In preparing financial statements, management must make several estimates. These range from depreciation estimations to impairment estimations. However, estimates prove to be one of the contentious areas between external auditors and management. There are a lot of misconceptions that management has about estimates. This short article seeks to clarify some of them.
Some managers think that estimates should be made by the auditors when they come for audit. We had one finance manager in a client company who chose not to compute annual depreciation. His reason was that since the auditors were going to change his computed depreciation, then there was no point in him computing it. On the other extreme, some managers think that their estimates are beyond any questioning. They think that no one external to their business should ever ask a question. Some managers think that a thumb sucked figure is good for an estimate. When auditors question the fairness of the estimate, they get emotional. Our experience shows that emotions can be avoided if there is clarity, and the estimation is done properly.
First it is important for management to realize that they have the obligation of estimating. They should own the estimates and confidently stand by them. The auditors must not estimate anything on behalf of management. Here is the problem, if auditors were to make estimates, who stands to check on their work? If auditors were to make a mistake in the estimation, how would it be picked? Besides, auditors may not have the detailed understanding of the matter subject to estimation at the same level as management. So having auditors to do management’s work in coming up with an estimate that is likely to be wrong and should be avoided.
In most cases management is made up of qualified accountants who have considerable experience. Regardless of that, management still asks how estimates are done. The accountants within the company should refer to the Financial Reporting Standards, seek guidance and work out all the estimates properly. There should be no excuse whatsoever. It does not matter that auditor will seek to adjust the estimate in one way or the other. In fact, management should take due care in the estimation and produce robust output that they can stand by and defend from the criticism of outsiders such as auditors and investors. The main reason why auditors seek adjustments is because the estimates would not have been done with due care. The starting point is usually failure to follow the requirements of the International Financial Reporting Standards (IFRS). One may not blame the auditors for this. Assumptions that go into estimation need to be plausible and judgements made should be sound. This may require multi-level reviews within the company during the process of estimating.
Once done by management, estimates will face a barrage of incisive questions from the auditors and the investors. That is just the name of the game. Auditors will want to understand the estimate, the reasonableness of assumptions and judgements made, and the accuracy of the input data used. Auditors will challenge all aspects of the estimate. Where enough work has not been done by management in coming up with the estimate, it will easily collapse and be condemned. This may not go down well with management, but it is important that they understand that it is necessary for the auditors to provide such challenge and criticism. If anything, it enhances the quality of the estimate.
Estimation is not a thumb sucking exercise. It is a disciplined and logical process that management should embark on. Management needs to demonstrate this process to the auditors, and this makes life easy for both parties. Trouble comes when management cannot demonstrate this logical process that leads to a figure or a range of figures. Things get easy when management proactively document this process. The documentation may clearly show what management tries to achieve, the methods used and why, the assumptions made and their rationale, judgements made and their justification, source of input data and its reliability, the necessary computations and triangulation tests done. In this way auditors will find it easy to review and offer any correction or adjustment suggestion. They may ask some further questions but surely if a thorough thought process has gone into the estimation, it should stand any challenge.
Our experience shows that management does not take estimates seriously enough. Yet to auditors, estimates are a high-risk area of the audit. Rightly so, estimates may cause material misstatement of financial statements if they are not correct. This can be a result of fraudulent financial reporting or honest error or lack of rigor on the part of management in the estimation process. Even more important to management, if they are done properly, the financial information will be useful for decision making. In one company, management never bothered to estimate stock obsolescence. When auditors came at year end, they proposed audit adjustments that almost wiped away the whole profit. Had these estimates been done properly during the year, appropriate measures would have been taken to manage the company’s stock levels.
Given the sensitivity and importance of estimates in the financial statements, management needs to take ownership and pay sufficient attention to the estimation process. They should proactively document the process. Management should also expect their estimates to be questioned and criticized by the auditors. They are not sacred cows, and they should be ready for criticism. There is no need for emotions in a process which should be logical.