Financial statements are historiography, based on facts and mostly hindsight, right? In part it is, but that is certainly not true of all financial statements. There are elements in every financial statement that are based on your estimates and expectations. We call these the estimate items in the financial statements.
Estimate items
Estimation items can appear in various places in the financial statements. Examples include:
Valuation and useful life of goodwill;
- Provision for obsolete inventory;
- Income recognition of projects in progress;
- Bad debt provision;
- Major maintenance provision;
- Claims and disputes.
Primarily, you are responsible for preparing the financial statements, and therefore for making the best estimate of these estimation items. In what way the best estimate can be made depends on the degree and extent of estimation uncertainty.
Estimation uncertainty
For a number of estimation items, you can make a good estimate yourself relatively easily. This applies, for example, to the determination of the result of projects in progress and the provision for obsolete inventory. For the first item, knowledge of the progress of the project is decisive, for the second your knowledge of the sales market. Because of your years of experience and detailed knowledge of the production process and the market, you have a good idea of the variables involved. This allows you to make the best estimate.
With the bad debt provision, the situation is slightly different again. After all, how do you determine how likely it is that you will receive the receivable. You usually have limited insight into your buyer's current financial position. The information on the basis of which you have to make the estimate is therefore softer and results in greater estimation uncertainty.
This estimation uncertainty becomes even greater when there are incidental situations, with a reliance on a third party and where specific detailed knowledge is required. This applies, for example, to legal proceedings. Here the probability of success is important for the question of whether a provision should be included in the balance sheet and subsequently for what amount. For such estimates it may be necessary to engage external experts. In legal proceedings, this will often be the lawyer who assists you in these proceedings and who can help you make the best estimate.
Still historiography?
In a way, estimation items also involve historiography and looking back. A year from now, when the next financial statements are prepared, you can look back and see for yourself how the estimates made at the time turned out and whether they were indeed the best estimates. You can then use this knowledge to make the estimates for the next financial statements even better.