As an audit group, our team considers the impact of accounting estimates based on management assessments, judgments and assumptions in a company’s financial statements.
If you have heard news about financial scandals, with some leading to the closure of companies and the suing of their CEOs and CFOs, you would realize that most of the misstated financial items resulted from fraud – or the intentional misstatements of balances – using the management’s estimates and judgments. Examples of these include using the longer estimated useful life of assets, which results in bigger-than-actual profits and overstated assets; capitalizing expenses when these should be expensed, resulting in overstated profits and assets; using wrong assumptions to show bigger recoverable amounts for an asset that should be impaired, again resulting in misstated profits and assets; and avoiding provisions for claims/liabilities that would understate expenses and liabilities, resulting in bigger profits.
How do we make a fair conclusion on the reasonableness of accounting estimates based on management estimates, assumptions and judgments? If material accounting estimates have a significant impact on the company’s financial statements, much information should be gathered, including understanding the process used in determining these estimates. We would consider in our audit the test of controls surrounding the determination of estimates. As auditors, we must practice professional skepticism and consider fraud in our audit.
Despite the above steps, some audits may still fail and may not be able to uncover the misstatements. Management plays an important role in making sure that the balances are free of material misstatements.
As an auditor, and I’m not making excuses here, it would be difficult to uncover misstatements if the management and the finance people connive in committing fraud and misstating financial statements. We do ask the management in every audit whether they are aware of fraud in their organization, or if they are comfortable with existing controls, and whether these controls are operating effectively to detect and even prevent fraud. The common answers that we get are: 1) fraud is not happening, 2) they are not aware of any fraudulent activities that will have significant financial impact, and 3) controls are operating effectively. If a material fraud has been committed even with these answers, the most likely true situation is that there is undisclosed fraud, and that controls, procedures and policies may have not been complied with or are not really operating effectively.
At the end of the day, we go back to the basics of good internal controls, which include the tone at the top management’s commitment to integrity and doing the right thing. Some of the questions to ask are the following:
How does management communicate its targets and objectives for the year?
Are there undue pressures created by reiterating the need to meet revenue and profit targets; are there key performance indicators (KPIs) that will translate to bonuses for both management and employees?
Does management equally emphasize the need to adhere to policies that will dictate accurate sales reporting: Did sales really occur? Were products delivered and accepted by customers? Can the company enforce collections?
Does management ensure completeness of expenses accrued in the books to show the proper amount of net profit for the year?
Are we compliant with tax rules and will we report the right amount of income for income tax purposes?
In all these, being able to hire and retain competent people with the right values is very important. A person’s character, values and attitude in the workplace are fundamental. These are as important as, or sometimes even more important than, someone’s technical skills. Why would an employee who is technically good choose to compromise a good job with a temporary gain? An example would be the story of an accounting clerk who created a fake company account and forged signatures to channel some of the company’s collections into his personal account. He is technically good in being able to hide such fraud for a long time, but not wise enough to realize that the time will come when this will be uncovered, and that this has only earned him temporary gain.
Isn’t this also true for those involved in big financial scandals? Would such cases ever happen if people had the right values, and if management had been very clear that doing the right thing is just as important as meeting revenue and profit targets?
Management estimates, assumptions and judgments can be reasonable but as disclosures in the financial statements go, “Estimates, assumptions and judgments are continually evaluated and are based on historical experience and other factors, including expectations of future events that are believed to be reasonable under circumstances. Management makes estimates, assumptions and judgments concerning the future. The resulting accounting estimates will seldom equal the related actual results and have a significant risk of causing a material adjustment in the company’s financial statements within the next financial years.”
Years of experience in doing the audit of a company; understanding the industry and the nature of the transactions; the auditor’s view and assessment of the company’s processes including controls; management commitment to controls – all these will provide the basis for a conclusion on the reasonableness of accounting estimates. While these are significant financial items, a more careful audit process will be necessary, with the expectation that the estimates will not materially be different when the actual amounts are determined.
Gina S. Detera is an assurance partner, corporate responsibility leader and accounting consulting services co-leader of Isla Lipana& Co./PwC Philippines. Email your comments and questions to firstname.lastname@example.org. This content is for general information purposes only, and should not be used as substitute for consultation with professional advisors.