What is accounting estimates in auditing?

   

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April 19, 2022 April 19, 2022/ Steven Bragg

An accounting estimate is an approximation of the amount of a business transaction for which there is no precise means of measurement. Estimates are used in accrual basis accounting to make the financial statements more complete, usually to anticipate events that have not yet occurred, but which are considered to be probable. These estimates may be subsequently revised as more information becomes available. Changes in accounting estimates impact the current period and future periods, but have no impact on prior periods.

The amount of an accounting estimate is based on historical evidence and the judgment of the accountant. The basis upon which an accounting estimate is made should be fully documented, in case it is audited at a later date.

Examples of Accounting Estimates

Examples of accounting estimates are a loss provision for an environmental damage claim, a loss provision for a bad debt, and a loss provision for warranty claims.

April 19, 2022/ Steven Bragg/

What do Audit Committees need to understand about accounting estimates and disclosures and what questions should they be asking their management teams and auditors to ensure that accounting estimates and disclosures are appropriate?

This discussion was led by Ashley Wood, Audit Quality Leader for our financial services assurance practice. Ashley was on the Australian Auditing Standards Board for 3 years where he led the Australian implementation of this new standard on Estimates.

This was followed by Q&A between Doug Niven, Chief Accountant ASIC and Jan McCahey, Lead Partner Assurance Quality and Risk on ASIC's expectations and approach in this area.

Key points for Audit Committee members

• Allow more time in your Audit Committee agendas at 30 June, to challenge and debate the estimates.
• It’s not just the responsibility of the Audit Committee and finance team, estimates require input from many different facets of the organisation, and that is when an estimate is making best use of all of the information.
• Management can expect more questions and will need to provide a greater level of detail and clarity to auditors and provide an overview of the process from start to finish.
• Expect more detailed and informed memorandums prepared by management setting out the key assumptions, methods and processes that have been adopted to derive the provision. Having the alternatives written down, not only focuses management's attention, but it provides a good encapsulating document for Audit Committees to review and consider, especially for high risk profile estimates.
• Expect more scrutiny and challenge over disclosures. The new standard requires the auditor to sign off on them as reasonable as opposed to being adequate under the old standard.
• Expect to see more debate around the Audit Committee table. You may expect more representations being requested of you by the auditor.

Setting the scene

Virtually all financial statements include accounting estimates, e.g. expected credit loss provisions, legal disputes, customer remediation provisions, the impairment of intangibles and fair value of investment properties. But there are also smaller estimates in financial reports such as accruals; depreciation and long service leave. This standard applies to all of those accounting estimates.

Accounting estimates have become more prevalent and prominent in financial reports each year and COVID has created an additional lens to look at these estimates through.

Estimates have always featured highly in the ASIC Top 10 areas of focus. They feature in the ASIC audit quality findings of where the audit profession needs to focus. They are regularly in the key audit matters part of the audit opinion, as Directors on listed boards would be aware. In other words, estimates are everywhere in financial reports and they are increasingly important.

The new standard; its scope and it applicability

Against that backdrop, there is a new Auditing Standard ASA 540 Auditing Accounting Estimates and Related Disclosures effective for financial years commencing after the 15th of December 2019.

December reporters would have been already just through their first audit under this new standard. For 30 June reporters, the upcoming 30 June 2021 reporting date will be your first time and so you will probably start to hear and feel it a lot more in the months to come. No doubt you would have already seen the impact of the new standard auditors in the annual audit plan.

The standard applies to all accounting estimates, whether they're recognised on the balance sheet, (e.g. provisions) or disclosed at the back of financial reports (e.g. contingent liabilities or the fair value estimate of financial instruments that are measured at cost). In other words, estimates are not just restricted to the balance sheet, estimates are found throughout the financial report and that's important to take that into account.

As auditors, we are focused predominantly on material misstatements, However, we also need to assess for understatement. Strictly speaking, the estimate may be below our materiality threshold, but we still have an obligation to assess whether it is rightfully that number, or whether there is a risk of it being understated.

Reasons for the AUASB revising the standard

There are 4 core reasons for the change in the auditing standard:

1. Audit risks are evolving due to a more complex business environment. Compared to five or 10 years ago, there is much greater need for forward looking information in financial reports. For example, the expected credit loss for bad debt provisioning recently involved looking backwards but is now very much forward looking under AASB9. Similarly, with the new lease accounting standard, some leases used to be on the balance sheet . Virtually all leaves now have come onto the balance sheet and require estimates to derive these measurements.
   
2. There was a general consensus that auditors needed to apply more professional skepticism to estimates. There were demands by both the regulator and the Auditing Standards Board for auditors to ask more questions, be more probing and have a more challenging mindset. And as we’ve seen, the language has certainly changed.
3. There was also a need for improved communication and transparency in financial reporting. Disclosures are the story that informs the readers, who don't have the same level of information as the Directors, management or the auditors. There was a gap that needed filling to provide a greater level of transparency. More communication with the Audit Committee and Board Directors was required of auditors and more transparency between those two parties.
4. Last, the new standard has been written to be more explicit on scalability. The auditor must undertake more work around estimates with a higher risk profile than those that don't. i.e auditors would naturally be required to spend more time on auditing goodwill impairment than an accrual. The old standard was not as explicit in guiding the auditor where to spend time.

Key changes to the standard

There are a number of key changes made by the standard:

1. Each and every estimate has a different risk profile. The standard is much more explicit and specific around the auditor's assessment of where on the spectrum the estimate lies. An estimate, by its nature, has an inherent lack of precision, there is a degree of estimation uncertainty. In other words, it's not a balance that we can tie through to a contract, agreement, bank statement or invoice. The more assumptions that need to be made using non-observable data, the longer the forecast period, the more a methodology is bespoke to the organisation, the greater level of estimation uncertainty. Examples include legal claims or the fair value of a level three instrument infrastructure asset that has very few comparables. Auditors and management need to understand where on the spectrum the estimate lies with regard to estimation uncertainty.
2. The second aspect that drives the risk profile of an estimate is complexity. While one can have estimates with a high level of estimation uncertainty, the calculations may be quite straightforward. It could be an A x B model that isn't requiring huge data sets and interrelationships. The key is knowing what is A and what is B. The other end of the spectrum is, for example, an expected credit loss model, which is taking huge amounts of information from many different systems, looking at interrelationships, and using very complex probability of default loss calculations to arrive at the estimate.
3. The next area is subjectivity. The standard talks about subjectivity versus estimation uncertainty. Subjectivity is around the limitations in our knowledge where there isn't something to reach out to. For example, customer remediation provisions are very prevalent in some financial reports and require a large amount of subjectivity.
4. Lastly, the new auditing standard talks about other inherent risk factors, such as susceptibility to management bias. For example, are management fees, performance fees, bonuses or share incentive plans calculated as a result of this estimate? To what level does this estimate have an underlying potential risk of bias?

As Audit Committees start to work with management on 30 June estimates, it's important to understand not only what the estimates are but also whether they are at the higher end and the lower end of the risk profile. And what are the key assumptions? This makes for a more enriched conversation on estimates.

The new standard mostly impacts the planning, understanding and evaluating stages of the audit lifecycle; the execution phase less so. For this reason, much of the enhanced audit work will happen behind the scenes between the auditor and management in understanding and evaluating where each and every estimate lies on the risk profile as it relates to your entity.

Once that understanding is clearly gathered and plotted on that spectrum, the auditor can then derive an audit approach that provides sufficient and appropriate comfort or assurance over the various estimates.

What will it mean for Audit Committees?

All stakeholders should expect to spend more time and provide more challenge to the process of deriving, approving and auditing the estimates. There will be a substantial uplift across all stakeholders as we move through this first year cycle.

It will give rise to more dialogue and debate in Audit Committee meetings.

So one practical takeaway is to allow more time in your Audit Committee agendas at 30 June, to go through the estimates, and have the appropriate time to challenge and debate them.

It’s not only the Audit Committee and finance team management that will be impacted by the new auditing standard, but many others within the business may have to contribute to deriving the estimate. For example, valuation specialists, taxation teams, pension specialists or anyone from the business who is providing input into the various assumptions. While the finance team will often “own” the provision, it needs so much input from many different facets of the organisation, and that is when an estimate really is making best use of all of the information.

Management can expect more questions and more time spent in that interim stage, i.e. the months we're going through now in the lead-up to 30 June year end. Auditors need to better understand the process that management goes through. And management will need to provide a greater level of detail and clarity to auditors and provide an overview of the process from start to finish. The auditor will essentially be asking the process that is followed before ending up in the trial balance and financial report? We'll be spending more time in our walkthrough meetings.

One would also expect more detailed and informed memorandums prepared by management setting out the key assumptions, methods and processes that have been adopted to derive the provision. The “telling of the story” is so important here because estimates, by their nature, are unknown. It is important to be very clear in writing, not just verbally, what management and the Board knew at 30 June and importantly, what information they didn't know.

Often these estimates are looked at months or years later, with the benefit of hindsight. A clearly articulated memorandum that has been prepared by management, with the feedback of the auditors will help you to walk through and tell the story of how they went about it.

For example: articulating what we knew and didn't know; the alternatives considered; the reasons for not going down path B and C; but rather path A because... Having the alternatives written down, not only focuses management's attention, but it provides a detailed all encompassing document for Audit Committees to review and consider, especially for the more higher risk profile estimates. It's also useful to have ‘in the top drawer’ if and when questions are asked in the future.

We should also expect more scrutiny and challenge over disclosures. Under the old standard, the auditor was required to understand whether disclosures were adequate. The new standard takes that one step further requiring the auditor to sign off on them as reasonable. There will consequently be more pushing and probing around the disclosures because that is the narrative that is in the public domain and can help educate the judgments and estimates and that's where sensitivity is so important.

Last, expect to see more debate around the Audit Committee table. You may expect more representations that come from either management or the board from the auditor, because the bar has been raised.

Q&A with Doug Niven, Chief Accountant ASIC

From a regulatory perspective, why are accounting estimates and disclosures of estimates so important to you and your focus?

Estimates pervade many areas of the financial report, and I won’t list everything, but there’s impairment, fair values of properties, financial instruments, even expected credit losses which we often think is only for banks, but impacts everyone around receivables and loans. There is a degree of uncertainty and judgment involved in these and they can significantly impact on the net assets and profits of entities, depending on the assumptions that are made.They involve uncertainty, complexity, judgment and applying skepticism from a Director's point of view. Under COVID-19, this has just been highlighted even further as uncertainties we were facing last year continue to exist for particular industries. In the lead up to 30 June, Directors, preparers and management need to think about changes in the uncertainties - perhaps some more clarity, perhaps different assumptions. So it's not just a matter of putting in enormous effort for 30 June 2020 or 31 December 2020. Things may have changed, and we need to think about it all again.

Usually the financial report, despite continuous disclosures, doesn’t have the same sort of information that's available to company management and the Directors, such as more granular information around forecasts. And we know not all users are equal in the market either. I think a good point was made around the disclosure side of this as well, to the extent that there is uncertainty, it’s important to disclose what those uncertainties are, what the assumptions were made. This will allow people to understand how the estimates were derived and to some degree, comparability across entities within the same industry and other industries as well.

While we're talking about the estimates, disclosures in the operating and financial review are going to be important as well so that people understand what's driving the business, the risks, the strategy, the future prospects - they all tie together.

In reviewing financial statements, ASIC will often ask companies to explain certain treatments that they seem to apply in their financial reports. What are some of the common issues that crop up in the area of estimates ...say that you find as a result of reading through financial statements or once you're in a conversation with a company?

When we first review financial statements on a proactive basis, our selections are risk based. We don't know if there’s necessarily a problem with the financial report from just reading the financial statements, particularly in the area of estimates. There might be some red flags or indicators that cause us to raise questions but it's only when we get into the information that we get a better understanding of what's happened, despite the level of disclosure in financial reports.

One of the issues that commonly comes up is companies adopting unrealistic assumptions. Even before COVID-19, we had cases where historically companies weren't meeting forecasts, for example, with its underlying asset values. If they're not meeting forecasts year on year, why is that? Why should we think that they're going to be accurate with their forecast now, particularly if assumptions have never come to fruition in previous years?

We also look for inconsistencies with other information, whether it's statements in the operating and financial review or in other estimates. How has the company tested the assumptions e.g through sensitivity analysis, benchmarking inputs to markets, different levels of inputs and the adequacy of disclosure.

And finally, one of the things that we often find is insufficient challenge and attention by Audit Committees and Directors. We don't often get positive feedback after we've dealt with a company on a matter but on occasion, we will get an email from the Chair saying on reflection it was a good process and they should have done more.

You mentioned before that you won't be able to get enough information necessarily, by just reading the financial reports. And so that will inevitably lead you to be in dialogue with the company, or perhaps even asking for some information to be provided. And I think it just might help Directors, if you could give a sense of the sort of information you might end up asking the company to provide?

While it will vary from estimate to estimate, the starting point is the model supporting an estimate. Obviously we would want to see how that model is constructed and operates. We look at what has been considered by the board because that often summarises the key analysis and assumptions. That could include minutes, papers considered by the board, and other internal analysis. For example if we're looking at a commodity price assumption, there may be many key underlying assumptions around market supply chains, competitors, the economy and government restrictions. So we look at all of those things that go into the analysis of why an assumption is reasonable.

Under COVID-19, we're also looking for proper consideration of factors that might affect a particular industry or company e.g. travel restrictions, vaccine rollouts, supply chains, foreign economies and climate change. We've been looking at correspondence with third parties around these estimates. Part of it is just understanding the business and the markets in which the company operates. Sometimes it's easier to do that face to face meetings with companies. But that is key to understanding how estimates have been impacted. Some examples include changes in distribution channels such as the shift from bricks and mortar retail to online, technological change, government regulation and just what is the new norm post COVID 19 which is very relevant to certain property valuations. We also look at the ability of the company to develop estimates based on history and explanations of why those assumptions and estimates are realistic.

What are the top things that Boards and Audit Committees should focus on in their discussions around estimates?

Part of this is around making sure management has applied appropriate expertise to derive the estimates? Do they need to bring in experts or do you want to get your own advice around matters?

As Directors, it's about your expectations and the questions you ask management. Directors can challenge estimates quite well without having a lot of technical knowledge about how they were constructed. Just to say “why have you adopted this assumption? To my knowledge it is not reasonable.” Budgets, forecasts, investor presentations and recent prospectuses are important, but it is really about asking the difficult questions. It's always good to ask the stupid questions because sometimes the stupid questions are the best questions to ask in challenging people. We also provide guidance in information sheet (INFO 203) about the areas for focus and questions for Directors on impairment of non-financial assets.

At a session last year on impairment, you emphasised the importance of getting disclosure into both the financial report and the operating and financial review to give a clear idea of what was happening, but also giving some protection if people are looking with the benefit of hindsight later.

Disclosure is definitely important. We say “disclose, disclose, disclose”. In the current environment, particularly around estimates, disclosure of these assumptions is so important to use as a financial report. It's about disclosing where there's estimation uncertainty and key assumptions. But it's also about being specific and informative. Generalisations aren't very helpful. You need something that's specific to the circumstances, the company and the estimate you’re looking at.

Often disclosures are missed around impairment. If there was a reasonably foreseeable change in assumptions, would there be an impairment loss? Sensitivity analysis is very important, if this assumption changes by this much, what does that mean? That's partly a disclosure question, but also about testing the estimates internally. We also saw deficiencies in the operating and financial reviews, we were looking for what was driving that. A lot of credit goes to the many Directors and auditors for the effort that went into 30 June 2020 financial reports and operating financial views. But there were some companies where we knew the industry and the company was heavily impacted by COVID-19 factors or others pre-dating the virus, that didn’t mention those factors in the operating and financial review, or were too generalised or short to be useful. The other thing is attributing causes to the right things. If something's happened, don't just say it's COVID-19, if it was pre-existing or unrelated.

Finally, I’d add non-IFRS financial information and how that's used looking forward. A lot of companies had impairment losses at 30 June 2020. As circumstances change, if there is a reversal impairment, and the underlying profit excluded the impairment losses, we'd be concerned if your underlying profit included the impairment reversal. That’s the sort of thing to watch out for.

Sensitivity analysis is key, but you could end up with many multiples of sensitivity analysis, depending on the number of assumptions in your estimates. Do you need to look at all of them, and then work out which ones drive the biggest change, or are you just looking for the outside parameters, e.g. most optimistic versus most pessimistic? Would you expect some kind of disclosure over a range of outcomes?

Some sensitivity analysis does go to common sense. There's so many assumptions that go into estimates and some have a bigger impact than others. You wouldn't necessarily take the most extreme outcomes. It does go to the degree of uncertainty, judgment and circumstances. It may be that small changes in the key assumption about a discount rate could have a big impact. It's about thinking, what is going to be the most meaningful and useful to readers of financial reports.

In the contingent liabilities standard, one of the criteria on recognition of liabilities was reliability of measurement. Are we being pushed through this standard to think about reliability of measurement in a different way, that involves a lot of assumptions and disclosures?

We should be cautious about reliability in the provisions and contingent liabilities standard, because if you read the standard carefully, it's not setting a hurdle for reliability as high as some might think. The standard recognises that provisions are by their nature more uncertain than most other balance sheet items and generally an entity will be able to determine a range of possible outcomes and make an estimate that is sufficiently reliable. There's going to be uncertainty in many things and it would be unhelpful if this resulted in many assets and provisions not being recognised on the balance sheet and only shown in the notes as contingent liabilities and contingent assets. We've looked at companies that have not recognised a provision based on reliable measurement where in ASIC’s view it was in fact sufficiently reliable. That's where it comes into disclosure around any estimation uncertainty and the assumptions that were made. We had a case where there was an incredibly large asset and the financial statements were not clear that the outcome was either going to be that number or zero. It ended up being zero. Disclosure was incredibly important. It's easier when you have large populations where sometimes things average out. But I’d be cautious about not recognising provisions based on reliability. There will be some cases but I don't think the bar is as high as most people think.

Post COVID-19, there's been a number of industries that have been impacted across the market more than others. What industries or sectors are likely to have a heightened level of scrutiny from ASIC through this reporting period, and the next few reporting periods?

There’s some consistency with the ones that we looked at last year, so for example the travel industry and transport without being too specific. Other industries can be affected by supply chains, or where customers are. We're getting very positive feedback about the economic conditions in Australia and I’ve heard that the US economy is performing well. But you have to think about where the exposures are. Our original list last year ran to 40 industries. We were mainly focused on the ones who could be adversely affected, but we were interested in some that were positively affected. We were concerned that what happens when COVID-19 finishes, is it transparent to everyone or will things perhaps not be as good post COVID-19.

ASIC reviews the work of auditors. What are the key areas that auditors need to improve on in this area? I know that our Directors might appreciate knowing just how they might be helping you hold our feet to the fire on some of these issues as well.

I’ll start by saying we've all got common objectives here. We are all concerned about making sure that their markets are properly informed. We have focused on estimates with auditors for a number of periods. We do have findings in those areas and a lot of that overlaps with our expectations of companies as well. Some of it was around understanding the business, the risk assessment, applying professional skepticism and just standing back to ask if this makes sense?

Audit Committees play an important role. While they don't rely on the external audit - they rely on management and their own processes - they play an important role in supporting external audit quality, which is important in terms of market confidence in financial reports. In ASIC’s Information Sheet 196 Audit quality: The role of Directors and Audit Committees, we talk about Audit Committees making sure that they’re communicating with the auditors around risk areas, ensure they are focusing on the right things, applying the right experience, challenging things and applying professional skepticism. In a sense, what we're expecting of auditors to some extent, we're asking Audit Committees to challenge their auditors around the same things.

Last year there were some changes for the health insurance industry because of the unusual circumstances which have gone on longer than anticipated. Are you anticipating issuing any updated guidance in relation to the provisioning at 30 June because initially it wasn't expected there would still be this uncertainty 12 months later?

In the frequently asked questions on our website, about matters for the attention of Directors and auditors, we included a paragraph on private health insurance and deferred claims liabilities. We didn't want to rewrite accounting standards ahead of a new insurance standard, but under the specific circumstances of COVID-19 conditions, we had restrictions on non urgent / elective surgery. Policyholders had procedures deferred and would be expected to continue their insurance knowing that they could not make a claim until those procedures occurred, so liability should be taken up.

In recent weeks APRA put out a release to private health insurers in his area. That release highlighted ASIC view that it went beyond COVID-19 for restrictions on elective surgery and could include people voluntarily deferring procedures under COVID-19 as well. So we might make a minor tweak to our frequently asked question to include the voluntary part.