In today’s unprecedented market conditions, it can be challenging to predict metrics that underlie your company’s accounting estimates. Examples of key “unknowns” include how much longer certain pandemic issues will continue, how federal stimulus spending will affect the economy over the long run, and the extent to which tax laws and environment regulations may change under the Biden administration.
Your predictions on these matters could, in turn, have a material impact on your company’s financial statements. Inaccurate predictions could lead to restatements or write-offs in future periods.
Accounting estimates may be based on subjective or objective information (or both) and involve some level of measurement uncertainty. Some estimates may be easily determinable, but many are inherently subjective or complex. Examples of accounting estimates include allowances for doubtful accounts, work-in-progress inventory and uncertain tax positions.
Fair value measurements are another type of accounting estimate. Under U.S. Generally Accepted Accounting Principles (GAAP), a fair value measurement represents “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value is the basis for recording assets and liabilities in a business combination and measuring impairment of long-lived assets, goodwill and other intangible assets.
Accounting estimates involve a high degree of subjectivity and judgment and may be susceptible to misstatement. Therefore, they require more auditor focus.
Auditing standards generally provide three approaches for substantively testing accounting estimates and fair value measurements. During fieldwork, the auditor selects one or a combination of these approaches:
1. Testing management’s process. Auditors evaluate the reasonableness and consistency of management’s assumptions, as well as test whether the underlying data is complete, accurate and relevant.
2. Developing an independent estimate. Using management’s assumptions (or alternative assumptions), auditors come up with estimates to compare to what’s reported on the internally prepared financial statements.
3. Reviewing subsequent events or transactions. The reasonableness of estimates can be gauged by looking at events or transactions that happen after the balance sheet date but before the date of the auditor’s report.
Expect your auditors to give extra attention to your accounting estimates this year. They may ask more in-depth questions or perform additional testing procedures. Some items may require a different measurement technique than you’ve used in the past. Contact us before audit season begins for help making estimates, based on market research and the use of specialists, that will withstand scrutiny.