Every waking day is a fusion of decisions, involving estimates and judgments. We start our day hitting the snooze button to get a few more minutes of sleep, giving in to our assumption that traffic will not be as heavy as usual. Unsurprisingly, as much as we wish that the trip would be smooth, it is not.
In the above scenario, it is common to miss out certain variables and even the basic factors (e.g., historical traffic flow, opening of classes, number coding, Uber or Grab surge – except holidays, which we surely mark heavily on our calendars). These (missed) variables and factors make life more complicated, test our patience at times, or drive us to make possibly poor judgments.
During heavy traffic, we throw snide remarks and pass judgments at unknowing drivers and pedestrians, whom we always assume to be on the wrong side of the road – literally. Even worse, our poor estimate of road traffic brings us to hurry or practice aggressive driving, increasing the risk of a road accident. Indeed, our daily grind is influenced by the estimates and judgments we make.
When played out in the accounting world, estimates and judgments are as important as actual cash flows and collected revenues. The unceasing “improvements” in accounting standards, coupled with new products and market volatility, are creating divergent paths and hence, traditional concepts and principles can also evolve into varying interpretations.
Additionally, these new accounting concepts and principles could easily result in inconsistencies, mainly arising from the absence of clear-cut definitions and too much subjectivity.
Finally, these accounting updates and changes became the pivotal point for estimates and judgments to take center stage and play a far more crucial role in making sure that financial statements are free from material misstatements.
Knowing the difference
The accounting landscape defines estimates as approximated amounts in the financial statements with no precise means of measurement, oftentimes requiring judgment to arrive at the final amount. On the other hand, due to the growing complexity of accounting standards and principles that offer a wide array of permissible solutions, judgment becomes crucial in selecting the more reasonable accounting estimate and acceptable conclusion.
The underlying difference is the use of management call in making the judgment. Estimates are anchored on assumptions and inputs based on historical data and future changes in the financial markets. Judgments go through the process of reasoning and evaluating information on why certain accounting positions were taken by the management. In a perfect accounting world, estimates and judgment should be free from biases. Fortunately, there is no such thing as 100 percent accuracy in making estimates and judgment. And to a certain degree, biases are allowed to creep in during the decision-making process. Make sure, though that these biases make complete and perfect business sense, and do not unduly benefit a certain financial user or group.
Sharpening the process
It is never easy to explain in simple English the assumptions and inputs used in calculating the estimates. It’s even more difficult to document the thought process on how an estimate and the final amount are made. With the expanse of bases to cover before coming up with a reasonable estimate and unbiased judgment backed by hard facts and business sense, a process is actually required.
PwC’s CFOdirect 2017 Point of View outlined one decision-making framework that included a five-step process. Here is the simplified version:
1. Understand the economics or the transaction
Fully understanding the transaction and related key terms at the onset is far more important than worrying about the accounting concept. Do thorough research, review documents and contracts, and collaborate with key management.
2. Understand the literature or the accounting standard and principles
After coming to terms with the facts and data gathered, consider the applicable accounting standards and interpretations. If none, consider similar transactions or precedents and evaluate its underlying principles. A word of caution: practice due care when applying interpretations and other available guidance. One can easily get entangled with subjectivity and biases.
3. Form a conclusion
Arriving at a conclusion should not only be putting two standards or concepts together. Always consider the legal impact and compliance with existing rules and regulations. Biases on certain accounting information that can swing a user’s decision should also be eliminated.
For your conclusion to stand on its own during scrutiny, a detailed documentation of the thought process should be made. This includes details of facts and circumstances, applicable accounting standards, alternative views considered, as well as information on key management involved in discussions.
Significant estimates and judgment should be provided with disclosures in the financial statements. More importantly, disclosures must be presented in a manner that a financial user can easily understand the accounting transaction. Be transparent.
There are definitely far more reliable checkpoints to guarantee reasonableness of estimates and judgment. The only invariable and of paramount importance that should not be taken away from the five-step process is integrating business sense and transparency for all financial users.
Coming to grips with the results
Cutting corners would not get one ahead of the curve but may spell trouble for the doer and his employer. As estimates and judgment do not offer 100 percent precision, the flexibility of arriving at the most acceptable and reasonable choice seems endless. However, narrowing the confines of a decision to certain assumptions without the benefit of facts and business sense will not make the cut. The same is true for passing judgments.
In either case, if you don’t want to be judged and be thrown under the bus, don’t pass a poor one.
Corina Molina is the assurance director of Isla Lipana & Co./PwC Philippines. Email your comments and questions to email@example.com. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.