Art Franczek
The accounting process requires many estimates to be made for ongoing and recurring business activities. In determining the number of years over which to depreciate a fixed asset, the accountant, working with expert engineers estimates how long that asset can be used for productive purposes in a company. Estimates are used in almost every aspect of accounting because actual concrete numbers are often not available at the financial statement date. These estimates require the use of reliable informed judgment. In determining the Bad Debt provisions of a company, management makes an estimate of it’s uncollectable accounts based upon the company’s past experience, likewise when a provision for Warranty Expense is booked, past experience is closely reviewed. There are many examples throughout IAS that require the use of estimates. It must be noted that independent auditors strictly review these estimates compiled by management and if these estimates are not reasonable the auditors will seek changes to the financial statements.
International Accounting Standards involve the extensive use of estimates in their accounting requirements and these IAS’s describe many procedures as to how those estimates should be made. The recently issued (1998) IAS 37 deals with the accounting for Contingent Assets and Liabilities. A Contingent Liability is defined as a possible obligation that arises from past events and whose existence will be confirmed by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise. In other words, a company can incur a liability if some future event takes place. IAS 37 sets out the criteria as to when a liability should be accrued on the company’s financial statements. These criteria are as follows:
1) If a contingency is probable and the amount reliably estimated an amount should be accrued in the financial statements.
2) If a contingency is merely possible and capable of being estimated then it only needs to be disclosed in the notes to the financial statements.
3) If the contingency is considered to be remote then neither accrual nor disclosure is required.
It is important to note that these criteria (i.e. probable, possible and remote) are judgments that are made by management and their expert consultants (eg. attorneys and engineers. The amount that may be accrued is an estimate. A good example of this situation would be when a company is sued for $1,000,000 during the year 2000. If in the judgment of their attorneys it is a remote likelihood that the company will lose the lawsuit, then no disclosure or adjustment is required. If the attorneys determine that it is possible that company may lose this lawsuit and estimate that $500,000 may have to be paid then this only needs to be disclosed in the company’s financial statements. If the attorneys determine that it is probable that the company will lose and the estimated amount is $700,000, then the company is required to accrue an expense of $700,000 for this lawsuit in it’s 2000 financial statements. As we can see the judgment of management and its experts is involved in every variant of this case and can be changed if outside auditors disagree with management they can change the assumptions that were made. If a gain contingency (i.e. if the company might receive $1,000,000 as a result of a lawsuit) then the gain should not be recognized until the lawsuit is settled.
International Accounting Standard # 10 deals with Events after the balance sheet date and defines those events as events, both favorable and unfavorable, that occur between the balance sheet date and the date when the financial statements are authorized for issue, these events can either require an adjustment, or merely required an additional disclosure. Some examples of events that require adjustment might be a settlement of a lawsuit that was merely disclosed in the financial statements. Refer to the example that was given in the analysis of IAS #37, if the $500,000 that was only disclosed in the notes to the financial statements in 2000 was settled for $500,000 in February of 2001 (before the financial statements were issued) then an adjustment of $500,000 (additional expense) would be required. Other examples of the application of IAS #10 would be if a major customer declared bankruptcy and this required the writing off of a large receivable. IAS #10 also addresses the issue of whether or not a company’s financial position has deteriorated sufficiently between the balance sheet date and the financial statement date as to question if company was viable as a Going Concern.
IAS #19 and IAS #26 deal with the accounting for Employee Benefits and Retirement Benefit Plans. In both cases significant use of estimates is required particularly with the estimates regarding the life expectancy of It’s employees employing actuarial methods of estimation. IAS #19 deals with five categories of employee benefits a) short-term i.e. wages, sick-pay, vacation-pay and other benefits b) post-employment benefits such as pensions, c) long-term benefits such as long-term disability and deferred compensation, d) termination benefits and e) equity compensation benefits. IAS #19 makes an important distinction between defined contribution plans and defined benefit plans. Defined Contribution Plans are retirement benefit plans under which amounts to be paid as retirement benefits are determined by the contributions to a fund together with accumulated investment earnings thereon. Under a Defined Benefit Pension Plan, amounts paid are determinable, usually by reference to employees’ earnings and/or years of service. It is under the defined benefit plan that various actuarial methods are applied to determine the amounts paid to its’ beneficiaries. IAS #26 complements IAS #19 in that it applies to the rules on accounting for Defined Benefit and Defined Contribution plans.
Another International Accounting Standard that makes significant use of estimates is IAS #11 on Construction Contracts. The purpose of this IAS is to provide guidance with regard to the recognition of revenue on Construction Contracts (i.e. contracts that apply to the construction items such as a building or a ship and extend beyond a one year period). Two methods of revenue recognition are allowed, Completed Contract and Percentage of Completion. Under the Completed Contract method no revenue is recognized until the contract is completed. Percentage of completion uses estimates at each stage of completion to determine how much revenue should be recognized in a given accounting period. A ratio of the costs incurred during a given period over the total costs is multiplied by the total revenue on the contract to arrive at the income recognized for a particular period.
International Accounting Standard #34 on Interim Financial Reporting is intended to provide guidance for companies which provide financial statements on an interim (i.e. quarterly) basis. Because much of the financial data in these financial statements is not final, estimates are used for many of the numbers provided. Inventories are estimated by using methods such as the gross profit method which applies an annual average of gross profit from the prior year and applies it to the current quarter’s inventory to arrive at an estimated cost of goods sold and gross profit. Other expenses such as taxes, advertising and repairs and maintenance are prorated to the particular quarter based on an annualized estimate. It is important to note that in cases where actual numbers for the period are available that they are preferable to estimates because they reflect the normal trends of an enterprise.
IAS 8, Net Profit of Loss for the period, Fundamental Errors and Changes in Accounting Policies provides guidance on how companies should account for Errors, Changes in Accounting Policies and Changes in Accounting Estimates from one period to the next. The IAS principles of Comparability and Consistency are quite important in applying this IAS because if there are changes in Accounting Policy, for example, (i.e. Inventory methods such as LIFO and FIFO), the Retained Earnings must be adjusted to reflect the cumulative effect of this change so that the Financial Statements are comparable from one period to the next. Changes in Estimates (i.e. estimates of Bad Debts) should require an adjustment to prior year’s financial statements.
These particular IASs involve many different applications of estimates. Other Standards also include the use of estimates but perhaps to a lesser degree. The use of estimates in accounting is a widespread practice and in order to insure the transparency of Financial Statements much guidance is provided to maintain the reliability and reasonableness of these estimates.
Art Franczek is an Associate Dean/Professor of Accounting/Taxation, American Institute of Business and Economics in Moscow. He can be contacted by phone/fax