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- Accounting Basics
- What are Accounting Principles
- Accounting Cycle
- Accrual Accounting Basis
- Cash Basis Accounting
- Matching Principle of Accounting
- Conservatism Principle of Accounting
- Revenue Recognition Principle
- Prudence Concept in Accounting
- Cash Accounting
- What are Accounting Policies?
- Relevance in Accounting
- Accounting Estimates
- Mark to Market Accounting
- Prior Period Adjustments
- Cash Accounting vs Accrual Accounting
- Break Even Point In Accounting
- Operating Cycle
- Fiscal Year
- Fiscal Year vs Calendar Year | Top Differences | Examples |
- Financial Reporting
- Financial Statements
- Accrual vs Provision
- Accrual vs Deferral
- Temporal Method
- Interim Financial Statements
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- Consolidated Financial Statement
- Audited Financial Statements
- Financial Statement Audit
- Internal Audit vs External Audit
- Interim Reporting
- Accounting Scandals
- Quality of Earnings
- Audit Risk
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- Leasehold vs Freehold
- IFRS vs US GAAP
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- Accounting for Fair Value Hedges
- Debit vs Credit in Accounting
- Single Entry System in Accounting
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- Journal in Accounting
- Adjusting Entries in Journal
- General Journal
- Accounting Journal Entry
- Ledger in Accounting
- T Accounts
- Account Balance
- Journal vs Ledger
- General Journal vs General Ledger
- What is Trial Balance ? | Examples | Steps | Prepare | Errors
- Nominal Account
- Adjusted Trial Balance
- Reconciliation of Books | Types, Best Practices | Useful Tips
- Petty Cash | Meaning | Template | Accounting | Example
- Petty Cash Book
- Debit Note | Debit Notes Accounting & its Top Characteristics
- Credit Note
- Debit Note vs Credit Note | Top 7 Differences (Infographics)
- Drawing Account
- Balance Sheet
- Balance Sheet
- Balance Sheet Purpose
- Capital Expenditure Formula
- Statement of Financial Position
- Accounting Equation
- Assets vs Liabilities | Top 9 Differences (with Infographics)
- Equity vs Assets
- Trial Balance vs Balance Sheet | Top 10 Differences You Must Know!
- Balance Sheet vs Consolidated Balance Sheet
- Bank vs Company Balance Sheet
- Banks Balance Sheet
- Commitments and Contingencies
- Management Discussion & Analysis
- Revenue Reserve vs Capital Reserve | Top 7 Differences
- Revenue Reserve
- Capital Reserve
- Capital Receipts vs Revenue Receipts | Top 8 Differences
- Capital Lease vs Operating Lease | Top Differences You Must Know!
- Debt vs Equity Financing | Advantages | Disadvantages | Example
- Internal vs External Financing | Top 7 Differences (Infographics)
- Available for Sale for securities
- Held to Maturity to securities
- Non-Performing Assets (NPA)
- Cash and Cash Equivalents | Examples, List & Top Differences
- Cash Equivalents
- Restricted Cash
- 3 Types of Inventory | Raw Material | WIP | Finished Goods
- Ending Inventory Formula
- Average Inventory Formula
- Closing Stock
- Inventory vs Stock
- Current Assets
- FIFO vs LIFO
- First In First Out (FIFO)
- Last in First Out (LIFO)
- LIFO Reserve
- Non-Current Assets
- Accounts Receivables? | Definition, Accounting Examples
- Accounts Receivables Factoring
- Trade Receivables
- Net Realizable Value (NRV)
- Allowance for Doubtful Accounts
- Accrued Revenue
- Liquid Assets
- Quick Assets
- Marketable Securities on the Balance Sheet | Top Examples
- Trading Securities in Balance Sheet
- Prepaid Expenses
- Prepaid Insurance
- Tangible vs Intangible Assets
- Tangible vs Intangible
- Contingent Asset
- Tangible Assets
- Deferred Tax Assets
- Capital Expenditure (Capex)
- Capex vs Opex
- Salvage Value
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- Fixed Capital vs Working Capital | Top 8 Differences (Infographics)
- Impariment of Assets
- Negative Goodwill
- Goodwill Valuation
- Capitalized Interest
- Accounts Payable | Days Payable Outstanding | Formula |
- Current Liabilities | List of Current Liabilities on Balance Sheet
- Accrued Liabilities
- Accrued Interest
- Notes Payable
- Accounts Payable vs Notes Payable
- Revolving Credit Facilities
- Bonds Payable Accounting
- Bad Debt Reserve Allowance
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- Financial Liabilities | Definition, Types, Ratios, Examples
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- Accounts Receivable vs Accounts Payable
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- Financial Lease vs Operating Lease
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- Shareholders Equity
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- Outstanding Shares (Definition, Formula) | Stocks Outstanding
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- Retained Earnings (Formula, Examples) | How to Calculate?
- Retained Earnings Formula
- Statement of Retained Earnings
- Appropriated Retained Earnings
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- How to Calculate Net Worth of a Company | Formula | Top Examples
- Owners Equity
- Preferred Shares
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- Common Stock vs Preferred Stock | Top 8 Differences You Must Know
- Stocks Vs Shares
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- Shareholder Equity vs Net Worth | Top 5 Differences You Must Know!
- Stock vs Option
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- Income Statement
- Income Statement | Top Examples | Template | Format | Analysis
- Variable Costing Income Statement
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- Purpose of Income Statement
- Cost of Goods Sold
- COGS Formula
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- Net Income Formula
- EBITDA Formula
- Operating Expense (OPEX)
- Interest Expense
- LTM EBITDA
- Non Recurring Items
- EBIT vs EBITDA | Top Differences | Examples | Calculation
- Depreciation – Formula | Types | Most Comprehensive Guide
- Depreciation Tax Shield
- Accelerated Depreciation
- EBITDA vs Operating Income
- Straight Line Depreciation Method
- Sum of Year Digits Method of Depreciation
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- Land Depreciation
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- Amortization of Intangible Assets
- Depreciation vs Amortization
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- Non Cash Expense
- Accrued Income
- Share based compensation
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- Margin vs Profit
- Net Operating Loss (NOL)
- Tax Shield
- Sundry Expenses
- Trade Discount
- Percentage of Completion Method
- Interest vs Dividend | Top 9 Differences (with Infographics)
- EBITDA vs Net Income
- EBIT vs Net Income
- EBIT vs Operating Income
- Operating Income vs Net Income
- Cost vs Expense
- Expense vs Expenditure
- Accounting Profit vs Economic Profit
- Income Tax vs Payroll Tax
- Tax credits vs Tax deductions
- Tax Evasion vs Tax Avoidance
- Regressive Tax
- Gross Income vs Net Income
- Profit vs Revenue
- Revenue vs Earnings
- Revenue vs Net Income
- Revenue vs Income
- Profit vs Income
- Revenue vs Sales
- Revenue vs Turnover
- Capitalization vs Expensing
- Income Statement vs Balance Sheet | Top 5 Differences You Must Know!
- Statement of Comprehensive Income | Items | Colgate Example
- Variance Analysis
- Other Comprehensive Income
- Partial Income Statement
- Income Summary Account
- FOB Destination
- Explicit Cost
- Implicit Cost
- Direct cost vs Indirect Cost
- Fixed cost vs Variable cost
- Price vs Cost
- Hard Cost vs Soft Cost
- Period Cost vs Product Cost
- Overhead Costs
- Nopat vs Net Income
- Marginal Costing vs Absorption Costing
- Marginal Cost Formula
- Margin vs Markup
- Markup Formula
- Contribution Margin vs Gross Margin
- Cash Flow Statement
- Statement of Cash Flow
- Cash flow from Operations | Formula, Calculations & Examples
- Operating Cash Flow Formula
- Cash Flow from Investing Activities (Formula & Top Examples)
- Cash Flow From Financing Activities | Formula & Calculations
- Cash Flow Analysis
- Pro Forma Cash Flow Statement
- Fund Flow Statement
- FFO (Funds from Operations)
- Direct vs Indirect Cash Flow Methods
- Cash flow vs Net Income | Key Differences & Top Examples
- Cash Flow vs Fund Flow | Top 8 Differences (with Infographics)
- Accounting Careers
- Accounting Interview Questions
- Financial Accounting Careers
- Top Accounting Firms
- Big Four Accounting Firms
- Forensic Accounting
- Cost Accounting
- Financial Accounting
- Accounting vs Engineering
- Finance vs Accounting
- Bookkeeping vs Accounting
- Accounting vs Auditing
- Accountant vs Actuary
- Bookkeepers vs Accountants
- Accounting vs Financial Management
- Cost Accounting vs Financial Accounting
- Cost Accounting vs Management Accounting
- Financial Accounting vs Management Accounting
- Public vs Private Accounting
- Accounting vs CPA
- Controller vs Comptroller
- Personal Banker Job Description
- Accounting Firms in Australia
- Accounting Firms in Canada
- Top Accounting Firms in US
- Accounting Firms in Singapore
- Accounting Books
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
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#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 in 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.
Accounting Estimates Video
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.
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