We have learned how to measure a transaction that has already occurred or taken place and for which either some value /money has been paid, or some valuation principles are to be adopted for their measurement.
But certain items can not occur and cannot be measured, but they are necessary to record in the books of the account using certain valuation principles. For example, provision for doubtful debts. For such items, we need some value. In such a case, reasonable estimates are required to be made.
Financial statements provide investors and analysts with information about a company’s ability to manage its financial transactions and build value in the organization. Accountants collect information to use when creating financial statements. This information includes both actual and estimated amounts.
Accounting estimates require the accountant to determine what financial value to record when the actual amount is unknown.
Effect of Accounting Estimates
Accounting estimates in historical financial statements measure the effects of past business transactions or events or the present status of an asset or liability. Examples of accounting estimates are.
Net realizable values of inventory and accounts receivable, property and claim receivable on insurance loss, revenues from contracts accounted for by the percentage-of-completion method, pension, and warranty expenses etc. A lot of experience and prudence are required to make the provisions.
The measurement of certain assets and liabilities is based on estimates of uncertain future events. As a result, of uncertainties involved in business activities, many financial statement items cannot be measured with a degree of accuracy but only can be estimated.
Therefore, the management makes various estimates and assumptions of assets, liabilities, incomes and expenses as on the date of preparation of financial statements. Such estimates are made in connection with depreciation computation, amortization, and impairment of assets, provision for doubtful and bad debts, employee benefits etc.
An estimate may require a revision if changes occur regarding circumstances in which the estimates were based or as a result of additional and confirmed results. Changes in accounting estimates mean differences arising between earlier estimated computation and actual results.
Few illustrations of changes in accounting estimates
- A company incurred an expenditure of $10, 00,000 on the development of the patent. Now the company has to estimate how many years the patent would provide benefits to the company. This information should be based on the basis of the latest information.
- 5% of the amount will not be recovered means the company is expecting some loss on the collection of the amount from sundry debtors for which provision for doubtful debt is made.
- A company dealing in long-term construction contracts uses the percentage of completion method for recognizing the revenue at the end of each accounting year. Under this method, the company has to make adequate provision for unseen future contingencies, Since provisioning for unseen contingencies requires estimation, there may be excess or short provisioning which is to be adjusted in the period when it is recognized.
- The company has to provide taxes which are also based on the estimation as there can be some interpretational differences between profit shown by books of account and profit computed by the income tax authorities.
An accounting estimate is an approximation of a financial statement element, item, or account in the absence of exact measurement. In other words, it refers to items/account balances that are subject to management judgments, appraisals and management assumptions. Accounting estimates are made based on management’s knowledge and experience of past and current events. Meaning to say, management is responsible for establishing the process and controls for preparing accounting estimates. Accounting estimates should be made properly in a reasonable manner since they may have a significant effect on a company’s financial statements.