Updated July 20, 2023
What is Accounting Estimates?
Accounting estimate is termed as the method by which the values of the accounting line items are determined either by the means of accounting principles, judgments, or past experiences. Such line items do not have a set value and or carry any accurate method of quantifying it.
It can be termed as the methodology that the accountants utilize to ascertain the estimates of the accounting line items. The accountants just simply cannot debit or credit estimates on their own assumptions or judgments. They rather employ accounting principles as specified and earmarked by the regulatory authorities. By doing such an application of accounting principles, the accountant prepares correct journal entries which are the basis of preparing the correct financial statements. Once the accounting principles are applied and the correct estimates are computed, the estimates are then passed by the accountant as a credit or debit in the journal entries and thereby preparing the accurate financial statements.
Features of Accounting Estimates
Some of the features are given below:
- Identification of requirements of the accounting estimates.
- Identification of the factors that has an impact of the accounting estimates.
- Application of correct accounting principles and assumptions applied and utilized to determine the correct estimates.
- The accounting principles selected and assumptions applied should comply with the requirements earmarked as per the international accounting standard board.
- It should comply with all definition types, recognition criteria, measurement concepts applied specifically for the income, expenses, assets, and liabilities.
The examples are as follows:
- Estimates on Warranties: The business that offers warranties on the services and products have to either assume them or have to establish warranty related costs through judgments. In such a scenario, a warranty estimation model needs to be formulated that is to be in line with the accounting principles and current laws. The model can be derived from the analysis of periodic patterns which the business may record on the day to day basis.
- Estimates on the Pension and Retirement Obligations: To arrive at the cost of pensions and the related obligations on retirement, the companies or business must assume the discount rate and anticipated long-term returns that is earned on the assets, growth in the salaries, rates of retirements and inflation levels along with the rate of mortality.
- Allowances of Bad Debt and Credit Losses: The provisions for loss of credit or bad debt may change from time to time as per the exchange rate changes and the changes in the recording of the accounting principles.
- Estimation of Contingent Liabilities: The contingent liabilities are termed as liabilities that may happen in the future. Their estimations are always subjective and depend on the happening future events such as judgments passed on any law suits or honoring of established product warranties.
- Estimation of Goodwill: The goodwill of a business is estimated normally when one company sells to the other business at a cost that is generally more than the fair value of the business. Goodwill tends to carry indefinite life and their review on any levels of impairment is done on an annual basis.
- Estimation of Depreciation Expense: The depreciation can be estimated on several methods. As per the requirements of financial reporting, most business adopts the straight line depreciation method. As per the requirements of the taxation laws, the business has to report depreciation on the modified accelerated cost recovery system.
- Estimates on Account Receivables: The account receivables are generally interest bearing and their estimates are derived from the issued invoices. Their future estimations are based on the past due accounts as per the contractual payment terms.
Change in Accounting Estimates
The change in accounting estimates happens from time to time as these are not fixed and rather are reported as per the governing principles, assumptions or judgments as made by the accountants. The accounting estimates generally involve judgments in line with the anticipated future earnings and obligations which specifically pertains to assets, liabilities. The information on such estimates is based on the current estimates and prevailing laws whether related to taxation or accounting. As laws and principles are amended from time to time, such estimates modify accordingly and they would be in line with the changed principles or laws.
To standardize the reporting of estimates, international accounting standard 8 has been incorporated that looks into the change in the accounting estimates and corresponding errors. The IAS 8 states that the change in the accounting estimates has to be recognized in the revenues and losses account for the time period wherein such change happened and took place. It is to be observed that whether such changes in accounting estimates impact that specific period or it impacts the upcoming financial years or periods. Prior year ends are not impacted with the change in the accounting estimates.
Only substantial errors in the value of accounting estimates impact the recording of those estimates in the prior period. Therefore, it can be concluded that the change in accounting estimates would impact the financial statements on a prospective basis and not on a retrospective basis.
Difference Between Accounting Estimates and Accounting Principle
The accounting principle is basically a set of rules or procedures that applied to determine how financial information would be recorded and computed. On the other hand, the accounting estimates are the values that are actually applied by the accountant either through judgments or through the application of the accounting principle. The examples normally comprise of inventory valuation changes or revenue recognition modifications.
This would look into the changes of bad debt and the depreciation value. The adoption of the accounting principle can be done on a retrospective basis and not on a prospective basis when applied to financial statements. The adoption of accounting estimates, on the other hand, can be done on a prospective basis and not on a retrospective basis when applied to financial statements.
Why is it Important?
These are important as it helps business to determine correct values of the accounting line items that are in question. The correct values can be presented to the shareholders and by doing this the company is able to showcase its worth to their rightful owners.
This is a guide to the Accounting Estimates. Here we also discuss the features of accounting estimates along with examples. You may also have a look at the following articles to learn more –