What Are Accounting Estimates and Why Are They Important?

This is part I of 3 in a series on “The risks associated with accounting estimates”.

In an ideal world, accounting for business transactions would be straightforward with prescribed instructions for how each should be recorded. Significant accounting principles and standards have been issued under, for example, the US Generally Accepted Accounting Principles (US GAAP) and International Financial Reporting Standards (IFRS).  

However, considerable judgement is still required within the accounting profession. There is uncertainty in numerous areas, requiring evaluation, assessment and judgement to estimate their impact. For example:

• Will all my customers pay the invoices I have issued?
• Will my asset generate the returns that I projected, or could it be impaired?
• What percentage of customers will submit a warranty claim, and how much will repairs cost?
• Will my original cost estimates for a construction project be accurate at the time of completion, and will they exceed the contract value?
• When will future cash flows be generated from a new business venture?

For an overview of what lawyers need to know about accounting judgments, watch our 45-minute webinar here.

A key focus area for global enforcement agencies

"Judgements and estimates are subjective. Different people may draw different conclusions from similar facts."

This could be for a myriad of reasons including knowledge, experience, bias and risk appetite.  Accordingly, accounting estimates are often called into question by enforcement agencies and regulators – often with the benefit of hindsight, but also with the knowledge that accounting estimates provide the opportunity for fraudulent conduct.  

Each year, the US Securities and Exchange Commission (SEC) brings a number of actions against corporations and individuals for incorrect application of accounting estimates, some tantamount to fraud. (See Part III of this series for examples of recent cases.)

Distinguishing between accounting policies and estimates

AS 2501: Auditing Accounting Estimate, Including Fair Value Measurements defines an accounting estimate as “a measurement or recognition in the financial statements of (or a decision to not recognize) an account, disclosure, transaction, or event that generally involves subjective assumptions and measurement uncertainty.” ¹

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors clarified the relationship between accounting policies and accounting estimates by specifying that a company develops an accounting estimate to achieve the objective set out by an accounting policy. Developing an accounting estimate includes both:

• selecting a measurement technique (estimation or valuation technique); and
• choosing the inputs to be used when applying the chosen measurement technique.

Change in accounting principle vs accounting estimate

Companies have in the past found themselves under regulator scrutiny when accounting treatment appears to have been altered. Questions are asked around whether there has been a change in accounting principle, a change in estimate, or the correction of an error. Such questions can be difficult to answer and require judgment.

The distinction between a change in accounting principle and a change in accounting estimate is important. A change in accounting principle is generally applied retrospectively (by amending prior period accounting records), while a change in accounting estimate is applied prospectively, affecting only current and future periods.  

Companies traditionally don’t want to amend previously issued financial statements to avoid enhanced scrutiny or perceptions that prior accounts were inaccurate, even if this is not the case.  Accordingly, companies may elect to inappropriately present changes in accounting as a change in estimate as compared to a change in principle.

Change in estimate vs accounting error

Distinguishing a change in accounting estimate from the correction of an error is also important and can be challenging. While a change in accounting estimate results from new information that has developed since a prior reporting date, an accounting error reflects the misapplication of information that was available/known, or should have been known, at the prior date.  

Accounting Standards Codification (ASC) 250-10-20 states that a change in accounting estimate results from incorporating new information or modifying the estimating techniques affecting the carrying amount of assets or liabilities as of the date the change is made.  

On the other hand, ASC 250-10-20 includes as an example of an accounting error in previously issued financial statements, the oversight or misuse of facts that existed at the time the financial statements were issued. While the misuse of preexisting facts can constitute an error, if done with intent, it would represent fraud and open the corporation and individual(s) to enforcement.

The implications for companies

Reporting entities should consider the following questions to help differentiate between a change in accounting principle, a change in estimate, or the correction of an error:

• What was the rationale for the accounting change?
• Did the estimation model change, or just the inputs?
• Why did the inputs to the estimation model change and when was the change in inputs supportable?
• Is the reporting entity applying the accounting principle to a new business, new balances, or new transactions, or is the accounting principle applicable to balances and transaction streams to which it should have been applied in the past?
• If the accounting results have changed significantly, can the changes be substantiated by developments in the business?

Companies need to thoroughly document their analysis surrounding accounting estimates and judgements, including answering the questions posed above. Accounting estimates, like other estimates, are made based on imperfect information and are therefore likely to be incorrect. When materially incorrect, the company’s judgement and those responsible for it will be called into question, including whether or not there is evidence of an intent to deceive.  Only a thorough documentation of what was known at the time – not just within the accounting department but the business as a whole – will support a defence that the accounts were prepared in good faith.  Hindsight is a powerful tool for those doing the questioning. To successfully defend your company, be prepared to respond with complete, clear and contemporaneous documentation.

[1] The International Accounting Standards Board had previously not defined the term accounting estimates and issued amendments to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors to clarify how companies should distinguish changes in accounting policies from changes in accounting estimates.

Read the full series  

• Part 2 of 3: The increased complexity of accounting estimates in today’s economic environment ‍
• Part 3 of 3: Recent enforcement actions stemming from accounting estimates