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 (Revised) defines an accounting estimate as: “A monetary amount for which the measurement, in accordance with the requirements of the applicable financial reporting framework, is subject to estimation uncertainty”, where estimation uncertainty is defined as “susceptibility to an inherent lack of precision in measurement”.
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.
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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.
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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 estimation uncertainty, subjectivity and complexity
Where the required monetary amount for an item in the financial statement cannot be measured with precision through a direct cost or price then estimation uncertainty arises.
In these circumstances, management needs to use judgement in selecting and applying methods, assumptions and data in making the estimate and in selecting the amount for recognition or disclosure in the financial statements. The process of making the estimate can be complex and/or subjective.
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.
Under ISA 540 (Revised), the auditor needs to undertake a separate assessment of inherent risk in order to assess the risk of material misstatements at the assertion level for accounting estimates. This assessment is based on inherent risk factors such as estimation uncertainty, subjectivity and complexity. The level, existence and interaction of each of the inherent risk factors in an accounting estimate will vary and determine where on the spectrum of inherent risk a particular accounting estimate lies, and this will impact the associated risk of material misstatement.
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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Example |
