Putting emphasis on disclosures: accounting estimates and judgements
The key risk in the accounting profession is the misuse of accounting judgements and estimates which are either too conservative or too aggressive. Currently, accounting judgements and estimates are not clearly defined apart from the requirement of paragraph 122 of International Accounting Standards (IAS) 1, which requires entities to disclose accounting judgements distinct from accounting estimates applied. While it is a controversial issue to discuss, it is clear that judgements and estimates are intertwined such that both are subjective and have significant financial effect.
In my previous post regarding the accounting scandal currently faced by Toshiba in Japan, it is clear that accounting judgements and estimates have been exercised too aggressively resulting to significant misstatement as a result for its financial statements. As of this writing, Toshiba still estimates a downward adjustment of $1.22 billion (accumulated misstatement from 2008 to present) as a result of its previously aggressive accounting stance.
Current accounting standards does not have explicit prohibition against management’s application of judgements and estimates. Rather, the application of the current principles-based accounting standards provides a freer exercise of judgement and estimates considering that financial statements should reflect not just the past transaction but the present status of the company. And we have to agree, without accounting judgements and estimates, financial statements can hardly be relevant to users of the financial statements. For the purpose of those not in the accounting profession, the purpose of the financial statement is to present a company’s financial position (as of the reporting date), financial performance (for the reporting period) and cash flows (for the reporting period). Therefore, the purpose of the exercise of judgements and estimates in accounting is to provide a better picture of the financial position and performance of a company at a given point in time.
Accounting judgements and estimates are usually exercised to determine fair valuation and to determine percentage of completion or work done. In essence, accounting judgements and estimates, when applied within the context of responsible accounting, would help in producing more relevant financial information and more accurate reporting of the company’s financial position and performance. As the adage explains, with great power comes great responsibility. Management is in a unique position to put these judgements and estimates into play and within the context and parameters allowed by the current accounting standards. As in the case of most accounting scandal, the fault lies not in falsified journal entries but rather in extreme exercise of aggressive accounting stance.
A big question now asks the role of the auditor in these circumstances. Frequently, when these accounting scandals erupt, the first point of blame will be on the auditors who are expected to provide the users of the financial statements assurance that the financial statements are free from error. As most readers of my blog is in the profession, it is notable that the above definition is wrong due to two points:
1. Assurance provided by an audit is only reasonable assurance; and
2. An audit does not provide assurance that the financial statements are free from error, rather, simply free from material error or misstatement.
These two points are accepted in the profession and as far as the legality of the issue is concerned, but the users of the financial statements clearly believes that auditors should have spotted these issues before branding the financial statements as audited. This is clearly an issue which needs to be addressed on in the long run but is not expected to fully reduce the blame on the auditors once an accounting scandal erupt. Auditors cannot be excused of the blame in accounting scandals as most of these resulted from significant aggressive accounting estimates and judgements which should have been clearly disclosed in the financial statements. Indeed, this is a mayhem of the accounting profession.
Accounting standards currently requires disclosure of accounting estimates and judgements applied in coming up with the financial statements but provides only limited instances where these are required. Currently, International Financial Reporting Standards (IFRS) requires detailed disclosures on the following accounting judgements and estimates:
1. Those involving financial instruments (IFRS 7)
2. Those involving share-based payments wherein a valuation model is used (IFRS 2)
3. Those involving defined benefit plans (IAS 19)
4. Those involving fair value measurements (IFRS 13)
The above items are those more complex accounting that are required to have detailed disclosures on the accounting estimates and judgements applied and to provide a related sensitivity analysis to provide the users of the financial statements an insight as to the implication of a certain percentage movement in the underlying estimate or data. While the above disclosure requirements provide a tremendous insight to the users of the financial statements, they are very limited in contrast to the number of items which requires judgements or estimates to be applied. The following are examples where accounting judgement or estimate is applied:
· Classification of a financial instrument as either trading security or available-for-sale
· Estimating percentage of completion for long term revenue contracts
· Estimating impairment losses for financial and nonfinancial assets
· Estimating useful lives of finite life assets
· Estimating value-in-use
Those are just some of the examples where accounting estimates and judgements are applied which could have potentially large impact on profit or loss. Current practice in the accounting profession for these is just to insert a generic (boilerplate) narrative disclosure either in the accounting policy section or in the accounting judgement and estimates section of the financial statements without any reference to potential fluctuations resulting from varying levels of estimates.
International Standards on Auditing (ISA) 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures, currently provides a catch-all requirement for the audit of accounting estimates and the related disclosures. After considering the requirements of the current auditing standards, it all refers back to the requirement of the accounting standards and require auditors to ensure compliance with the disclosure requirements of the accounting standards.
While auditors may disagree with management on the lack of disclosures as to the accounting judgements and estimates which the auditors assessed to be significant, management is still in a unique position to determine which accounting judgements and estimates are material enough to warrant a disclosure in the financial statements. In these situations, auditors are not in a position to further push a disclosure to be placed in the financial statements as these disclosures are covered by management’s judgement as well. The dilemma is a circular risks which ends up with the disclosures being within the control of management.
So do I mean that auditors can’t do anything with it and just have to deal with it? Not necessarily. The International Auditing and Assurance Standards Board (IAASB) is issuing an amendment to ISA 700 (among others) to update the previous simple auditor’s report which does not provide any additional information as to the audit issues encountered and key accounting disclosures that auditors would like to highlight to the users of the financial statements. Effective 2016, auditors are empowered to provide users of the financial statements a commentary of the Key Audit Matters (KAM) aside from the standard audit opinion issued.
Is this game changing? That depends on how much an auditing firm is serving as an underdog of the management. Well at least some balls are rolling in the right direction now.