Accounting estimates are approximate amounts used in financial statements when a figure cannot be measured with certainty at the reporting date. They are unavoidable under accrual accounting, which records revenues and expenses in the period they belong to, often before the final outcome is known. Common examples include the allowance for uncollectible receivables, the useful lives of fixed assets, warranty obligations, inventory write-downs, and the fair value of certain assets.
Estimates are not guesses. They are judgments based on past experience, current conditions and reasonable expectations, and they are expected to be revised as better information arrives. US GAAP sets out how revisions are handled, the SEC expects public companies to discuss their most significant estimates, and auditors test them as part of every audit.
Accounting estimates in plain terms
A restaurant owner closing the books for the year knows that a few customers who ate on credit will never pay, but not which ones. The new oven will probably last about eight years, but nobody can say exactly. The owner still has to produce figures today.
So the owner makes sensible estimates based on experience: perhaps two percent of credit sales will go unpaid, and the oven will be spread over eight years. If later information shows the estimate was off, the owner adjusts from then on. Estimates let the accounts be timely and reasonably accurate, rather than waiting years for perfect answers.
Common accounting estimates
- Uncollectible accounts. Businesses estimate the portion of receivables that will not be collected and record it in an allowance for doubtful accounts, with a matching bad debts expense.
- Depreciation inputs. The useful life and salvage value of each asset determine annual depreciation.
- Warranties. A company selling goods with a warranty records a warranty liability for expected future repair costs when the goods are sold.
- Inventory. Slow-moving or damaged stock is written down when its net realizable value falls below cost, which requires estimates of selling prices and costs to sell.
- Contingencies. A probable loss from a lawsuit that can be reasonably estimated is accrued as a loss contingency.
- Other areas. Pension obligations, income tax positions, impairment tests, credit losses on loans and fair values of financial instruments all involve significant estimation.
Making and recording an estimate
Suppose a wholesaler has $400,000 of receivables at year-end, and its experience shows that about 2 percent will prove uncollectible. It estimates the allowance at $8,000. If the allowance already has a $1,500 credit balance, the adjusting entry debits Bad Debts Expense and credits Allowance for Doubtful Accounts for $6,500. The receivables are then reported at a net $392,000, which is the amount the company expects to collect.
Good estimates are documented: the data used, the assumptions made, and the reasons for them. Many companies compare previous estimates with actual outcomes each year to see whether their methods are biased.
Changing an estimate
When new information shows an estimate should be revised, the change is a change in accounting estimate. It is applied prospectively, in the current and future periods, with no restatement of earlier years. For example, if a machine bought for $100,000 with no salvage value was being depreciated over ten years, and after four years management concludes it will last only three more, the remaining $60,000 carrying value is depreciated at $20,000 a year for the next three years.
A revision based on new information is different from an error. If the original estimate ignored facts that were available at the time, or involved a mathematical mistake, the correction is treated as an error and may require restatement.
Disclosure and audit
The notes to the financial statements describe significant estimates and the uncertainty around them, particularly where a reasonably possible change in the near term could have a material effect. Public companies registered with the SEC also discuss critical accounting estimates in management's discussion and analysis, explaining how sensitive reported results are to the key assumptions.
Auditors give estimates particular attention because they are subjective and can be biased, deliberately or not, toward a desired result. An independent auditor tests the method and data behind each significant estimate, develops an independent expectation where practical, reviews later events that confirm or contradict it, and looks for patterns of management bias across estimates.