Mastering Accounting Estimates: Key to Fair Financial Representation
Accounting estimates are a crucial part of preparing financial statements that ‘present fairly the state of affairs and business of the company’, per the Companies Act requirements. Estimates are required when amounts related to assets, liabilities, revenues, or expenses cannot be directly measured and must be inferred or calculated using available data.
These estimates help represent the company's financial position more accurately by predicting outcomes and hold specific significance for accountants and auditors.
Understanding Accounting Estimates
Estimates, by their nature subject to uncertainty. They are based on the judgments made by management informed by historical data and current economic trends. Common examples include:
Depreciation of Assets: Calculating depreciation expense based on the expected useful life and salvage value of assets.
Allowance for Doubtful Accounts: Estimating the receivables likely to remain uncollected.
Provisions for Warranties: Estimating potential future costs from product warranties.
Valuation of Financial Instruments: Determining the fair value of financial instruments or investment properties when market prices aren't available.
Methods Used to Determine Accounting Estimates
Different methodologies can be used to come up with accounting estimates. The nature of the item and the reliability of available data is generally considered to determine which methodology will work the best.
Historical Data Analysis: When estimating bad debts, a company may look at historical percentages of unpaid debts relative to total sales. The percentage of previous years can be applied to predict the estimated bad debts for the current year.
Forecasting Models: For estimating depreciation, companies might use life-cycle analysis of similar assets to predict useful life and salvage values.
Expert Opinions: Valuations of complex financial instruments or legal claims might rely on assessments from external experts due to the specialised knowledge required.
Estimation Uncertainty as an Inherent Risk
The primary challenge of making estimates is the inherent uncertainty that is present due to the need for subjective judgment. Estimations can be influenced by biases or flawed assumptions, especially in volatile environments like fluctuating markets or economic downturns. Estimation uncertainty is an inherent risk that there may be material misstatements in the financial statements. Accountants must acknowledge this uncertainty, aiming to reduce it by providing estimates as accurate as possible within the scope of available data.
Below is a list of common situations that can increase the risk of misstatement in accounting estimates.
Not a True and Fair Estimate
What constitutes a "fair" presentation for an estimate can differ depending on the asset or liability. For example, inventory might be considered fairly valued if priced at the lower of cost or net realizable value, while contingent liabilities might be valued at zero unless they are being assessed in the acquisition of a subsidiary. These definitions can stretch depending on the situation, making it essential to know the specific valuation rules for each significant asset or liability.
Management Bias
Bias is forever present in estimates can occur naturally and is not always intentional. For instance, during a corporate takeover, management might undervalue assets to negotiate a lower purchase price. Optimism or established habits in preparing estimates can also introduce bias, affecting the reliability of the results.
Inadequate Data and Controls
Reliable estimates depend on solid data and effective controls. If the systems for collecting and processing information are weak, estimates, such as the impairment of financial assets, are likely to be off the mark.
How to Reduce Estimation Uncertainty
To reducing the uncertainty around estimates focus should be placed on:
Using the appropriate method and data
The methods and data used should be suitable for the specific estimate and align with the financial reporting standards. To calculate an accounting estimate, management must select a method that fits the nature of the estimate and complies with applicable financial standards. For instance, depreciation might be calculated using the straight-line method, while loan losses could be estimated using historical default rates. The chosen methods and the associated data need to be appropriate, reliable, and relevant.
Using Reasonable Assumptions
Assumptions made should be defensible and consistent with other estimates and known business information.
Ongoing Review
Estimates should be regularly reviewed and updated based on new information or changes in circumstances, to remain relevant and accurate.
Documenting Accounting Estimates
Accountants should keep detailed records that support the estimates reported in financial statements. The documentation should include:
Methods and Assumptions: Detailed descriptions of the methodologies and assumptions used in making the estimates. This includes justifications for choosing specific methods and any relevant mathematical or statistical models applied.
Data Sources: Records of all data sources utilized, highlighting whether the data was historical or projected, internal or external, and how it was integrated into the estimation process.
Changes and Revisions: A log of any changes or revisions made to previous estimates, including the reasons for such adjustments and the impact on the financial statements.
Expert Consultations: Details of consultations with experts, if any, including the experts' qualifications, the scope of their advice, and how their input influenced the final estimates.
Rationale for Technique Selection: Explanation for selecting particular estimation techniques, reflecting the appropriateness and relevance to the specific financial context.
Auditors' Focus
Auditors examine whether accounting estimates are free of material misstatements and adhere to the reporting framework. They assess risks associated with estimation uncertainty, the complexity of calculations, and potential bias from management. Auditors check that the methods, assumptions, and data are applied consistently and judiciously, and they ensure disclosures about these estimates are clear and comprehensive.
CASE STUDY: ESTIMATING ALLOWANCE FOR DOUBTFUL ACCOUNTS
Background
XYZ Corporation, a manufacturer of electronic components, sells products to various retailers on credit terms. As part of their year-end financial processes, XYZ Corporation needs to estimate the allowance for doubtful accounts, which is an essential accounting estimate. This estimate adjusts the gross accounts receivable to the amount that is expected to be collected, reflecting the credit risk and customer payment behaviour.
Objective
To determine an accurate estimate for the allowance for doubtful accounts that reflects the potential credit losses for the financial year.
Data Collection
The financial team at XYZ Corporation starts by collecting data:
Accounts Receivable Aging Report: This report categorizes receivable balances based on the length of time an invoice has been outstanding.
Historical Data on Credit Losses: Records of credit losses categorised by customer type and ageing period.
Current Economic Factors: Analysis of current economic conditions that might affect customers' ability to pay, such as a downturn affecting the retail sector.
Methodology
Historical Percentage Method: Using historical data, XYZ Corporation calculates the percentage of receivables that turned out to be uncollectible for each aging category over the past five years. These percentages are adjusted for any current economic factors or changes in credit policy.
Example Calculation:
0-30 days: 1% historically uncollectible
31-60 days: 2.5% historically uncollectible
61-90 days: 4% historically uncollectible
Over 90 days: 10% historically uncollectible
Adjustments for Current Conditions: Given a recent economic downturn, the company has decided to increase the percentages by 0.5% for each category to accommodate increased credit risk.
Calculation:
The accounts receivable ageing report shows the following:
0-30 days: R500,000
31-60 days: R200,000
61-90 days: R100,000
Over 90 days: R50,000
Applying the adjusted percentages:
0-30 days: R500,000 x 1.5% = R7,500
31-60 days: R200,000 x 3% = R6,000
61-90 days: R100,000 x 4.5% = R4,500
Over 90 days: R50,000 x 10.5% = R5,250
Total Allowance for Doubtful Accounts = R7,500 + R6,000 + R4,500 + R5,250 = R23,250
To record the allowance for doubtful accounts of R23,500, you would make the following journal entry in the accounting records:
Journal Entry - Allowance for Doubtful Accounts
DateAccount TitleDebit (R)Credit (R)[Specify Date]Bad Debt Expense23,500Allowance for Doubtful Accounts23,500
Explanation:
Debit the Bad Debt Expense account: This increases the expense account, reflecting the cost to the business due to potential credit losses. It represents the estimated amount of receivables that are not expected to be collected.
Credit the Allowance for Doubtful Accounts: This is a contra account to Accounts Receivable. It increases by the same amount as the bad debt expense, indicating the portion of receivables that are estimated to be uncollectible.
Documentation
Detailed documentation includes the ageing report, historical loss rates, rationale for the adjusted increase due to economic conditions, and the calculation methodology.
Consultations with the sales and credit management team regarding any specific customer risks are also documented.
Conclusion
The estimated allowance for doubtful accounts for XYZ Corporation at the end of the financial year is R23,250. This accounting estimate helps in presenting a more accurate and realistic view of the company’s financial health in its financial statements.
Use CIBA’s Example Working Paper Template to Document Accounting Estimates
Learn more about drafting financial statements - enroll to CIBA’s Drafting Financial Statements (IFRS For SMEs) 2024 CPD course
What you will learn
Attending this webinar will equip you with the following skills:
Be refreshed on the key elements that all financial statements cover such as revenue and property, plant and equipment.
Evaluate the messaging conveyed to financial statement users through narrative notes, emphasizing effective communication of key information.
Gain awareness of significant areas identified for potential changes under the IFRS for SME Accounting Standard exposure draft, assessing the potential implications for their clients and companies.
Examine indicators of going concern and other non-financial disclosures, recognizing areas that may necessitate additional attention and consideration.
Scrutinise the financial statements being prepared, ensuring alignment with user objectives and meeting their needs effectively.
