Using accounting estimates

Some financial statement items cannot be measured precisely but can only be estimated. This is called an accounting estimate.

These accounting estimates come in all shapes and sizes and the overarching goal can vary between forecasting the outcome of an event to estimating the fair value of a financial statement item. Examples of accounting estimates include:

Provisions for irrecoverable debts;
Assessing the valuation of tangible fixed assets based on market information; and
Estimating the costs arising from litigation or claim settlements.

IFRS requires management to base their estimates on information that best reflects the entity’s circumstances prevailing at the date of the estimation. However, the availability and reliability of information used to support an accounting estimate can vary widely which gives rise to estimation uncertainty. It is those estimates that include a significant level of estimation uncertainty that pose the greatest risk of material misstatement that fall into the scope of IAS 1 and require attention.

Estimate vs judgement

Estimates and judgements are key drivers of the amounts recognised in the financial statements.

IAS 1.122 requires the disclosure of judgements made by management in applying the accounting policies of the entity, such as whether to consolidate an investee company.

In terms of accounting estimates, IAS 1.125 requires the disclosure of information about the assumptions the entity makes about the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year.

Auditing accounting estimates

As auditors, we must investigate whether an accounting estimate gives rise to a material misstatement, which could be a result of the incorrect application of an estimation method, poor data or management bias.

Under the requirements of ISA 540, auditors will consider the following when assessing whether accounting estimates are reasonable:

The method, including where applicable the model, used in making the accounting estimate;
Relevant controls;
Whether management has used an expert;
The assumptions underlying the accounting estimates;
Whether there has been or ought to have been a change from the prior period in the methods for making the accounting estimates, and if so, why; and
Whether and, if so, how management has assessed the effect of estimation uncertainty.

We will also cross-check the outcome of the above to the disclosures made in the financial statements to ensure the disclosure of the accounting estimate is in line with the requirements of the relevant financial reporting standard and includes the necessary level of detail to the user of the financial statements.

Disclosure requirements

IAS 1 requires entities to make detailed disclosures which describe the accounting estimates that have the most significant effect on amounts recognised in the financial statements. As mentioned above, entities should distinguish between estimation uncertainty and judgements first and foremost.

The key to disclosing accounting estimates is the use of company-specific detail that pinpoints the areas of estimation uncertainty and provides useful information to the user of the financial statements. The FRC specifically dissuades from the use of boilerplate language in its Corporate Reporting Thematic Review of November 2017.

Entities should disclose information about the assumptions which the entity makes about the future, as well as other major sources of estimation uncertainty. In particular, the assumptions and other sources of estimation uncertainty disclosed that will relate to estimates that require management’s most difficult, subjective or complex judgements.

Disclosure requirements in accordance with IAS 1.129 include (where relevant):

The assumptions used and any quantification of such assumptions;
The method of estimation used, including any applicable model;
The expected resolution of an uncertainty and the range of reasonably possible;
Outcomes within the next financial year in respect of the carrying amounts of the;
Assets and liabilities affected; the sensitivity of the carrying amounts to the methods, assumptions and estimates, underlying their calculation, including the reasons for the sensitivity.

Example of a good disclosure

Impairment of non-current assets

Impairment reviews for non-current assets are carried out at each balance sheet date in accordance with IAS 36, Impairment of Assets. Reported losses in the Beef and Grain divisions were considered to be indications of impairment and a formal impairment review was undertaken.

The impairment reviews are sensitive to various assumptions, including the expected sales forecasts, cost assumptions, capital requirements, and discount rates among others. The forecasts of future cash flows were derived from the operational plans in place to address the requirement to increase both volumes and margins across the two divisions.

Real commodity prices were assumed to remain constant at current levels.

Discount rate: Current central bank prime MIMO benchmark rate is 15% and with inflation at around 3.5%, the benchmark real interest rate is around 11.5%. The real rate assumed in these forecasts is 12.5%, consistent with prior years.

Current nominal bank borrowing rates are 19%, but these are expected to fall further as the economy returns to growth and inflation remains stable. The Beef division is not sensitive to an increase in the discount rate to 15.5%.

Grain division: The forecasts for the Grain division show a return towards the 10-year moving average with meal sales increasing to 27,000 tonnes in FY-20 (Year ending 31 March 2019: 16,791). A shortfall in the projected volumes of 10% or a reduction in the gross margin of more than 20% would lead to an indication of impairment.

Beef division: The forecasts for the Beef division show volumes of all meat products improving to 1,600 tonnes in FY-20 (Year ending 31 March 2019: 1,260 tonnes) and to 1,800 tonnes in FY-21. A fall in forecasted sales volumes of 3% or a reduction in budgeted gross margin of 3% would be required to trigger the need for a further impairment. The assets of the Beef division were impaired by $ 3.1m in the year ended 31 May 2016 following the decision to destock the ranches. The Board continues to evaluate the development of these assets, however it is too early to consider whether or not the previous impairment charge should be reversed.

No impairments were recorded in the year ended 31 March 2019 or the year ended 31 March 2018.

Source: Agriterra Limited annual report, year ended 31 March 2019.

Example of a bad disclosure

Impairment reviews for non-current assets are conducted at each balance sheet date. Reported losses in the Beef and Grain divisions were considered indications of impairment and a formal impairment review was undertaken. The assets of the Beef division were impaired by £3.1m in the year ended 31 May 2020.