Often times companies deal with business transactions that are subjective and require the use of judgment and accounting estimates. For example, what is a reasonable useful life of a fixed asset for depreciation purposes? What amount of warranty reserve should be booked for a new product? Or, what accrued liability balance should be recorded at year-end related to repurchase obligations or guarantees? The list goes on and on (see par 16 for some examples of accounting estimates).
FASB Statement of Financial Accounting Concepts No. 6 (CON 6) at ¶ 46 addresses the necessity of accounting estimates in financial statements:
A highly significant practical consequence of the features described in the preceding two paragraphs [regarding the effects of uncertainty in financial statements] is that the existence or amount (or both) of most assets and many liabilities can be probable but not certain. The definitions in this Statement are not intended to require that the existence and amounts of items be certain for them to qualify as assets, liabilities, revenues, expenses, and so forth, and estimates and approximations will often be required unless financial statements are to be restricted to reporting only cash transactions. (emphasis added)
Because an integral part of these accounting estimates are management’s judgments and estimates, which are susceptible to bias, error, and potentially fraud, it is imperative to understand how accounting estimates are established and what management considers in recording the estimates.
This may sound relatively straightforward; however, as an example public company auditors (who routinely review and audit accounting estimates as a profession) continue to struggle when it comes to adequately auditing and documenting their assessments of the reasonableness management’s accounting estimates and assumptions. In fact, the PCAOB, the public company auditor’s regulatory body, summarized the results if its 2015 inspections, identifying certain recurring audit deficiencies, including (1) auditing internal control over financial reporting, (2) assessing and responding to risks of material misstatement, and (3) auditing accounting estimates, including fair value measurements.
Further, because accounting estimates are inherently susceptible to bias, error, and potentially fraud, they can often contribute to legal disputes.
Guidelines for assessing accounting estimates
From my experience as a former Big 4 auditor and as a forensic accountant on sometimes large, complex legal disputes, I have developed some questions that are helpful when assessing the reasonableness of significant assumptions or judgments used in accounting for estimates:
- What is the method used in making the accounting estimate, including model(s) used?
- What are the relevant key controls?
- Has management used an expert? If so, what are the qualifications of the expert?
- What are the assumptions underlying the accounting estimates? Are they based on reliable, relevant and accurate data?
- Did management consider alternative assumptions or outcomes?
- What was their reason for rejecting the other assumptions or outcomes?
- Has there been or ought there to be a change from prior period in the method(s) used for making the accounting estimates? If so, why?
- Has management performed a sensitivity analysis to assess the reasonableness of its assumptions?
- Did management assess the effect of estimation uncertainty? How so?
- Given the degree of uncertainty in their estimate, how did management get comfortable with their final conclusion?
While I don’t believe all of these questions need to be considered in all situations, they can be used as a guideline for assessing the reasonableness of accounting estimates.
Application
Once I assisted an expert in writing a report in a complex legal dispute. The opposing expert opined that an error in accounting estimate in the defendant’s financial statements was material because of alleged reliance on inaccurate data in establishing the accounting estimate. My team adapted some of the above guideline questions in the context of the dispute to rebut the opposing expert’s opinions. By having a strong understanding of the assumptions employed by the opposing expert, we were able to decide (1) if they were based on reliable, relevant and accurate data or (2) if they were based on data that was not appropriate given the facts and circumstances of the dispute.
Ultimately my team constructed a strong position and our expert opined that number of the opposing expert’s assumptions were unreliable, irrelevant, and/or inaccurate. In fact, to provide some insight into how drastically an accounting estimate could change depending on the assumptions and judgments applied, the opposing expert opined that the range of potential error caused by the alleged misstatement was from hundreds of millions to billions of dollars. Our position was that the accounting estimate in the tens of millions of dollars was appropriate given the facts and circumstances. Such a large range seems to be commonplace in legal disputes because of the grey area in applying assumptions and judgments.
In summary, reviewing accounting estimates requires professional judgment and experience. Having a qualified professional who understands the accounting requirements and application of the standards can greatly assist a party to a legal dispute in protecting itself from potentially significant financial and reputational exposure.