Oct 29, 2014
From the Audit Committee Institute
Over the past year, regulators have stepped-up their efforts on a number of fronts to ensure that significant accounting judgments and estimates applied by management—fair value estimates, impairments, revenue recognition, etc.—present a fair and accurate picture of the company’s financials. Typically, these estimates are subjective, require assumptions about matters that are highly uncertain, and can vary widely (a slight change in assumptions can have a big impact)—so the focus by regulators is not unexpected.
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The message from regulators is clear: Quality financial reporting requires a disciplined, robust, and unbiased process to develop accounting judgments and estimates. The PCAOB has announced a renewed focus on auditing significant accounting estimates, and expressed concern about the number and frequency of adverse inspection findings pertaining to estimates. The SEC continues to emphasize the importance of disclosures regarding critical accounting estimates, and its Division of Enforcement has formed the new Financial Reporting and Audit Task Force, which will use data analytics to analyze MD&As—a clear sign that the SEC will heighten its scrutiny in this area.
All of this points to the importance of having a robust audit committee discussion about management’s processes for establishing significant accounting judgments and estimates, as well as the audit committee’s related oversight processes. We recommend the following areas of focus:
- Understand management’s processes for establishing significant judgments and estimates. A disciplined, robust, and unbiased process for establishing key judgments and estimates—followed consistently—is an essential component of the company’s financial reporting process. What are the company’s key judgments and estimates and how are they developed? What are the key inputs? What models are used? Who is involved in the process—do we have the right skills and resources? To what extent are experts involved? Are controls around these processes adequate?
- Consider the audit committee’s process for evaluating significant judgments and estimates. Given the complexity of many financial reporting issues, including judgments and estimates, many audit committees periodically take a deep dive into a particular area most critical to their company.
- And, as a matter of routine—at least annually—audit committees evaluate the range of significant judgments and estimates that impact the company’s current financial statements. How? By challenging the assumptions that underlie the judgments and estimates. How have the assumptions been impacted by recent events and economic conditions? What is the range of potential impact on future financial results? Have we stress-tested the assumptions? Are the assumptions consistently applied? Were there any significant changes in accounting estimates or models used in making the estimates during the past year? If yes, why were the changes made and what impact did they have on the financials and the company’s compliance with regulatory requirements or loan covenants?
- Benchmark the company’s disclosures regarding critical accounting estimates against peers. The SEC has repeatedly stressed the importance of explanations regarding the company’s most critical judgments and estimates, and the likelihood that materially different amounts would be reported under different conditions or using different assumptions. Are the company’s critical accounting estimates consistent with others in the industry? Are they more or less aggressive? Do the company’s disclosures provide incrementally useful information, such as sensitivity data about the estimates, or are they boilerplate or redundant?
- Tap the external auditor’s resources and expertise across industries and segments to help put issues in context. Is the auditor satisfied with management’s resolution of important judgment issues relating to the financial statements and disclosures? In light of the PCAOB’s criticism regarding the sufficiency of audit procedures related to significant accounting estimates, has the auditor addressed the PCAOB’s concerns?
Finally, given the formidable challenges of making sound judgments in a business environment that is increasingly complex and uncertain, audit committees need to be sensitive to management biases and other common “judgment traps”. Indeed, many audit committee members continue to cite “groupthink” and the “rush to solve” as significant concerns, and express the need to hear more dissenting views.