The accounting world may seem filled with hard facts. Either the money is in the account, will be in the account, or it isn’t … right? Well, that’s not always the case.
There are some situations when it’s difficult to know exactly how much money you need to account for. For example, accounting for the depreciation of vehicles. Because you can’t write off the cost of the vehicle when you incur the expense, you have to keep track of it over time. This makes it hard to tell exactly how vehicles will depreciate, so you have to do the next best thing: make an accounting estimate. Read on to learn more about types of accounting estimates.
What is an accounting estimate?
So, what is the definition of accounting estimates? The truth is that accounting estimates aren’t exact. They are good faith estimates you put in your company’s financial statements when:
- The exact numbers aren’t available just yet
- You can’t gather past data on a timely, cost-effective basis
Again, you can use an accounting estimate to account for the depreciation of equipment, but that’s not the only reason to use an estimate. You may also want to account for possible future liabilities, like the judgment of a lawsuit.
Types of accounting estimates
There are several types of accounting estimates out there that can help your business run smoothly. Here is a list of some accounting estimates you should know about:
- Uncollectible receivables
- Ending inventory
- Depreciation expense
- Goodwill
- Contingent liabilities
- Warranty expense
- Projected benefit obligation
Uncollectible receivables
If your company sells goods or services on credit, you should familiarize yourself with how to estimate uncollectible receivables. Why? Because some customers may not pay off their debt, and you still have to balance your books.
With the accrual method of accounting, you report revenue from sales or services on the income statement and report related accounts receivable on the balance sheet until customers pay off their invoices. If customers don’t pay their bills, you need to account for those uncollectible receivables.
If customers don’t pay their bills, you must:
- Report the estimated uncollectible accounts (e.g., bad debts or doubtful accounts) on your income statement
- Report the estimated amount of the accounts receivable to be collected in the contra asset account (allowance for doubtful accounts)
How to estimate uncollectible receivables
To estimate uncollectible receivables, prepare an aging of accounts receivable. The aging of accounts receivable gives an account of every balance sorted by the number of days an invoice is past due. The longer a bill goes unpaid, the more likely it is that the bill becomes uncollectible. You must make an estimation of uncollectible receivables by looking at your aging of accounts and the number of days an invoice is past due.
You can estimate uncollectible receivables by dollar amount or by percentage.
Dollar amount
To use the dollar amount to estimate your uncollectible receivables, look at your aging of accounts and the bills that are long overdue (e.g., those that are unlikely to be paid in full). Credit the account Allowance for Doubtful Accounts with the estimated amount that is uncollectible. For example, if your company’s accounts receivable is $50,000 and you estimate that your uncollectible receivables total $5,000, credit $5,000 to the account Allowance for Doubtful Accounts. Then, debit your Doubtful Accounts Expense account $5,000.
Percentage
To use a percentage to estimate your uncollectible receivables, find the average uncollectible receivables for your company or industry.
If you find that .15% of your sales are uncollectible, you can use this percentage to debit Doubtful Accounts Expense and credit Allowance for Doubtful Accounts. For example, if your company has $90,000 in credit sales for the month, record an entry to debit in Doubtful Accounts Expense for $135 ($90,000 x 0.0015) and credit $135 to Allowance for Doubtful Accounts. Remember that the percentage of uncollectible receivables isn’t set in stone and changes over time. Come back to your aging of accounts receivable to adjust the percentage as needed.
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Ending inventory
Inventory changes over time. But despite your best efforts, you may not be able to count the inventory on hand at the end of an accounting period. This can happen if your:
- Staff is too busy to conduct a physical count
- Shipping activity spikes at the end of the month, making it impossible to do a physical count
- Counting process takes up too much time and/or labor
There are two different ways to estimate your inventory:
- Gross profit method
- Retail inventory method
How to use the gross profit method to estimate ending inventory
The gross profit method estimates your inventory by comparing your company’s historical gross profit percentage to the current data about net sales and cost of goods available for sales.
Follow these steps to estimate your ending inventory with the gross profit method:
- To find the estimated value of your ending inventory, you first need to know the gross profit margin from the previous year. To find your gross profit margin, subtract your cost of goods sold (COGS) from net sales.
Net Sales – COGS = Gross Profit Margin Ratio
- Next, find your estimated gross profit for the period by multiplying your net sales by your gross profit margin.
Net Sales x Gross Profit Margin = Estimated Gross Profit
- Subtract the estimated gross profit from net sales to find the estimated cost of goods sold.
Estimated Gross Profit – Net Sales = Estimated Cost of Goods Sold
- Finally, subtract the estimated cost of goods sold from the cost of goods available for sale to find the estimated value of your ending inventory.
Estimated Cost of Goods Sold – Cost of Goods Available for Sale = Estimated Value of Ending Inventory
How to use the retail inventory method to estimate ending inventory
The retail inventory method can be useful for retail businesses that need to track the cost and retail sales price of their inventory. Here’s how you can estimate your ending inventory with the retail inventory method:
- Subtract net sales from the retail value of goods available for sale to find the retail value of your ending inventory.
Net Sales – Retail Value of Goods Available for Sale = Retail Value of Ending Inventory
- Find your cost-to-retail ratio by dividing the cost of goods available for sale by the retail value of goods available for sale.
Cost of Goods Available for Sale = Cost-to-retail Ratio
Retail Value of Goods Available for Sale
- Then, you can find the estimated cost of ending inventory by multiplying the retail value of ending inventory by the cost-to-retail ratio.
Retail Value of Ending Inventory x Cost-to-retail Ratio =
Estimated Cost of Ending Inventory
Be careful with trying to estimate your ending inventory for multiple products. The retail inventory method depends on the cost-to-retail ratio, which can vary from product to product. The estimates change as the ratio changes.
Depreciation expense
Chances are you need equipment and vehicles to run your company. However, these things depreciate over time. Once you buy them and put them to work, they start to lose their value. You can offset an asset’s loss in value with its cost by depreciating the expense. When you depreciate an expense, it helps lower your overall taxable income.
How to estimate the depreciation assets
You can estimate the depreciation of vehicles or equipment using multiple methods. Usually, businesses use the straight line depreciation method as required by financial reporting. To use this method, deduct the same amount of depreciation every year for the useful life of the equipment.
Taxation laws may require you to use the modified accelerated cost recovery system (MACRS). MACRS lets you deduct more at the beginning of an asset’s life and less later on. To use MACRS to estimate depreciation, deduct a higher percentage of the asset’s total cost during the first few years you own it. Later, your deductions will become smaller as you approach the end of the asset’s useful life.
See IRS Publication 946 for more information.
Goodwill
If you are looking to sell your company or merge with another company, you need to know about a goodwill estimate. Goodwill is an intangible asset that can increase the price of a company to exceed the fair market value of its net assets.
So, what does a company’s goodwill include? Here are some of the things that make up a company’s goodwill:
- Positive reputation
- Loyal customer base
- Brand recognition
- Skilled workforce
- Proprietary technology
Since it’s hard to say exactly how much a company’s goodwill is worth, you have to make a goodwill estimate. Private companies can choose to amortize their goodwill over a period of 10 years.
How to calculate goodwill estimates
Follow these steps to estimate the goodwill of your company during an acquisition or a merger:
- Look at your most recent financial statement to find the value of your company’s assets, including current, non-current, fixed, and intangible assets.
- Determine the fair market value of the assets. If you use an accountant, you can ask them for help finding FMV.
- To find the adjustments, subtract the FMV and the book value of each asset.
FMV of Asset – Book Value of Asset = Fair Market Value Adjustment
- Find the excess purchase price by subtracting the purchase price paid to acquire your company from the net book value of your company’s assets.
Purchase Price Paid for Acquisition – Net Book Value = Excess Purchase Price
- Finally, to find your goodwill estimate, subtract the excess purchase price from the FMV adjustment.
Excess Purchase Price – Fair Market Value Adjustment = Goodwill Estimate
Contingent liabilities
Contingent liabilities depend on the outcome of uncertain events, like a pending lawsuit. It’s possible, but not a given, that contingent liabilities will become actual expenses in the future. The generally accepted accounting principles (GAAP) outline three specific categories of contingent liabilities:
- Probable (e.g., likely to occur and reasonably estimated)
- Possible (e.g., neither probable nor remote)
- Remote (e.g., neither likely to occur nor reasonably possible)
You don’t have to record all of these contingencies in your financial statements. In fact, the only contingent liability you should record are probable contingencies. Put possible contingencies in the notes of your financial statements. And don’t include remote contingencies.
How to estimate contingent liabilities
To report a probable contingent liability in your financial statement, two things must be true:
- It is possible to estimate the value of the contingent liability.
- The probable contingent liability has more than a 50% chance of becoming a liability. You should consider a contingent liability with less than a 50% chance of happening as possible. Do not reflect possible contingent liabilities in your balance sheet.
To record a contingent liability credit your Accrued Liability account and debit your Expense account. Contingent liabilities aren’t always contingent. Some contingent liabilities will become actual liabilities some point in the future. When this happens, debit the Liability account on your balance sheet and credit your Cash account, and make the appropriate entry in the associated expense of the income statement.
Warranty expense
You should know about warranty estimates if your company sells products covered by warranty. A warranty is a business contract between you and the customer guaranteeing you’ll repair, replace, or refund a product if it doesn’t meet certain standards.
The Financial Accounting Standards Board (FASB) states that you should recognize warranty expenses when they are both probable and can be estimated.
How to estimate warranty expenses
To record warranty expenses in your financial statements, debit the Warranty Expense account and credit the Liability account when you sell the product. If the product is defective and needs to be repaired or refunded, that new cost reduces the Liability account. If you need to replace the product, reduce both the Liability and the Inventory account since the product is going to come out of your inventory.
Warranty expenses impact your income statement whenever a sale occurs, even if no warranty claims occur for the period. If the warranty expense is probable and you can estimate the amount of the expense, recognize it in the same period as the revenue of the sold products. Whenever a claim appears in future accounting periods, the costs will reduce the warranty liability account.
To find the estimated warranty expense, you’ll need to know the:
- Number of units sold during an accounting period
- Estimated percentage of sold products that will probably need repair, replacement, or a refund
- Average cost of repairing or replacing products covered by warranty
Finding the warranty expense estimate is easy:
- Estimate the number of sold product units that may be defective. To do this, multiply the total number of units sold by the estimated percentage of defective units.
Total Number of Units Sold x Estimated Percentage of Defective Units =
Product Units That May Need Repairs or Replacement
- To find the estimated warranty expense multiply the product units that may need repairs or replacement by the cost of repairing or replacing a product unit.
Product Units That May Need Repairs or Replacement x Cost Per Unit to Repair or replace =
Estimated Warranty Expense
Projected benefit obligation
The projected benefit obligation (PBO) is the present value of an employee’s pension. Knowing your company’s PBO is key to understanding future pension obligations. Without it, you may not have the money to pay for employee pensions.
How to estimate your projected benefit obligation
Follow these steps to know the PBO of your company:
- Take a look at your company’s balance sheet and find the funded status of your pension plan. This could be a non-current asset, a current liability, a non-current liability, or all three, depending on the plan.
- Find the current fair market value of the pension plan’s assets. To do this, add together the beginning balance of the fair market value of the plan’s assets, any contributions paid into the pension plan, and the return on the plan’s assets. Once you’ve done this, subtract the benefits paid out for the year.
Beginning Balance of the Fair Market Value of the Plan’s Assets + Contributions Paid Into the Pension + Return on the Plan’s Assets – Benefits Paid During the Year = Current Fair Market Value of the Pension Plan’s Assets
- Once you have the current fair market value of the plan’s assets, you can find the PBO. To do this, subtract the plan’s funded status from the fair market value of the plan’s assets.
Plan’s Funded Status – Current Fair Market Value of the Pension Plan’s Assets = PBO
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