Definition: An estimate, as it relates to the creation of financial statements, is a calculation of a financial transaction for which no exact value is determinable, and is based upon judgment, historical understanding, and experience.
What Does Estimate Mean?
What is the definition of estimate? Accountants use estimates when it’s not possible to calculate an exact figure supporting a financial transaction, but it is known that a future transaction will occur and it’s reasonably estimated. Typically, accountants will apply a consistent methodology between the different account periods. This methodology may rely on estimates for the basis of the financial statement transaction.
When and how do accountants use estimates? The use of estimates may be required for a vast number of reasons. Typically, they are ultimately required when information to support an exact figure is not available, or the issue generating the transaction is not complete, and therefore may be pending at the time of a financial statement close.
Accountants will use all information available, including historical trends, past experience, and judgment to estimate the true value of a financial transaction. Depending on the value of the transaction and its impact on the financial statements taken as a whole, additional disclosures may be required.
Disclosures outline how the estimate was derived and the risks associated with the true transaction value differing from the estimate. In some instances, subsequent differences between the actual amount of the financial transaction, and the estimate, may require subsequent adjustment to the financial statements.
There are many different types of accounting estimates and each typically requires a specific treatment. Let’s take a look at an example.
Example
Let’s say you’re an accountant, working for a company who has an ongoing lawsuit. It’s time for you to complete your year-end close procedures and make all necessary entries to ensure your financial statements are accurately presented to the best of your knowledge. Given that the lawsuit is still in process at year-end, you discuss the situation with the lawyers and management of the company to gain an understanding of the potential that the company could lose the lawsuit. While the outcome of the lawsuit is impossible to determine, the potential amount to be paid to the plaintiff is reasonably valued at $500,000, based on input from various members of the company associated with the case.
That said, the estimate of $500,000 would be the most conservative value to use when determining the impact of the transaction on the financial statements. In this case, as the accountant you may suggest that an accrual entry is booked to recognize the $500,000 expense during the year in which the case was initiated. Additional disclosures describing the lawsuit as well as how the $500,000 estimate was derived would also be included in the footnotes to the financial statement.
Summary Definition
Define Estimate: An accounting estimate is the application of judgment, historical experience, and any other pertinent information that may apply to the determination of the value of a financial transaction for which no exact amount is attainable.
