Investors gain access to the internal financial structure and operations of a company by reviewing its financial statements. Companies prepare financial statements using a variety of accounting techniques. While there are standard accounting practices that all businesses follow, investors still need to know which data is based on an estimate to get the most complete picture of a company's fiscal health.
Accounting standards allow for the use of estimates in certain instances. Estimates are preferable to omissions, and allow companies to complete their accounting processes in a timely fashion. Groups such as the Financial Accounting Standards Board (FASB), which prepares the definitions and standard practices that businesses follow, note where and how estimates should appear in financial statements. Companies are responsible for disclosing their accounting estimate methods so that investors can compare financial statements on a level playing field.
When to Estimate
In general, estimates are acceptable only when actual data is not available. In some cases this is because the data is not yet collected or calculated. In others, estimating is necessary because the item being accounted for doesn't have a clear value. For example, one of a company's major assets is its portfolio of patents. However, because there is no market price for patents, accountants must estimate their value to list them as assets on a corporate balance sheet.
Companies use accounting estimates for internal procedures and documents. This is the case with budgeting, which relies on a series of cost estimates and demand projections to determine how a company plans to spend its money, and how much income it expects to make. Static budgets represent these estimated plans, while flexible budgets are the final versions that incorporate any changes along the way. Budget variance refers to the difference between these accounting estimates and actual figures. Analyzing variance helps a business make more accurate estimates.
In some cases, estimated accounting is significantly different from actual financial results. In these cases accountants can return to past financial statements and insert the actual data. While it may be to late for investors to change their decisions, this provides a more accurate historical accounting record. For example, if a company sells patents for much more than an accountant estimated their value to be, the corrected financial statement will show greater assets and increased owners' equity. Moving forward, income from the parents can go into new financial statements as an actual number, replacing the estimate.
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