Basis of Estimating
Most of the noted Chapter 11 bankruptcies are directly tied to failures related to estimates. Many of these companies overstated their revenues by understating reserves for bad debt. Remember, when customers buy product, sales are credited and accounts receivable are debited. Often the customer can’t pay or refuses to pay. Companies estimate how much is not going to get paid by debiting expense for bad debt and crediting a contra account to receivables. This contra account is commonly called ‘reserve for bad debt’. If underestimated, then the corresponding profit is overstated (the debit for bad debt isn’t higher thus increasing the profit) giving the illusion of a well performing operation.
Examples of noted Chapter 11 filings tied to poor estimates include:
* QWest Communications – inflated sales by $1.16 Billion from 2000 – 2002
* Sunbeam Corporation – $41 Million from 1996 – 1998 related to bad debt
* WorldCom – $50 Billion (yes Billions) related to goodwill
Even in small business estimates are used on an everyday basis. Look at your typical residential contractor, first he estimates a job’s costs and the associated indirect costs plus an estimated cost for overhead. Once the job is completed, an estimate is generated for warranty work (call backs for defective materials or inferior workmanship). Then there are estimates made for uncollectible accounts, employee time off, contingent liabilities (such as the cost for an accident or a lawsuit) and fair market value of assets (depreciation and amortization).
With large publicly traded companies, Generally Accepted Accounting Principles (GAAP) require estimates for multiple asset, liability and expense items. Accountants are called on to make these estimates. Experience is the number one estimating basis. This is referred to as the accrual (actual) method. The secondary tool is really an engineered calculation using scientific application to determine the most likely outcome. Both of these methods are explained in the next two sections.
Actual Experience Method
It is human nature to have patterns. Most people rise up in the morning at the same time, eat at a particular hour, and go to sleep at the same time. Business is no different. Patterns develop and it is the job of the accountant to identify some of these patterns.
This is where estimates come into play. As explained in regulator accounts, budgets are a perfect example of using patterns to determine future sales and the associated costs. Patterns develop over a course of four to five years. By tracking the details, accountants can easily identify ongoing patterns. Here is an example of customer default rates related to sales on account for propane for a local distributor.
. 2011 2012 2013 2014 2015 Total
Propane Sales $1,683,209 $1,446,955 $1,703,110 $1,861,432 $1,968,305 $8,663,011
Uncollected $47,816 $42,762 $45,623 $53,918 $57,513 $247,632
% Bad Debt 2.84% 2.96% 2.68% 2,89% 2.92% 2.86%
The five-year running average is 2.86% which is a reasonable estimate of uncollectible sales on account associated with the delivery of propane. The lesson addressing bad debts explains in detail how this is recorded to the books for accounting purposes.
Sometimes the experience relationship isn’t necessarily driven by the average related to sales, but by the skills of the team providing services or making the product. Take a look at this example.
Vision Data is a software engineering company that produces custom software for state, regional and local governments. Vision Data uses a team approach for projects whereby engineers are divided into three distinct levels:
Senior – The team is composed of individuals with a least six years each of experience writing customized software.
Junior – The team has two senior level managers and the balance of the team(s) are composed of members with at least two years of experience. The teams are tasked with mid-level projects that may have only one or two phases of complex formulas.
Intern – All new software engineers start out at this level with junior engineers as managers. Projects are simple copy/paste formats with some customization and possibly a single phase of complex reconfiguration of the software.
Vision Data has an hourly charge per team member per level to reflect the difficulty involved. The projects are discounted at each level for project costing to comply with the contracted agreement. Naturally the total discount rates are higher for the intern level. Estimates are used to discount invoices and to evaluate each team’s performance in comparison to other teams at this level. Here is a team comparison report for the intern level:
VISION DATA INC.
Team Comparison Report – Intern Level
Projects Completed January – June 2016
Team ‘A’ ‘B’ ‘C’ ‘D’ Total
# of Team Hrs 1,698 2,971 4,343 3,340 12,352
Sales @ Full $214,797 $408,513 $475,559 $464,260 $1,563,129
Contracted $ 157,280 365,400 285,690 308,250 1,116,620
Discounts $57,517 $43,113 $189,869 $156,010 $446,509
Effective Rate 73.22% 89.45% 60.08% 66.40% 71.43%
Effective $/Hr $92.63 $122.99 $65.78 $92.29 $90.40
If an accountant were to estimate gross profit for the upcoming six months, it is obvious Team ‘C’ dampens the overall average earnings. As contracts are assigned, it may be better to allocate less to Team ‘C’ or reassign team members to elevate overall performance. This same approach is used with manufacturing, construction projects and professional engagements.
A third form of estimating actual experience involves location or timing. The medical profession, specifically hospitals and doctor groups use workloads over time to try to level the overall workforce to meet demand. A great example exists with children’s hospitals. Historical records identify reduced demand during summer months due to family vacations and education commitments. So hospitals reduce their nursing staff during the summer months accordingly to reduce overall costs.
Experience is the absolute best tool to calculate estimates for assets, liabilities and income statement variables. Another estimating tool is a bit more sophisticated; but is necessary, engineered estimates.
The scientific or engineered method is customarily used with depreciation, amortization, warranties and extraordinary items such as contingencies. This method involves application of scientific principles. With depreciation, the utility of equipment is matched against the value reduction in fair market value in comparison to the actual physical use of the device. Since most pieces of equipment comprise hundreds of parts with some parts having longer life expectations than others, the value change reflects an algorithm of multiple cost charges.
So an estimate is used to determine this utility cost. Fortunately, a lot of science is already documented with depreciation schedules. So common everyday equipment has an established history of utility consumption and a corresponding percentage of cost.
Take for example the purchase and use of marine craft. A typical small fishing boat (< 100′ in length) with an engine room and a regular maintenance schedule will have an estimated life of 15 to 20 years or about 50,000 hours of operation. So an accountant can simply divide the total cost of the boat by 50,000 to derive a value of depreciation per hour of use. Here is a schedule for one boat in a fleet over eight years.
TECUMSEH FISHERIES, INC.
Depreciation Schedule – ‘Marlin Spike’
Original Cost: $1,287,642 Engineered Hours: 57,250 Depreciation Per Hour: $22.49
Year Hours Recorded Deprc/Hr Depreciation Accumulated Depreciation
2011 2,891 22.49 $65,019 $65,019
2012 3,114 22.49 70,034 135,053
2013 3,382 22.49 76,061 211,114
2014 2,217 22.49 49,860 260,974
2015 3,446 22.49 77,500 338,474
2016 3,305 22.49 74,329 412,803
*2017 3,150 22.49 70,844 483,647
*2018 2,500 22.49 56,225 539,872
Each year is an estimate of the actual cost utility involved for the ‘Marlin Spike’.
Based on the information, it looks like the Marlin Spike will last around 20 years. Notice in years 2014 and 2018 that the actual and expected utility is lower than other years. This is because the boat receives its regular hull maintenance and upgrades every four years as a part of its regular maintenance schedule.
As for the other items requiring estimates with engineered solutions, professionals are hired to provide underlying data via research/studies to determine value. Take for example an oil field. Engineers use geological surveys, audio tests, well samples and more to determine the volume of the oil, natural gas and other energy sources to create production capacity. These results are instrumental in calculating the lease rights, royalties and working interests for various parties involved.
In the mining (includes liquid retrieval) industries, depletion is used to estimate drawn amounts and remaining balance for the purpose of financing, production and overall value of the field. The insurance industry uses actuarial science to estimate losses for the respected products. Lawyers use similar principles to determine lawsuit contingencies (liabilities) once the likelihood is certain and measurable for a loss.
For the reader, you must not only understand how it is calculated but also how this information is reported to management and owners.
Estimates In Financial Reports
The reader of financial reports is alerted to the use of estimates in the notes section of the financial reports. The notes traditionally have one or two sections identifying the use of estimates and their impact on the financial statements (balance sheet, income statement and cash flows statement). Most accountants identify schedules or the science used to estimate the results.
Many real estate based operations use appraisals to report to investors current fair market values of the underlying assets to assist in determining ownership value or their respective shares or percentages. Appraisers use the scientific approach to estimate the fair market value of the property.
Homeowner associations buy property management studies to evaluate the remaining life expectancy of the common assets (roads, fixtures, landscaping, drainage, dumpster pads, exteriors of buildings, community property and more) and the estimated cost to bring the assets to a like new status. These estimates are then used to charge homeowners enough to build a reserve fund to cover the impairments. These schedules are included in the notes to a homeowner’s or condo association financial reports.
For a reader of financial reports, the key is the test of reasonableness with the estimates used. Underestimate costs and the profit is overstated and the assets are overstated. Overestimated costs understates profit; both extremes create a misleading balance sheet.
Summary – Estimates
Estimates are an intricate part of accounting as most businesses use this tool to fairly state their financial position. It is used with depreciation, calculating employee benefits, determining a reserve for bad debt, setting warranty amounts and addressing extraordinary items such as contingencies. There are two widely accepted methods to estimate these expenses. The first is the historical or actual amounts incurred related to some volume indicator. This tool is used for bad debt calculations and employee benefits. A second method is a science based tool using engineered calculations for utility. This is often done with depreciation and contingencies. This method is also used in many contracts related to leases and intangible rights.
All estimated amounts are explained in more detail in the notes section of the financial reports. The creator of the notes (usually the accountant) explains the method used and a summary schedule affecting the current year and several years into the future. The next five lessons go into detail about estimates for depreciation, employee benefits, bad debts, warranties and extraordinary items. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.