FINANCIAL REPORTING AND IR

There are certain areas of accounting and financial reporting that are relatively straightforward. For example, determining the amount of cash in the bank or recording a payable owed to a vendor typically should not involve significant complexity.

On the other hand, determining the fair value of an asset or whether one company ‘controls’ another requires an assessment of the facts and circumstances, the use of observable and possibly unobservable information and, ultimately, that management make decisions in the face of uncertainty. In a complex organization, accountants are inevitably forced to make numerous judgments and estimates when preparing a company’s financial statements. 

The difference between a judgment and an estimate

While both are required when preparing a company’s financial statements, many judgments have related estimates. For example, is there a trigger to test for impairment? (That is a judgment). And how much is the asset impaired? (That’s an estimate). Similarly, management generally is required to apply ‘judgment’ in making an estimate.

In the accounting standards, both are considered relevant for disclosure to investors. International Financial Reporting Standards (IFRS) requires separate disclosure of both (i) estimates; and (ii) those judgments that do not involve estimations. 

IFRS requires the disclosure of judgments, apart from those involving estimations, that have been made in the process of applying the company’s accounting policies and have the most significant effect on the amounts recognized in the financial statements. Judgments often relate to a choice between two or more alternatives in the application of an accounting policy to specific facts and circumstances. Examples of judgments include:

• whether or not a company has control of another company and therefore should consolidate it;
• whether or not substantially all the risks and rewards of ownership of an asset have transferred to another party such that it has been ‘sold’; and
• whether or not there is sufficient evidence that a company with a history of losses should recognize a deferred tax asset (the measurement of the deferred tax asset is subject to estimation).

IFRS also requires disclosure about assumptions underlying management estimates that may result in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. For example, estimates often include assumptions about the future, including:

• the future selling prices used in estimating the net realizable value of inventory;
• the assumptions on which cash flow forecasts, growth rates, discount rates, etc. are based in the estimate of an asset impairment; and
• the assumptions made in forecasting future taxable profits to determine the amount of deferred tax assets it is appropriate to recognize.

Importance of judgments and estimates

The judgments and estimates required to be made by management can affect the financial performance or position that is reported to investors – often in a material way.

Disclosure of the most important judgments enables users of financial statements to better understand how significant accounting policies are applied and enables comparisons between companies regarding the basis on which management makes these judgments. The disclosure of information about the assumptions that have the most significant effect on those estimates enhances the relevance, reliability and understandability of the information reported in financial statements.

The perspective of regulators and investors

Given the significant impact judgments and estimates have on the financial performance and financial position of a company, regulators are keeping a close eye on the quality of disclosures companies are making.

In the recent OSC Staff Notice 52-723[i], the OSC Office of the Chief Accountant noted that disclosures related to fair value have been a recent area of focus. A Staff review determined that the quality of disclosures varied, with some reporting issuers providing less company-specific information than others – and the use of boilerplate or vague disclosure is not meeting the Staff’s expectations. Rather than simply complying with minimum disclosure requirements, the Staff encourages companies to view these disclosures as another opportunity to communicate relevant information to investors.

This sentiment is echoed by investors who, when polled[ii], say they expect entity-specific insight into the judgments and estimates made by management. These include sensitivity of balances and earnings stemming from elements of estimation and judgment.

Taking a fresh look at disclosures

As the year-end reporting cycle winds down and annual general meetings are held, companies may consider taking a fresh look at their disclosures relating to estimates and judgments.

One approach to start this process is to read a paragraph or section from the year-end financial statements relating to a significant judgment or estimate. Consider whether, when reading the section in isolation, an investor is given company specific facts and information, or if the paragraph could describe any company in the industry. While everyone in the industry makes similar judgments and estimates, it is the unique facts, circumstances, process and inputs used by the company that investors and regulators are seeking.

Andy Brown, CPA, CA is a Senior Manager, and Rob Brouwer, FCPA, CPA is Canadian Managing Partner, Clients and Markets, for KPMG LLP in Canada.