Not every financial statement item is able to be precisely measured. Often, your company will have to make a best-educated guess to account for items that are not able to be specifically determined. This is where accounting for estimates comes into play.
Auditing standards define an accounting estimate as “an approximation of a monetary amount in the absence of a precise means of measurement”. Your company may have several financial statement items that do not have explicit, known values associated with them. Examples of financial statement areas where estimates may be needed are:
- Allowance for doubtful accounts
- Reserves for inventory obsolescence
- Depreciable asset lives
- Potential impairment of investments or other assets
- Warranty obligations
- Long-term contracts
- Litigation settlements and/or judgments
Our goal as auditors is to obtain sufficient, appropriate audit evidence to determine whether the estimates being put forth by you are reasonable and adequate. Depending on your industry, the size of the estimate, and the nature of the account containing the estimate, the level of risk of material misstatement of an accounting estimate will vary.
It is important for your company when determining estimates that impact the financial statements to be extremely thorough. The goal is to avoid possible issues in the future if there are significant differences from actual results. It is a best practice to establish a method overall company-wide estimates and implement effective internal controls to be consistent with your accounting practices. The use of specialists may be necessary. And while estimates may result in a singular number, if uncertainty arises regarding the reliability of the estimate put forth, a range of numbers may also be applied.
Any disclosure in the financial statements or financial statement line items that include accounting estimates need to be in accordance with GAAP. Estimates are one area of accounting where creativity can be applied but within reason. Diligence is needed by both your company and us, as auditors, to make sure the estimates used in your financial statements are adequate.