Article

The Increased Complexity of Accounting Estimates in Today’s Economic Environment

March 11, 2024

This is part 2 of 3 in a series on “The risks associated with accounting estimates”.

The current economic environment reduces transparency and increases risks

There is a considerable volume of accounting standards and guidelines. However, such standards are not, and cannot be, prescriptive to each and every industry, type of transaction, or contractual term or condition. They are in many instances principles based, providing accountants and others a framework under which transactions are recorded and financial statements are prepared.

Estimates and judgements are essential components of financial accounting and reporting. They span across every company. Estimates cannot be avoided. However, some areas and industries can be more complex than others. One complex example would be a financial services company estimating the fair value of a Level 3 asset – most illiquid assets that are infrequently traded render it difficult to provide a reliable and accurate market price. On the other hand, a widget manufacturer with minimal components may have a less complex issue estimating the value of its inventory.

The estimation process

As stated in Part I, developing an accounting estimate includes both:

selecting a measurement technique (estimation or valuation technique); and
choosing the inputs to be used when applying the chosen measurement technique.

Estimates are therefore based upon assumptions that are derived from a combination of prior history, current circumstances, future obligations, and likelihood of future events occurring. Estimates also utilize numerous data sources internally across the business and externally. These form inputs that are fed into a model, or technique, that will determine or calculate the estimate.

"Estimates are complex and will inevitably be incorrect. They are also prone to manipulation."

For these reasons, estimates are complex and will inevitably be incorrect. They are also prone to manipulation, if a company is so inclined, in order to achieve a corporate or personal objective. Given they are subjective, a bad actor may manipulate data, utilize alternative sources, or knowingly misrepresent factors to justify a particular input or overall estimate.

In periods of uncertainty, the complexity of developing accounting estimates increases significantly, and so does the opportunity for further manipulation.

Increased risk areas

There are numerous risks associated with a company making changes to historical practices for computing estimates. We provide below a couple of examples that illustrate the questions that a company may need to legitimately consider when developing an estimate, highlighting the uncertainty that this creates, and the opportunity for wrongdoers to manipulate the outcome to their benefit.

Impairment triggers and calculations

With uncertainty in the economy, certain businesses may experience financial decline. Under US GAAP and IFRS, this may in turn trigger companies to consider whether assets may be impaired. An asset is considered impaired when its market value is less than its value recorded on the balance sheet.

Market value is frequently estimated through a discounted cash flow method, where expected future cash flows to be generated by the asset are discounted to present value using an appropriate discount rate. In an unstable market the following areas can be challenging to navigate:

How do you estimate future revenues if historical trends are not indicative of the current market? When will sales ‘return to normal’?
With rates of inflation significantly higher in the past three years than the prior two decades, how will costs be estimated? When will inflation decrease and reduce cost increases input to the model?
Will the recent extended credit terms taken by customers continue to impact my cash flows?
Will interest rates decease, and if so when, impacting my financing costs and/or discount rate?

Given the uncertainty associated with answering such questions, impairment analyses may be open to manipulation.

Warranty Expense

Warranty expense is the cost that a business expects to or has already incurred for the repair or replacement of goods sold. Warranty expense is recognized in the same period as the sale if it is probable that an expense will be incurred, and the company can estimate the amount of such expense.

Typically, a company would estimate the obligation by looking at the historical percentage of warranty expense to sales for the same types of goods. This percentage would be applied to the sales for the current accounting period to derive the warranty expense to be accrued. However, with the recent increase in labor costs, and inflation and supply chain issues impacting material costs, companies might ask:

Would historical percentages of warranty claims be representative of what is expected in the future?
What adjustments might the company make to account for such increased costs or changes? For example, is a shorter time period more appropriate?
Should the company recompute a revised historical warranty percentage using today’s cost structure?
What impact does my increased sales price, and therefore, revenue have on the warranty claim percentage?

Any changes to the inputs to the estimation model, or the technique/model itself leaves it open to manipulation.

Motives to manipulate estimates

The economic environment at present and over the past few years has increased the uncertainty surrounding accounting estimates. Companies will be required to make amendments to their historical techniques and inputs to account for changes to their business, customers and operations.

When senior management and audit committees consider such changes, they should be skeptical and consider the questions we posed in Part 1 of this series of articles. They should also consider the potential motives for someone engaging in the manipulation of estimates. These may include:

Do changes in the estimate, or estimates, permit the company to achieve its EPS targets?
Do the results trigger certain management compensation agreements?
Do the changes enable the business to comply with bank covenants or other financing obligations?

Senior management and audit committees should also ask:

What would the estimate have been applying the historical approach / inputs?
Do the changes in estimates all result in increased earnings to the business? (i.e., are they all ‘beneficial’ to the business)?
Have other scenarios been run and if so, what was the outcome of such scenarios? What weighting was applied if multiple scenarios were run?
Are estimates developed by the accounting functions consistent with what is being observed / experienced in other parts of the business?

Read the full series