Accounting is often regarded as a ‘black and white’ profession with right or wrong answers. This isn’t the case because accounting standards require accountants to make judgements and estimates when accounting for a variety of scenarios.
Here are two examples of estimates or judgements to illustrate why uncertainty is prevalent in the accounting of many businesses: doubtful debts and depreciation.
Accounting for doubtful debts
IFRS 15 Revenue states that businesses should record receivables representing amounts owed from customers. Most business-to-business (B2B) companies will give their customers a credit period of between 15 and 60 days to produce the cash to settle outstanding invoices. Therefore, trade receivables of this nature is often a significant balance at the period-end.
IFRS 15 goes on to require businesses to measure the value of receivables after a reduction for any expected credit losses. This rule requires the accounting team to make predictions about an unknown piece of information – how many trade receivables will not be fully paid?
Some accountants may be pessimistic, some may be optimistic. It is easy to recognize that even with a set of clear historical data, there will be a range of sensible numbers for the accountant to pick from when setting the value of their expected credit loss provision.
Accounting for depreciation
Fixed assets, also known as tangible fixed assets or non-current assets, are long term and often used productively by a business for 3 years or more.
IAS 16 Property, Plant & Equipment expects companies to estimate the useful economic life of a non-current asset. A depreciation charge recorded in the income statement will be calculated to gradually take the full cost of the asset through the income statement over this period.
Companies adopt simple rules of thumb for such assets, for example, Domino’s Pizza Group PLC (The UK operation of Domino’s Pizza group) applies the following broad policy when depreciating assets:
- Freehold buildings – 50 years
- Fixtures and fittings – 3 to 10 years
- Store equipment – over 5 years
[Source: Domino’s Pizza Group PLC Group of companies’ accounts made up to 27 December 2020 accessible here].
You’ll notice that this policy does not apply a rigid depreciation timescale to each asset category; it gives a range.
In this example, the senior finance team approved this official accounting policy, which contained these outline estimates, but individual accountants will need to apply their own judgement to apply these rules to each asset purchased by the organization.
Definitions and meanings
The definition of an accounting estimate is set out in the International Financial Reporting Standards, known as IFRS. This definition will be applied by the largest companies worldwide, including most publicly listed businesses whose shares trade on the world’s stock exchanges.
The accounting standard which covers accounting estimates – IAS 8 Accounting Policies, Changes to Accounting Estimates and Errors – was updated recently by the International Auditing Standards Board (the IASB), which is the group that own and revise the IFRS. On 12 February 2021 they issued a new version.
However, rather incredibly, this authoritative document does not officially set out a definition of the term ‘accounting estimate’. Therefore, the meaning of this phrase has been derived by the technical accounting teams within the leading global accountancy practices and enshrined within their own business books for practitioners. This has made the definition common knowledge, without it being dictated in an authoritative central text.
From these sources, we can understand that an accounting estimate is where an accounting value is exposed to significant estimation uncertainty. That is, the outcome of an event is uncertain. Practically, this allows us to highlight the following indicators that suggest a figure is an accounting estimate:
- It is calculated using at least one variable which is not readily known
- It necessitates a review of a historical ‘look-back period’ to inform the current measurement
- The figure, despite being calculated with the best knowledge available at the time, could eventually be proven wrong by future circumstances.
An accounting judgement is also not strictly defined by IAS 8. A judgement is best described as a binary ‘decision’ taken at an accounting measurement or recognition crossroads.
Judgements, like estimates, are made with the best information available to management at the time. However, they typically have fewer possible answers than an estimate.
Examples of judgements include:
- Whether an asset should be reported under one category heading or another, e.g., “Is this a current or non-current asset?”
- Whether impairment indicators exist that suggest an investment should be recorded at a lower value.
- Whether a liability should be classified as contingent or not
Difference between accounting estimates and accounting judgements
Three key points of difference between an accounting estimate and an accounting judgement are as follows:
1. Range versus a binary decision
An accounting estimate tends to have a range of possible answers, whereas a judgement will lead to a ‘yes/no’ or a limited number of options.
The recoverable value of a $3,000 receivable is an estimate, and its proposed answer will sit on a spectrum of possible dollar values.
In contrast, the decision to recognize the receivable within ‘financial instruments’ rather than ‘trade receivables on the balance sheet, following analysis of its underlying nature, only has two possible outcomes:
- to report it within the financial instruments caption
- to recognize it within the trade receivables caption
Therefore we can work backwards from the number of possible answers to help determine whether a dilemma concerns an estimate or a judgement.
2. Governance versus discretion
Accounting judgements are easier to consider ahead of time and enshrine the decision-making principles within a written accounting policy. A clear accounting policy document will enable an accounting team to reach a consistent judgement each time a consistent set of facts present itself.
Due to the infinite variability in the correct answer for an estimate, it is more difficult to cover off all eventualities in a formal written accounting policy document.
3. Restatement of financial statements
If an accounting policy is changed to instruct accountants to reach a different conclusion with the same set of inputs, this is a change of accounting policy under IAS 8 which will carry financial reporting implications.
Where a change in an accounting policy would have led to a materially different financial result reported in a prior period (had the new policy been applied at the time), then the business must retrospectively restate the results of the comparative period within the latest financial statements.
However, where an accountant merely becomes more pessimistic on the appropriate accounting estimate for an item following a change in circumstances, this does not warrant a restatement.
As stated above, there is no official definition of accounting estimate or accounting judgement within published materials of the IASB, which is the ultimate global accounting standard setter. However, through established practice and in-house technical specialists, we are able to provide a widely accepted definition of estimate and judgement.
Estimates usually involve a subjective measurement and a range of reasonable outcomes. Judgements involve a ‘yes or no’ decision which can be supported by the weight of factors that support one discrete answer over the next.
However, hold in mind that the undefined nature of this term means that it is possible that some accountants hold a different view than others regarding this definition, dependent on the internal advice of their own technical researchers. Therefore, accountants should exercise some caution when providing a precise definition to their own clients and always caveat this uncertainty.