7 tips for better client accounting estimates
Even though the stereotype of an accountant is someone who reconciles their bank account to the last penny, not everything we do is based on cold, hard, absolutely quantifiable numbers. On the cash basis, we need to be accurate, of course, but when we’re using GAAP and accrual basis accounting, there are many areas that call for estimates or judgment.
For example, we may have to make an estimate of an impairment loss for goodwill. Or, we may need to estimate the value of inventory items that will be sold at a loss. For cost accounting, we have to estimate a rate for overhead. The new revenue recognition standard, ASC 606, is full of situations where estimates are needed.
Sometimes, the difference between the exact number and an estimate is small enough that it doesn’t merit the extra time and effort needed to be precisely right. And, sometimes, an estimate is the best you can do.
One of my early projects as a CPA was to prepare a decade’s worth of tax returns for a deceased gentleman with a dozen or so rental properties. For some years, I found detailed ledgers of rental income and expenses, but for other years, I had only a jumble of receipts. To fill in the holes, I had to make a lot of estimates. The IRS accepted my work without any questions.
With all these estimates flying around, perhaps it’s not surprising that a 2017 briefing by the Public Company Accounting Oversight Board (PCAOB) – an organization tasked with overseeing audits of public companies – identified estimates as a continuing area of deficiencies in audits. On a global level, the International Forum of Independent Audit Regulators (IFIAR) found that 29% of all audit findings were related to estimates. According to the IFIAR report, “Most findings related to failure to assess the reasonableness of assumptions, including consideration of contrary or inconsistent evidence.
In response to those issues, both the PCAOB and the International Auditing and Assurance Standards Board (IAASB) recently released updates to their standards for auditing accounting estimates. The AICPA’s Auditing Standards Board has a project underway to update its own standard. A desire for convergence among the three organizations means that the three sets of standards will be similar.
So, if auditors – who devote considerable time to understanding the accounting standards – are having problems with auditing accounting estimates, how can we guide our clients so that they’re doing a credible job with estimates?
Here are seven tips to help your clients with estimates:
- Does the estimate appear reasonable? Is it realistic? Back in 1985, a realistic interest rate for a CD was 8%. Today, a CD will only earn about 3%. Beware of estimates that appear to be too optimistic or too pessimistic.
- Make sure there’s documentation that records the relevant facts and the reasoning surrounding the estimate. A comment on a spreadsheet cell, or a note on a workpaper takes just a few seconds, and will be invaluable when you or your client looks at that estimate months or years later.
- Do the assumptions underlying the estimate make sense? Are they consistent with other information? Are consistent assumptions being used across all parts of the business? For example, are sales forecasted to increase for one estimate, but forecasted to decrease for another estimate?
- Is the work being reviewed carefully? If one person is preparing a spreadsheet or other calculations for the estimate, is someone else checking to make sure the work is correct and that the formulas all work?
- Is there a process for regular reviews of estimates to see how they compare to actual amounts? Are large variances between past estimates and the actual numbers being investigated? This may be a sign that the method used for the estimate needs to be adjusted.
- Some estimates are best done by third-party specialists, such as actuaries or business valuation analysts. Does this third-party specialist have the right experience? Do they have a good reputation? Did they use appropriate models for their work? And, perhaps, more crucially, was the information provided to the specialist accurate?
- What could go wrong if the estimate is completely off? If there’s a lot riding on a particular estimate, it’s probably prudent to go with the most conservative number.
Developing estimates is part art and part science, and requires judgment to get numbers that are at least materially correct. Making sure your clients’ estimates are reasonable is another way we can help our clients!