This challenging period during the COVID-19 pandemic has made demand for reliable and transparent financial reporting rise even higher. The increasing uncertainty in accounting for complex business transactions requires not only present information, but in certain cases, also requires estimation in order to be properly accounted for in the books of account and sufficiently reported in the financial statements.
This pandemic has added a layer of uncertainty to an entity’s ability to achieve its long-term goals, requiring management to implement more frequent reviews of financial budgets and forecasts in assessing the valuation of corporate assets. In many respects, management applies estimation in financial accounting and reporting, posing unique challenges. For example, in accounting for the acquisition of a business, management estimates the valuation of assets and liabilities acquired and, in the process, must determine what information will be used and where such information will be sourced. Management also has to have a robust process for ensuring that the estimation transactions are processed and accounted for consistently, including the determination and application of the appropriate methodology especially when there are various acceptable approaches in the industry. While it is true that accounting estimation is not a new concept in management and financial reporting, it has become complicated yet inestimably valuable in this period of uncertainty.
Given such challenges, management can only put its best foot forward by using its deep experience and knowledge of the industry and exercise sound judgment based on the available information to properly measure and report these transactions in the books.
A PRUDENT EXERCISE OF JUDGEMENT
Management needs to exercise sound judgment in accounting for and recording estimation transactions based on the latest available information at the time the estimate is made.
To exercise prudence of judgment when dealing with estimation transactions, management needs to use the most up-to-date information about the transaction, select the most appropriate measurement method, and gather other relevant data in supporting the assumptions to be used in arriving at the estimate.
To make the most reasonable estimate, management must also ensure that there are appropriate controls in place within the financial accounting and reporting process. The entire financial accounting and reporting process generates the financial statement amounts, making it necessary to establish the appropriate and sufficient controls to ensure that the output from processing estimation transactions is reliable. This process includes the necessary risk assessments and related activities necessary to ensure adequate financial statement disclosures. These estimated amounts largely drive what should be recorded in the books and disclosed in the financial statements.
Management also needs to identify areas in the estimation process that are prone to error, and thus increase the risks of material misstatement and unreliable information in financial reporting. It must revisit the previous bases of accounting for estimates especially when the data and assumptions used are highly dependent on macroeconomic factors and thus are subject to frequent changes and would require regular reassessment. It will also need to be conscious of potential biases to ensure that it continues to objectively evaluate all required information when arriving at the estimates. It is likewise important to remember that anything that has been proven and accepted in the past may no longer be relevant considering the changing business landscape and business outlook.
ACCOUNTABILITY FOR ESTIMATIONS
Top management and those charged with governance bear the responsibility of formalizing and approving the estimation process. At times, management may need the assistance of experts particularly for more complex estimates. However, this does not relieve it of its responsibility to carefully evaluate the work of experts. The same is true in the selection of an appropriate financial accounting and reporting policy that will be used for such transactions, assessing the need to change from previous years’ assumptions and addressing the potential impact of the changes on certain financial reporting assumptions. The process to be used will depend on the level of risk and the nature of the estimate. Any significant changes in assumptions and models from previous years must be fully supported and the basis of the change should be documented.
Management may further need to thoroughly document the rationale behind the selection of estimation models and assumptions among various alternatives. This is to respond to any questions from users of the financial statements by showing the bases and processes that led to the amounts and disclosures. The more complex the estimate is, the more structured the process and risk assessment is expected to be.
WHAT’S NEXT FOR MANAGEMENT AND THOSE CHARGED WITH GOVERNANCE
The adoption of new and complex accounting standards as well as the evolving business landscape increases the demand for sound financial reporting that maximizes the use of available external information to produce reliable estimates. At the same time, management needs to ensure that it is still able to satisfy the information needs of stakeholders and users of financial statements. It will also need a robust assessment of all inputs used and strong justification behind the selection among various models in accounting for estimation transactions.
Beyond just compliance, management must consider how the disclosures help users of financial statements better understand the relevance of the estimate and its impact on the financial statements — from having adequate to reasonable disclosures. A robust risk assessment for estimates should be part of entity-level controls as it will set the tone for how transaction level controls will be set. For more complex and significant estimates, management and those charged with governance need to revisit their processes and controls and address the related risks identified on the estimation transaction.
Management must have its own stand-back approach to revisit and assess the effectiveness of the processes that are in place. This should enable it to accordingly revise the processes based on the evaluations done.
RISING TO THE CHALLENGE
The use of reliable estimates in financial reporting has become increasingly complex because of the pandemic. It is quite likely for regulators and other users of the financial statements to scrutinize and challenge financial statement estimates, as the estimation of these values are judgmental in nature. Accordingly, this would require closer collaboration between management and those charged with governance to ensure reliable and transparent financial reporting.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the author and do not necessarily represent the views of SGV & Co.
Benigno F. Leongson is an Assurance Partner of SGV & Co.