Predicting the metrics that underlie your company’s accounting estimates can be a challenge, especially in today’s unprecedented market conditions. There are several important “unknowns,” including how much longer certain issues involving the COVID-19 pandemic will continue, how the economy will be affected by federal stimulus spending over the long term, and to what extent tax laws and environmental regulations will change under the Biden administration.
Inaccurate predictions on these issues may have a serious impact on your company’s financial statements, and in future periods it could lead to restatements or write-offs.
Common accounting estimates
Both subjective and objective data (or a mix of both) may be used to arrive at accounting estimates, and there is always some level of measurement uncertainty involved. And while some estimates are easily determinable, many others are inherently complex or subjective. Allowances for doubtful accounts, uncertain tax positions, and work-in-progress inventory are a few good examples of accounting estimates.
Another important type of accounting estimate is the fair value measurement. A fair value measurement estimates “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” under U.S. Generally Accepted Accounting Principles (GAAP). In business combinations, fair value is used as the basis for recording assets and liabilities. Fair value is also used to measure impairment of goodwill, long-lived assets, and other intangible assets.
Testing estimates through auditing
Because they require a high degree of subjectivity and judgment, accounting estimates can be susceptible to misstatement and require more focus from auditors.
Generally speaking, auditing standards provide three basic methods for substantively testing accounting and fair value measurements. Auditors will typically select one of these approaches (or a combination of them) during fieldwork.
Method one: testing the process used by management
In this approach, the reasonableness and consistency of management’s assumptions is evaluated and auditors test to see if the underlying data is complete, relevant, and accurate.
Method two: creating an independent estimate
When this method is chosen, auditors use management’s assumptions or a set of alternative assumptions to arrive at their own estimates, then compare these estimates to what’s reported on internally prepared financial statements.
Method three: evaluating subsequent events and transactions
Finally, auditors may guage the reasonableness of estimates by examining events or transactions that happen before the date of the auditor’s report but after the balance sheet date.
Contact us for help
With all of the uncertainty this year, it’s likely that your auditors will pay extra attention to your accounting estimates. They may perform additional testing procedures or ask more detailed questions, for example. In addition, different measurement techniques may need to be used for some items. If you need help in making estimates that will withstand scrutiny and are based on market research and the use of specialists, we can help. Contact us before audit season begins.