Accounting always seems to be an exact science. There is a certain way to record transactions and there is no other way to do it, right? Not necessarily. While we often do know exact numbers from transactions, such as an amount of a sale or the amount of an electric bill, there are other amounts that need to be estimated in order to record the entry in the correct period.

Why Do We Need Estimates?

There are two reasons why we need estimates. One of these reasons is because most businesses use the accrual method of accounting. This method of accounting requires you to record expenses when they are incurred and not actually paid. This means that you will accrue for certain expenses in this month, even though you may not actually know the amount of the expense until the next month.

Another reason you will need estimates is because there are often uncertainties about future liabilities that you have to account for now in order to keep your books faithful and representative of your actual financial position. For example, if you know that it is probable that you are going to owe money for a big lawsuit in the near future, your stakeholders should know about it. Just ignoring it would mean that you are probably overstating your financial position. You need to estimate the amount that you will be losing, since the amount is still uncertain, and record it accordingly.

Estimating Your Reserves

One of the most common types of estimates that companies will often record are reserves. Reserves are those accounts that are meant to be netted against certain asset accounts for issues that relate to their realization. In simple terms, you record an asset, but you may not be able to keep all of it on your books because the party may not pay you. 

An accounts receivable reserve is very common. This is an estimate that you would make to determine how much you should record to take into account receivables that you will not actually get paid for from your customers. They might not pay because they do not agree with your stated price, or they might not pay because they went bankrupt. Whatever the reason, you have to account for that. One of the most common ways to estimate this amount is to take a monthly average of amounts of receivables not realized in the past and then add any one off transactions from the current month. This will help you estimate the amount receivables that you will not get in the current month.

Another reserve is often for excess and obsolete inventory. This is inventory that you have at your warehouse or plant that you do not think you are going to sell. You have to reserve for this and record it to show your stakeholders that you are recording this amount as inventory, but it will probably not ever be sold or put into production. A way most companies estimate this is by figuring out the average life of their inventory and then aging all of their inventory. Any inventory that is over the average life is added to the reserve.

Estimating Accrued Liabilities

Another common type of estimate that companies make has to do with the accrual of expenses that you know you are going to have in the future, but you are not really sure how much they will be yet. These are called accrued liabilities.

A common type of accrued liability would be an electric bill. For some companies, electric bills can be as much as $100,000. This means that they could swing from month to month by a factor of $10,000 or more, meaning that a poor estimate could lead to your financials being off by quite a bit before you reverse the entry and record the correct amount when you get the actual bill. Most companies will have a formula for determining the amount of their electric. It will often focus on prior year actual expenses and maybe even expenses from prior months. Accountants will usually then make judgmental changes for certain weather factors as well.

Another type of accrual that is an estimate are taxes payable. Companies do not often know what their actual tax bill will be until they have an accountant perform the calculations and give them a number for their provision. Even then, last minute changes could arise or the IRS or taxing body could dispute the calculated amount. This is where tax accountants come in handy for determining the estimated amount of tax that will have to be paid at the end of the year. Quarterly estimate payments are also estimates of annual taxes that require some thought and calculation as well.

What is the Key to Making Accounting Estimates?

Accounting estimates are actually very difficult to make. Unless you are extremely well-versed in the process and have been making the same estimates for a number of years, there are often factors that go into these estimates that you will forget to consider. The key to having a good estimate that cannot be challenged is making sure that it is reasonable and rational. For example, if you know that your average electric bill is $500 and you estimate that it will be $5,000 next year, that is not very reasonable or rational.

You also have to make sure that you are using a logical method of calculating the estimate. Generally, companies will use prior year or prior month actuals to determine their estimates. If there is a known part of the estimate, then you should also add that in as well. For example, if you are calculating your AR reserve and you know that one of your customers is bankrupt, add in all of their receivables to your estimate, since you know that amount will be exact.

Accounting estimates are allowed in businesses. However, it is important that you develop a systematic and logical way of calculating them that will yield reasonable and rational amounts for the accounts you are estimating. That is the key to great accounting estimates.