Accounting Estimates and Fair Value Measurements
Accounting estimates are clouded in uncertainty and assumption. Accounting estimates are derived from the initial and continuing measurement/re-measurement of a transaction or event reflected in the financial statements. Broadly, accounting estimates also include fair value measurements, for example, intangible assets, investments and derivatives or in purchase price allocations in a business combination. Thus for this post, references to accounting estimates include fair value estimates. Accounting estimates include both subjective and objective information and are almost always subject to measurement uncertainty. Skilled auditors typically spend a significant amount of time reviewing controls and challenging calculations for accounting estimates, as the high level of subjectivity and management judgment are more subject to misstatement or disclosure errors.
Follow These Practical Tips
Auditing firms have spent significant time and resources in developing more and more robust auditing procedures over accounting estimates. The auditing guidance is still evolving as the Public Companies Accounting Oversight Board (PCAOB) has noted numerous audit deficiencies, at both large and small audit firms, over their auditing of accounting estimates. The PCAOB has focused on this area and distributed additional considerations for auditors to consider in auditing accounting estimates. The PCAOB is currently working on a single standard for auditors of accounting estimates as current auditing guidance is a bit fragmented with multiple standards that were issued at different points in time. This new standard may be issued in the fourth quarter of 2015.
If companies do not pay enough attention to their accounting estimates, the external audit can become a painful exercise for company resources and auditors alike. Here are six tips to avoiding this potential sinkhole.
- Identify all accounting estimates that are used or required. Communicate to all accounting personnel the need for proper preparation and robust support of accounting estimates, including disclosures. Develop a plan and stick to it.
- Give adequate time to address estimate complexities. Sometimes companies leave documentation of accounting estimates to the last moment. Being on top of the estimates process should provide comfort that management’s expectations are being met.
- Adequately document your internal accounting controls over all your estimate processes. For public company audits, it is particularly important to have robust documentation.
- Do not leave accountability for estimates, including assumptions, entirely to third party experts, such as a third party valuation firm. Management is responsible for making, recording and disclosing accounting estimates, including the determinations of fair value that are part of, or reflected in the financial statements. Management must exercise its judgment over significant value-driving assumptions based upon its knowledge of past and current events, and its assumptions about future conditions. Full and blissful reliance on third party accounting experts is not appropriate.
- Fully understand and support assumptions. Companies must “defend” their estimates versus their auditors or other interested parties. Fair value calculations can be particularly difficult, especially where “observable inputs” are lacking. Overly simplified or unsupported management assumptions and overzealous expectations/assumptions must be avoided. A clearly documented procedure on how management landed on their estimate potentially saves time and avoids possible major headaches down the road.
- Ensure that your company personnel possess the proper experience and knowledge to oversee and take responsibility for the accounting estimates process and results. Use consulting or expert advice, as appropriate, to supplement management’s overall responsibilities.
If companies fully recognize and develop appropriate responses to the complexities of accounting estimates, external audit and other problems can be neatly avoided. In order to help you prepare for your next audit, we have prepared this FREE Guide "4 Point Checklist - Improving Financial Reporting Controls and Documentation over Accounting Estimates" available by clicking the button below.
Sam H. Carr is the Managing Partner of Carrtegra, LLC. Sam has over 30 years of experience in accounting, auditing, financial management and consulting. Sam has focused much of his career on process improvement and redesign. Sam holds an MBA and is a CPA, CIA, CISA and a Certified Compliance and Ethics Professional (CCEP). Sam is a finance and operations executive with broad-based experience that includes 12 years as a CFO or Chief Accounting Officer in both public corporations and private entities, and fourteen years with an international public accounting firm. Sam orchestrated an Initial Public Offering of a consolidation of dental practices throughout the United States. In addition to his IPO experience, he owns a powerful track record of demonstrated skills in a wide range of business environments including designing financing, mergers and acquisitions and growth companies. Sam has been the Chief Executive of a management consulting firm for the most recent 10 years. Sam’s focus has been substantially on quality of services and valued solutions as well as client and employee retention.