As the name suggests, an estimate is a rough calculation or judgment of an idea for which there exists no exact approximation. In simpler words, estimate is the guess of cost, number, size, value, or quantity of anything that you are not sure about. When you estimate something, you are making an approximate judgment of how it should be. The prime purpose of estimation is to land an approximation that is the closest to the actual result.
“Estimate refers to forming a rough opinion or approximation about something (quantity, value, number, size, weight, etc.) that is not certain.“
Estimate is the rough valuation of anything. When you are not sure about something, you may resort to waiting for the actual results to come forward. Or on the contrary, you may make an estimate based on your understanding and judgments. An estimate, being judgment-based can vary from person to person. Also, an estimate can deviate from the actual results to a great degree.
- Archie is fond of gardening plants. He tries a new crop every summer. This time he is planning to plant tomatoes all around his garden. However, tomatoes demand sufficient space and sunlight to grow well. Before he goes to buy the seeds, he needs to estimate how many plants can he sow.
To make a reliable estimate, he measures the total area covered by his garden i.e. 70 sq. Ft. Each tomato plant requires 27 inches planting area and at least 24 inches space should be left between two consecutive plants to promote air circulation. This way he can sow 6 tomato plants in a single row. And almost 7 total rows can be planted in the garden.
Therefore, he would need to buy enough tomato seeds to grow 42 plants (6 plants * 7 rows). This estimate made by Archie can prove right upon plantation. Or on the contrary, he might have some space left-back for more plantation. Or he might be able to accommodate less than 42 plants. Estimates are only a rough calculation and can be different from the actual results.
What is an accounting estimate?
“An accounting estimate is the anticipation or approximation of the value to be recorded, debited, or credited concerning the items for which no precise valuations can be made.”
Accounting is the art of recording. This primarily includes recording transactions; and each transaction is recorded against a numeric value that needs to be determined. However, sometimes, it is not possible to determine the value of a transaction or an event numerically. To post the entry into accounting books, therefore, estimates are made.
These estimates are based on specialized knowledge and are made by highly qualified people including professional valuers, actuaries, etc. These professionals use probability, financial mathematics, statistics, and other estimation techniques to land on realistic estimates. To be precise, estimates are massively used in accounting to anticipate future expenses and incomes, and to determine the fair value of certain assets and liabilities, provisions etc.
A very common example of accounting estimates
Application of Accounting Estimates:
- Warranty Provision:
Businesses usually offer warranty to their customers; particularly when dealing with electronics and other items prone to mechanical and technical defaults. Accounting standards demand the businesses to estimate the future expense that they might have to incur on account of warranty services (exchanging the products, offering a return or refund, etc.) and record it in advance.
To know the future warranty expense, an estimate is made keeping in view the past business practices. To understand better, let us look into the following example.
LMN (Pvt.) Ltd is engaged in the retail business of electronics. Electronics being subjected to technical defects; the company offers a one-year warranty to its customers. Within one year of sale, any kind of technical fault within the supplied electronics shall be compensated. Either the customer would get the electronic item replaced with a fresh piece or would get a full refund.
Every year almost 2% of customers come back with faulty machines. The repair/exchange cost for every faulty machine is approximately $100. This year LMN (Pvt.) Ltd. sold 300 machines. How much warranty cost would it yield over these sales?
300 sales *2% faulty products (average past trend) = 6 faulty machines
Total warranty cost to be incurred = 6 faulty machines * $100/ machine
Estimated warranty cost this year = $600
- Useful life of Assets:
Within a business, there are several capital assets. These can be the plants at a factory site, the machinery used for product assembling, the delivery vans, or any other equipment. Capital assets are distinguished from other assets based on their prolonged usage (more than once), their useful life, and their ability to generate revenue for a business.
For instance, when a business buys a manufacturing plant, it estimates how long should that plant work or how many units is it likely to produce. Based upon this estimate, such machinery is depreciated and charged to expense regularly. Here is how this works.
TTL Inc. is a company engaged in the spinning of cotton and textile manufacturing. For the cotton spinning purpose, it recently bought a new spinning machine for $1000. Based on the supplier’s claim, past practice, machine efficiency, and users’ reviews, it is estimated that this machine should work for 10 years. After 10 years, this machine would be no more of use and would have to be replaced with a new one.
Based on the accounting treatment for assets, the following depreciation should be charged every year for the next 10 years,
Depreciation Expense = $1000 / 10 years of life
Depreciation expense each year = $100
This estimate can certainly prove right or wrong. The machine may erode after 8 years only or it may make out for 12 years. Either of the situation is possible, however, based on the estimated useful life of the machine, the business can expense out the machine over 10 years reasonably.
- Bad Debts:
At times, most of the transactions of a business are on credit, which means the goods or services are provided to the customers and the payment is either received later or on installments. This is called as making sales on debt, where the customer owes payment to the business and is the debtor of the business.
Customers may not pay the outstanding payments for different reasons such as a financial crunch, bankruptcy, forgetfulness etc. In either case when the payment against the supplied goods or services is due, then there is a risk of nonpayment or a bad debt.
Accounting standards suggest estimating the amount of these future bad debts and recording them in advance. Bad debts are therefore recorded based on estimation. Let us understand this through the following example:
FRB Ltd. is a furniture-making company. It produces preliminary home furniture and often allows credit to its customers. This year up till now, it has achieved sales of $6500, out of which $500 is still due from customers. Here are the details of these sales,
- Chairs worth $80 sold to Mr. A.
- Tables worth $220 sold to Mr. B.
- Bed set worth $200 sold to Mr. C.
Based on their records and information gathered, the following are the observations made by the sales team of FRB Ltd.
- Mr. A has moved to another city and the debts from him are no more recoverable.
- Mr. B is facing some financial crisis and there is no probability of debt recovery from him.
- Mr. C has disputed his invoice and only a 50% recovery is expected from him.
Here is how the bad debt expense is estimated.
Debts Recoverable from Mr. A = $80 * 0% recovery chances = $0
Debts Recoverable from Mr. B = $220 * 0% probability = $0
Debts Recoverable from Mr. C = $200 * 50% Recovery possibility = $100
Total Recoverable Debts = $100
Total estimated bad debts = $500 – $100 = $400
There is an absolute possibility of the actual results being different from these estimates; Mr. A may transfer the funds from overseas. Or Mr. C may pay less than or more than 50% of his outstanding debts. However, bad debt estimates are a rough approximation of the results that may appear later sometime, and there exists no precise measurement of them in the present.
Common Methods used to make estimates:
Estimation is a purely subjective matter. It may vary from person to person and within different situations. Each situation may suggest which method should be used to make the relevant estimates and this method may vary with the circumstances. Below are the most commonly used methods for making estimates under different situations:
- High Probability Method:
Under this method, the probability of different available options is determined. An entity considers the most likely option from the range of possible alternatives. This method is the most suitable when presented with two (or only a few) options. Within accounting, this method is commonly used to estimate the consideration to be received from a contract or job, when it can vary. Here is an example to understand better
A construction company enters into a contract with a customer to build his office building for a fixed project price of $7000. Depending upon the construction of the building, the customer promises to pay a bonus of $1750, if he likes the construction and everything else?
Probability that the customer would like it = 70%
Probability that he wouldn’t like it = 30%
(these observations are based on the other contracts with this customer and overall business practices)
As this scenario has only two possible options, it is optimal to apply the high probability method to reach an estimate. The probability of customer’s likeness being high, we can anticipate winning the bonus amount of $1750.
- Expected Value Method:
Under this method, we consider a sum of the probabilities of all the possible alternatives. Alike the high probability method, this method has a massive application in the computation of variable consideration estimates. However, it is also used for other estimations. It is mostly used when presented with several similar possible alternatives or options.
A construction company is in contract with a customer for the construction of his office building for a fixed price of $8000. The terms of the contract are as follows,
If the company completes the construction of the desired building within two months, it will be entitled to a bonus payment of $1000. [Probability = 20%]
If the building is completed within three months, the company will be entitled to a bonus payment of $750. [Probability = 40%]
If the building is completed within four months, the company will be entitled to a bonus payment of $500. [Probability = 30%]
If it takes longer than four months to finalize the building construction, then the company would be entitled to no bonus payment. [Probability = 10%]
(Probabilities are based on the company’s past experiences with the completion span of such buildings and other relevant factors)
How much bonus can the company yield?
As the company is presented with multiple options, it is better to apply the expected value method.
$1000 Bonus * 20% probability = $200
$750 Bonus * 40% probability = $300
$500 Bonus * 30% probability = $150
$0 Bonus * 10% probability = $0
Total estimated bonus to be received = [$200 + $300 + $150 + $0] = $650
To revise the topic of estimates, here are some juicy points to keep in mind:
- Estimate refers to the anticipated value of something for which no precise measurement or value is readily available.
- An accounting estimate is the judgment or approximation of the amount that needs to be recorded against any transaction, or event which is to occur in the future.
- Accounting estimates are widely used in the determination of accounts receivable, bad debts, provisions, contingencies, liabilities, assets (useful life and depreciation), impairment, fair value of assets, etc.
- There can be various tools, methods, and techniques for reaching the right estimates. The two techniques commonly used in accounting are; the most likely amount method, or the expected value method.
- The most likely amount method captures the option with the highest probability to occur. It is the most preferable method when there are only two options.
- The expected value method takes the sum of all the possible options multiplied with their respective probabilities. It is preferable to be used when faced with multiple options or a wide range of possible alternatives.