While there are always challenges in supporting management accounting estimates, this year may be especially difficult considering the economic volatility arising from the COVID-19 pandemic. Accounting estimates are derived from or are based on certain models and inputs using either a “retrospective” or “prospective” approach. The retrospective approach uses a model based on some period of historical data and essentially says that the best predictor of the future is history. The prospective model seeks to project out future financial performance and may also rely on some historical data. We all know 2020 was a unique year, and how your business performed over the past year may determine what historical data management uses under both approaches.
Examples: Historical Data to Support Accounting Estimate Models
If the business has been negatively impacted by the volatile economy, with inventory and receivables aging, a retrospective model that uses reserve percentages applied to “buckets” of receivables/inventory based on aging may generate higher allowances for doubtful accounts and obsolescence, respectively.
Similarly, a company using a prospective method, with a “stress” test to review how well the company projected the results of the current year, may suffer challenges as the economy was more volatile than many predicted.
What Action is Needed by Management?
Accounting Standards Codification (ASC) ASC 330-30-3 states that “normal capacity is the production expected to be achieved over a number of periods or seasons under normal circumstances,” and while this guidance is for inventory capitalization, we believe the concepts are the same for other areas. Thus, management may consider bifurcating different periods or products and consider weighing their impact differently. This may help determine which costs are considered “abnormal,” and/or are weighed differently.
Obviously, this is an area that contains a great deal of management judgement and we would expect management to try several different models and vary the weights and inputs, to test the models’ sensitivity to said inputs. Regardless of the model and inputs used, remember that under AU-C Section 540.A59, management needs to demonstrate a good reason for any changes in estimates and adequately support management's contention that there has been a change in circumstances that warrants such change. To put it bluntly, management cannot make the change because it results in a “better answer.”
For public companies, the Public Company Accounting Oversight Board’s (PCAOB) AS 2501, Auditing Accounting Estimates, Including Fair Value Measurements, is effective for audits of financial statements for fiscal years ending on or after Dec. 15, 2020. This standard does not prescribe detailed audit procedures like historical auditing standards but rather is risk-based and scalable. Of particular interest is the use of specialists in the formation of audit estimates. Enhanced coordination between auditors and company specialists will be important for companies, as auditors will be identifying potential risks associated with audit estimates contained in financial statements based upon this standard.
How DHG Can Help
DHG can work with a company’s management team to understand company-specific estimates and help create or refine models that support those estimates. DHG has deep industry experience and can assist in documenting the arguments and justification surrounding a change in circumstances.
For questions on this and other related topics, contact your DHG advisor or email@example.com.