recommended articles on accounting.

• Forensic Accounting Skills
• Accounting Interview Questions and Answers
• Finance vs Accounting – Which is Better? (Top Differences)
• Management Discussion and Analysis
• SEC Filings Types

The post Accounting Estimates | Definition | Top Industry Examples appeared first on Learn Investment Banking: Financial Modeling Training Online.