There are few certainties in this world, particularly in the light of 2020. Even things in the sporting arena that would have seemed guaranteed, such as Liverpool FC never winning the Premier League, have come to pass.
In an ever-shifting landscape, the need for estimates and informed judgments in the accounting world is as important as ever. While the principles surrounding historical cost may be the easiest and most quantifiable, they are also not as relevant and current as many of the forward-facing principles, looking at items such as fair value or impairment. The principle of fair value or impairment is a contentious and judgmental area, but can underpin huge areas of a company’s financial statements.
Estimates and judgments will form key parts of financial statements, ranging from non-current assets to going concern. As companies look ahead to some of the most uncertain times many will have faced, the provision of information about these estimates and judgments to the users of statements is potentially more important than ever.
In October, the UK’s Financial Reporting Council (FRC) released its Annual Review of Corporate Reporting 2019/20. This examines how IFRS Standards are being applied in over 200 companies and offers a good overview of some of the major issues and common areas of weakness in the application of IFRS topics around the world. Yet again, as with the 2019 and 2018 annual reviews, the topic the FRC most frequently raises in the 2020 review is the application and disclosure of judgments and estimates.
The FRC notes that this year companies have improved their disclosures surrounding estimates and judgments, but there is still some way to go, particularly in relation to the detail provided by such disclosures. To explore what this means in a practical sense, we will look at the principles surrounding judgments and estimates relating to some of the key areas the FRC picks out.
The principle of fair value or impairment is a contentious and judgmental area, but can underpin huge areas of a company’s financial statements
Ten most frequently raised topics
1st Judgments and estimates
2nd Impairment of assets
4th Financial instruments
5th Alternative performance measures
6th Strategic report
=7th Statement of cashflows
=7th Provisions and contingencies
=9th Fair value measurement
=9th Business combinations
IAS 36, Impairment of Assets, is the second most frequently topic raised by the FRC, and judgments surrounding potential impairments are clearly going to be some of the most closely scrutinised in the current climate.
Some good principles for adequate disclosure around impairment reviews are as follows:
- Specific information should be given. Good disclosures regarding impairment reviews will identify and quantify specific assets that have been assessed, rather than give a generic overview that tangible or intangible assets are a source of estimation uncertainty.
- Assumptions made should be quantified. The value in use will be driven by the assessment of future cashflows associated with the entity. This is a significant prediction, and it is good practice for management to quantify the specific assumptions they have used in assessing these future cashflows.
- Sensitivity analysis should be provided. As with the quantification of assumptions, good disclosure will explain the sensitivity analysis that has been undertaken and will quantify the likely effect of changes in the assumptions made.
These three principles have been applied to issues relating to impairment, but can also be applied to other judgmental areas in the accounts that are not discussed here. This is particularly relevant in topics that may rely heavily on fair value measurements, such as accounting for pensions or share-based payment schemes.
The FRC notes that it made significant queries to entities over their expected credit loss provisions and disclosures to be made under IFRS 9, Financial Instruments. The three principles outlined above can also clearly be applied here. It is good practice to provide specific information about expected loss reviews.
The FRC notes in the 2020 review that the most common issues of poor practice relates to insufficient information about the recoverability of financial assets and a lack of quantification surrounding forward-looking economic scenarios.
A similar pattern arises under IAS 37, Provisions, Contingent Liabilities and Contingent Assets. The most common issue is a lack of sufficient information for users to understand the nature of provisions. As part of the annual review, the FRC also draws attention to the following changes in IFRS Standards that will affect the reporting of provisions and contingencies:
- IFRIC 23, Uncertainty over Income Tax Treatments (effective from 1 January 2019), which clarifies the recognition and measurement of tax when uncertainties exist
- Onerous contracts amendment to IAS 37 (effective from 1 January 2022), which identifies which costs should be considered when assessing whether a contract is onerous.
The discussion around estimates and uncertainties could go round and round forever. No one expects companies to make completely accurate predictions, particularly considering the events of 2020, but users are entitled to expect to see some good information underlying those estimates. If companies are continually challenged to do more of this, then it can only have a positive impact on the quality of financial reporting.