What is the definition of an accounting estimate?
A set of historical financial statements includes many amounts that cannot be calculated with certainty. This may be because the measurement or valuation of these amounts is dependent on the outcome of future events. It could also be that the information needed to determine the amount cannot be accumulated in a timely or cost effective manner.
ISA 540, Auditing accounting estimates including fair value accounting estimates, and related disclosures (ISA 540), currently defines an accounting estimate as: “An approximation of a monetary amount in the absence of a precise means of measurement. This term is used for an amount measured at fair value where there is estimation uncertainty, as well as for other amounts that require estimation.”
Accounting estimate or accounting policy?
It is not always simple to differentiate between what is an accounting estimate and what is an accounting policy.
Accounting policies are often prescribed by the financial reporting framework or by law or regulation. Regardless of being prescribed or elective, accounting policies represent the measurement bases to be used in reporting matters in the financial statements.
| Example: Inventories and work-in-progress are valued at the lower of cost and net realisable value on a first-in, first-out basis. |
Accounting estimates are the methods chosen to determine the monetary amount of the application of the chosen accounting policies.
| Example: Cost is calculated based on direct material, direct labour and overhead incurred to bring inventory to its present location and condition. Net realisable value is determined based on the estimated selling price less the estimated selling costs. |
To help preparers of financial statements, the IASB published an exposure draft (ED), Accounting policies and accounting estimates (proposed amendments to IAS 8). The ED proposes the definition of accounting estimate as: “Judgements or assumptions used in applying an accounting policy when, because of estimation uncertainty, an item in financial statements cannot be measured with precision.” This clarifies that accounting policies are the overall objectives and accounting estimates are the inputs used in achieving those objectives.
The importance of subjectivity
Accounting estimates will often be developed by management based on previous experience and knowledge and will therefore naturally include a certain amount of subjectivity. Because of this subjectivity, there is a risk of management bias.
In developing accounting estimates, an entity’s management uses information that is objective, such as the amount on an invoice, as well as information that is subjective, such as amounts expected to be invoiced.
Information that is subjective will have at least one, if not all, of the following risk factors:
- estimation uncertainty;
- judgement, including management bias; and
- complexity.
The level, existence and interaction of each of the factors in an accounting estimate will vary and impact the associated risk of material misstatement. Under ISA 540, the auditor also needs to determine whether any accounting estimates identified as having high estimation uncertainty give rise to significant risks. Further work is required for those accounting estimates that are determined to be significant risks.
Estimates in financial statements
It has become increasingly common to see accounting estimates in financial statements. The examples below are estimates that may be easily overlooked by auditors when determining an entity’s population of accounting estimates.
Examples include:
- Depreciation of tangible fixed assets
- Allowance for doubtful accounts
- Accrued expenses
- Stock obsolescence provision
- Litigation provisions
- Uncertain tax provisions
- Recoverability of deferred tax assets
Management will often have a lot of experience in developing these types of accounting estimates. They are likely to have well-established methodologies for estimating the amounts to be incorporated into the financial statements.
There are also less common accounting estimates that may be relevant to a specific industry or other economic situations.
Examples include:
- Warranty provisions
- Expected credit loss provisions
- Revenue recognised from long term contracts
- Impairment of intangible fixed assets or goodwill
- Property held at valuation
- Financial instruments
- Valuation of pension assets/liabilities.
New accounting standards may also introduce a need for new accounting estimates, as we have seen with the introduction of IFRS 9 Financial Instruments and expected credit losses.
How should estimates be determined and recognised?
Financial reporting frameworks provide parameters for how certain estimates are determined.
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