Beware! Estimates Dominate Financial Reports
Everyone knows that accounting is boring (not when I teach it, though), but, at least, people think it’s factual. No fake news. After all, accounting comes from counting―counting money, units of inventory, etc. All facts. Nothing further from the truth.
Except for a few items on the balance sheet, like cash and debt, practically all items on the balance sheet and the income statement are based on managers’ subjective estimates and projections. Hard to believe? Here are examples:
- Fixed assets and goodwill are presented on the balance sheet net of depreciation and amortization, both are managerial estimates.
- Accounts receivable (money owed by customers) are presented net of the bad debt reserve (expected non-payments)―again, an estimate.
- Inventories are often presented at market (replacement cost) value―an estimate.
- The pension expense―a big item for labor-intensive companies―is based on 4-5 different estimates (e.g., future wage increases, future gains on pension assets, etc.).
- Employee stock options expense too is based on 3-4 assumptions.
You get the point: There are hardly any facts in the information―assets, earnings― you receive quarterly from public companies.
Many of these estimates are no better than sheer guesses. Take, for example, the “gain on pension assets,” mentioned earlier. This key determinant of the pension expense requires managers to estimate the future (3-5 year) market performance of the funds set aside to cover retiree pension payments. Consider: Managers are asked to estimate the performance of capital markets over the next 3-5 years. Good luck estimating the market performance tomorrow.