Management estimates play an important role in both annual reports and other financial statements, such as those submitted to banks or investors. These estimates can have a significant impact on a company’s financial performance and on whether its financial statements give a true and fair view of its financial position, financial performance and cash flows. Management is therefore responsible for both the reasonableness of its estimates and the accuracy of the financial statements.
Unlike financial figures that can be measured precisely, such as a bank account balance, management estimates are based on available information, selected assumptions and professional judgement. Management must make estimates to the best of its knowledge and ensure that they are as reasonable and realistic as possible.
The process used to arrive at an estimate must be verifiable, so that the underlying data, assumptions and calculation methods can be understood. When new information becomes available or circumstances change, previous estimates must be revised. The impact of the change is recognised in the current and future periods on the same basis. Changes in estimates are not applied retrospectively.
Below, I discuss some of the most common management estimates that company executives encounter. Although reviewing the reasonableness and relevance of estimates is particularly important at the reporting date, management should also reassess and, where necessary, revise estimates during the reporting period when circumstances change.
When assessing receivables, management must consider all available information to determine their probability of collection as reliably as possible. At each reporting date, management must assess whether the receivables recognised on the balance sheet are likely to be collected and whether there are any indications of impairment.
Where such indications exist, the receivable is written down to an amount corresponding to the present value of the payments expected to be received in the future. The resulting impairment loss is recognised as an expense in the income statement for the reporting period, and the carrying amount of the receivable is reduced accordingly.
Writing down a receivable does not mean waiving or extinguishing it. The receivable from the customer remains outstanding, and the company retains the right to demand payment.
To ensure consistent and well-founded assessment of receivables, the applicable principles should be documented in the company’s internal accounting policies and procedures. When selecting an assessment method, consideration should be given to the number and value of receivables, their significance in relation to the company’s total assets and known risks.
Individually significant receivables and those with known indications of impairment should be assessed separately. If trade receivables consist of items with similar values and characteristics, an ageing analysis may be used. For example, based on historical collection experience, debtor payment behaviour and other available information, a company may decide to write down invoices that are more than six months overdue by 50%.
The probability of collection must be assessed for all receivables recognised on the balance sheet, regardless of their type or whether a payment schedule or special arrangement has been agreed. This also applies to loan receivables.
The assessment should take account of historical collection experience, the debtor’s previous payment behaviour and all other available information. Unreasonably optimistic assumptions should be avoided. Where a payment schedule exists, its actual performance must be monitored, as a payment schedule or balance confirmation alone does not demonstrate that the receivable will be collected.
For loan receivables, it is particularly important to assess the counterparty’s financial position and ability to pay. Adequate collateral may increase the probability of collection, but the value and realisability of that collateral must also be assessed separately.
In summary: the carrying amount of receivables must be based on management’s realistic and documented assessment of the amount that can reasonably be expected to be collected based on all available information.
References: Estonian Financial Reporting Standard guideline RTJ 3 “Financial Instruments”, paragraphs 22–32 and 41–43; RTJ 1 “General Principles for the Preparation of Annual Financial Statements”, paragraphs 74–78.
For many companies, inventories represent a significant proportion of the assets recognised on the balance sheet. Attention must therefore be paid both to their actual existence and to their correct valuation.
A physical inventory count provides management with important information about the existence, quantity and condition of inventories. One of its main purposes is to verify whether inventories recorded in the accounts actually exist and whether their quantities correspond to the accounting records.
The count also helps identify damaged, unusable, obsolete or slow-moving inventories. Such inventories must be written down to their net realisable value during the reporting period or written off if they have no value.
Although accountants or other employees may be responsible for conducting the physical inventory count, management is responsible for ensuring that the company has consistent inventory counting rules and impairment principles in place.
An inventory count should not merely fulfil a statutory requirement. It is an important management and internal control tool that helps protect the interests of the company and its owners. Depending on the company’s activities, the nature of its inventories and differences identified during previous counts, management may decide to conduct inventory counts more frequently than once a year.
More frequent counts give management a better overview of the existence and condition of inventories and allow shortages or impairment to be addressed more quickly.
Inventory valuation principles should reflect the specific nature of the company’s activities. Where inventories have a defined expiry date, it is reasonable to use a system that identifies expired products or products approaching expiry in good time so they can be written down where necessary.
Where a decline in inventory value cannot be linked to a specific date, but historical experience shows how quickly products tend to lose value, an ageing analysis may be used to assess the need for a write-down. Management-approved and documented principles simplify inventory counts and support consistent and well-founded reporting of inventories in the financial statements.
Regardless of how often the company conducts physical inventory counts, RTJ 4 requires the inventory list to be critically reviewed at the end of each reporting period to identify items whose net realisable value may have fallen below their cost.
Management should consider the need for an inventory write-down particularly when:
Where these circumstances exist, management must estimate the net realisable value of the inventories and write them down if that value is below cost.
In summary: the carrying amount of inventories must be based on a comparison between their cost and the net realisable value realistically and demonstrably estimated by management. Inventories are recognised at the lower of these two amounts.
References: RTJ 4 “Inventories”, paragraphs 19–22.
Fixed assets represent a significant proportion of the assets recognised on the balance sheets of many companies, while their correct valuation depends on several management estimates.
A physical inspection of fixed assets allows management to collect important information about their condition, use and potential impairment. This information is necessary for a reasonable assessment of their value.
The inspection does not necessarily have to take place at year-end, but its procedures and frequency should, as with inventories, be established in the company’s internal accounting policies and procedures.
Regardless of when the inspection takes place, management must assess at the reporting date whether there are indications that fixed assets may be impaired. Both unusable assets and assets that remain usable but are no longer involved in the company’s operations or generation of cash flows should be critically reviewed.
For such assets, the recoverable amount must be assessed and the asset written down or derecognised where necessary.
Management must also review whether the useful lives assigned to fixed assets remain appropriate. If the expected useful life of an asset differs significantly from the previous estimate, the estimate must be updated and the remaining depreciation period adjusted accordingly.
A change in the depreciation period is treated as a change in an accounting estimate. Under RTJ 1, its effect is recognised prospectively in the current and subsequent reporting periods. Previously recognised depreciation is not recalculated. Instead, the remaining depreciable amount of the asset is allocated over its revised remaining useful life.
Example: a fixed asset with an acquisition cost of EUR 100,000 was initially estimated to have a useful life of ten years. Using the straight-line method, annual depreciation of EUR 10,000 was recognised. After four years of use, management determines that the asset’s remaining useful life is three years rather than the previously expected six years.
Depreciation recognised during the previous four years is not adjusted. The remaining carrying amount of EUR 60,000 is depreciated over the following three years, resulting in annual depreciation of EUR 20,000 going forward.
In summary: as with other estimates, the carrying amount of fixed assets must be based on management’s realistic and documented assessment of their useful lives and recoverable amounts. Estimates must be updated when new information becomes available.
References: RTJ 5 “Property, Plant and Equipment and Intangible Assets”, paragraphs 21–30 and 50–75; RTJ 1 “General Principles for the Preparation of Annual Financial Statements”, paragraphs 74–78.
The carrying amount of investment property depends on the accounting policy selected by the company, which may also have a significant impact on the financial performance for the reporting period.
Under RTJ 6, investment property may be accounted for using either the cost model or the fair value model. Under the cost model, investment property is depreciated. Under the fair value model, its fair value must be assessed at each reporting date.
The following section focuses on the fair value model because its application requires management to estimate the fair value of the investment based on available data and reasonable assumptions.
When applying the fair value model, management must assess whether the fair value of the investment property can be determined reliably without undue cost or effort. This requires weighing the financial and time costs of the valuation against the benefit to users of the financial statements, the reliability of the estimate and users’ information needs.
If the company has a single owner and no significant external users of its financial statements, the benefit of obtaining a valuation may be limited. Where there are several owners or other significant external users, information about the fair value of investment property is generally more important.
The fair value of investment property is the amount for which the property could be sold in an arm’s length transaction between independent parties. Market value is the best indicator of fair value, but using a comparable transactions approach requires a sufficient number of recent transactions involving similar properties.
Such information may not be available at every reporting date, particularly where a property is distinctive because of its location, intended use or other characteristics. The use of a comparable transactions approach may therefore be limited and the resulting estimate uncertain.
In such cases, a discounted cash flow method is often used to determine the present value of the future net cash flows expected from the investment property. The more the fair value estimate relies on unobservable inputs and assumptions, the greater the uncertainty surrounding the estimate.
For this reason, companies should generally consider involving an external professional valuer when determining fair value. An independent valuer will usually have a better overview of market conditions, comparable transactions and the inputs used in valuation methods, and will be less influenced by internal company interests.
Using an external valuer does not, however, relieve management of responsibility. Management must assess whether the assumptions used and the result reached by the valuer are reasonable and decide at what value the investment property is recognised in the financial statements.
In summary: the carrying amount of investment property measured using the fair value model must be based on management’s realistic and documented assessment, using supportable inputs at the reporting date and an appropriate valuation method. Management remains responsible for the final estimate even when an external valuer is used.
References: RTJ 6 “Investment Property”, paragraphs 14–26; RTJ 1 “General Principles for the Preparation of Annual Financial Statements”, paragraphs 55–60 and 74–78.
When valuing assets, the underlying principle is that an asset should not be recognised on the balance sheet at an amount greater than the company expects to recover through its use or sale.
Under RTJ 5, assets showing indications of possible impairment must be tested for impairment at the reporting date. If an asset’s carrying amount exceeds its recoverable amount, the asset is written down to its recoverable amount.
It is important to consider indications of impairment for all assets recognised on the balance sheet. In addition to fixed assets, impairment may also be necessary for investments measured at cost and other assets.
An impairment test determines an asset’s recoverable amount, which is the higher of two figures: the asset’s fair value less costs to sell and its value in use. An asset is written down only when its carrying amount exceeds its recoverable amount.
An impairment loss is recognised as an expense in the reporting period as soon as the need for the write-down becomes apparent. Because of its potentially significant impact, recognition should not be postponed.
If the need for impairment results from new information or changed circumstances, it is treated as a change in estimate and prior periods are not adjusted. However, if reliable information indicating the need for impairment was already available to management but was not used, this may constitute an error and the expense should have been recognised in an earlier period. In that case, the necessary adjustments must be made in accordance with RTJ 1.
One important indication of asset impairment may be loss-making operations or a situation where the income or cash flows generated by an asset fall below budgeted levels.
Under RTJ 5, other indicators may include a deterioration in the economic environment or market conditions, a significant decline in the asset’s market value or physical condition, and the closure or planned closure of a business area.
The presence of even one such circumstance provides grounds for carrying out an impairment test, but does not automatically mean that the asset must be written down.
In summary: where there are indications of impairment, management must assess the asset’s recoverable amount using realistic and documented assumptions and recognise an impairment loss as soon as the asset’s carrying amount exceeds its recoverable amount.
References: impairment and the assessment of recoverable amounts are covered by RTJ 5, paragraphs 50–70. The principles governing changes in estimates and corrections of errors are set out in RTJ 1, paragraphs 74–85.
Correct classification of assets and liabilities provides users of financial statements with important information about the company’s liquidity and liabilities falling due in the near term.
When preparing financial statements, management must therefore review whether assets have been correctly classified as current or non-current and liabilities as current or non-current.
For example, many loan agreements contain covenants requiring the borrower to maintain agreed levels of equity, EBITDA or liquidity ratios. If the company has breached such a covenant at the reporting date, the lender may have the right to demand early repayment of the loan.
As a result, a loan previously recognised as a non-current liability must be reclassified as current. This also applies if the lender only confirms after the reporting date that it will not exercise its right to demand repayment.
It is important to remember that changes in accounting estimates resulting from new information or circumstances are a normal part of financial reporting. The effect of a change in estimate is recognised prospectively in the reporting period in which the change is made and, where necessary, in subsequent periods. It is not applied retrospectively.
A change in an estimate should not be confused with a change in an accounting policy. Under RTJ 1, the effect of a change in accounting policy is generally recognised retrospectively by adjusting comparative figures and, where necessary, the opening balances of the earliest period presented.
In summary: management must ensure at the reporting date that assets and liabilities are correctly classified according to their expected period of use, maturity and contractual terms.
References: the classification of assets and liabilities as current and non-current is covered by RTJ 2, paragraphs 14–19. Rules governing changes in accounting policies and estimates are set out in RTJ 1, paragraphs 69–78.
Business activities always involve risks that may adversely affect a company’s financial performance, financial position and ability to meet its obligations.
Under RTJ 1, management must assess the company’s ability to continue as a going concern whenever annual financial statements are prepared, not only when the company is already experiencing financial difficulties. The assessment must cover at least 12 months from the reporting date and take into account all information available when the financial statements are prepared.
The following circumstances in particular may indicate the need for a more detailed going concern assessment:
The existence of one or more of these circumstances does not automatically mean that the company is no longer a going concern. Management must assess their impact, prepare realistic cash flow and financial forecasts, and analyse the feasibility of planned measures, including refinancing, cost reductions or financial support from owners.
If material uncertainty regarding the company’s ability to continue as a going concern remains, the circumstances giving rise to the uncertainty and management’s assessment must be disclosed in the notes to the financial statements.
If the company has begun to discontinue its operations, or if it is probable that it will begin or be forced to do so within the next 12 months, the financial statements are not prepared on a going concern basis. Instead, the requirements of RTJ 13 apply and liquidation or final financial statements must be prepared.
In summary: whenever annual financial statements are prepared, management must assess the company’s ability to continue as a going concern for at least the next 12 months, disclose material uncertainty in the notes and, where the going concern assumption is no longer appropriate, apply the principles for preparing liquidation financial statements.
References: the assessment of going concern and disclosure of related uncertainty are covered by RTJ 1, paragraphs 36–37. Where the going concern assumption is inappropriate, RTJ 13, paragraphs 3–5 apply.
Management estimates are not merely a formality to be completed when preparing the company’s annual report. They are an ongoing process requiring regular assessment of the company’s assets, liabilities, risks and future prospects.
Reliable financial statements require estimates to be based on all available information, realistic assumptions and consistently applied methods. The process used to arrive at the estimates must also be documented and verifiable.
When new information becomes available or circumstances change, estimates must be updated promptly and their impact correctly reflected in the financial statements, even where this has an adverse effect on the company’s financial performance.
External specialists can support management in making estimates, but responsibility for the reasonableness of those estimates and the accuracy of the financial statements always remains with management.
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IFRS 18, income statement, financial reporting, IAS 1, management-defined performance measures, MPM, KPI, comparative information, IFRS 18 implementation.
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