No matter which might be the jurisdiction or prevailing accounting standard, the way to bet is that a consolidated financial statement will include certain amounts based on management’s best estimates. As such they are judgmental.
Hypotheses and estimates derived from partly objective and partly subjective information, are used in determining items like:
● Provisions for sales discounts and returns
● Amounts recorded for contingencies
● Depreciable and amortizable wares
● Recoverability of inventories produced in preparation for product launches
● Guesstimates on environmental liabilities
● Assumptions about pension and other post-retirement benefits
● Taxes to be paid on income.
Because of uncertainty inherent in such estimates, actual results may differ, sometimes significantly, from projections being made. In section 5, this differ- ence has been characterized as being the cost of forecasts – a notion that applies widely. Notice that variations in accounting estimates can have a potentially sig- nificant impact on financial statements.
Take as an example revenue recognition. Revenues from sales of products are typically recognized when title and risk of loss passes to the customer. But there are exceptions. For instance, in the United States revenues for domestic phar- maceutical sales are recognized at time of shipment, while for many foreign sub- sidiaries revenues are recognized at time of delivery.
Recognition of revenue requires reasonable assurance of collection of sales pro- ceeds, and completion of all obligations. Domestically, sales discounts are issued to customers directly at point of sale or indirectly through an intermediary whole- sale purchaser. Revenues are recorded net of provisions for sales discounts and returns, which are established at time of sale. This is a fairly objective procedure.
More subjective issues arise in connection to the provision for aggregate indirect customer discounts, which covers chargebacks and rebates. Chargebacks are dis- counts that occur when a contracted customer purchases directly through an inter- mediary wholesale purchaser. The intermediary, however, as an independent entity may apply its own discount policy – to all clients, or only to those in its priority list.
Unrecognized net loss amounts reflect experience differentials primarily relating to differences between expected and actual returns, as well as the effects of changes in actuarial assumptions – which are mostly judgmental. Expected returns are based on calculated market-related value of assets. US GAAP requires that gains and losses resulting from actual returns that differ from the company’s expected returns must be recognized in the market value of assets. Other juris- dictions follow different rules.
One of the major judgmental issues is the valuation of intangible assets. These consist primarily of client lists. Under SFAS 142, US GAAP, intangible assets which have finite lives continue to be amortized over their estimated useful lives and are subject to impairment testing under the provisions of SFAS 144
‘Accounting for the Impairment or Disposal of Long-Lived Assets’. The latter requires that intangible assets other than goodwill be tested for impairment whenever events or changes in circumstances indicate that the company’s carry- ing amount may not be recoverable. In these cases, senior management must assess whether future cash flows related to the asset will be greater than its car- rying value at the time of the test. Accordingly, the process of evaluating a poten- tial impairment is based on estimates and it is subjective.
● Sound accounting principles require that the measurements being made are objective and dependable
● But market values change rapidly and some of the factors included in met- rics are qualitative, therefore judgmental.
This should always be kept in mind when comparing accounting systems.
Within the context of this reference, an important part of a sound financial reporting procedure is the proper definition of significant financial events.
Well-managed banks analyse their performance on a reported basis determined in accordance with prevailing regulatory directives, accounting standards, and a nor- malized basis which excludes from the reported amounts certain items termed sig- nificant financial events. A rigorous policy sees to it that management uses figures adjusted for significant financial events based on underlying operational perform- ance of their business, insulated from the impact of one-off gains or losses such as:
● Non-recurring items
● Event-specific issues in a market sense
● Industry-specific material items
● Company-specific, but not industry-wide specific issues.
Examples of issues treated as significant financial events include the gain or loss on the sale of a major subsidiary, and restructuring costs associated with a major acquisition or downsizing. Notice that significant financial events are not a rec- ognized accounting concept under US GAAP, and many other national financial reporting rules. When this is the case, they must be handled with care, within available guidelines and in accordance with compliance rules.
It is always a sound policy to clearly identify all adjusted figures as such, properly disclosing both the pre-tax amount of each individual significant financial event and the net tax benefit (or loss) associated with each significant financial event in each period. In regulatory financial reporting business risk is typically reflected into the accounts only through its effect on profit and loss. To the contrary, in man- agement reporting business risk must be shown as the result of either:
● The company’s own action or inactions, or
● Competitive forces that need to be properly identified.
For instance, financial institutions face intense competition in all aspects of their business from asset managers, retail banks, other commercial banks, investment banks, brokerages and other investment services firms. The management accounting report should clearly show lost revenue by class of competitors and, sometimes, individual competitor firm.
Attention should also be paid to the fall-out from trends in the industry. For instance, the trend toward consolidation in the global financial services industry is creating competitors with:
● Broader range of products and services
● Increased access to capital, and
● Greater pricing power than classical banks.
At the same time, all companies are faced with operational risks. These are largely dependent on their ability to process a large number of transactions, appeal to diverse markets, trade in different currencies, and be the subject of many largely incompatible legal and regulatory requirements. As a result, any weaknesses in their systems and procedures can have a negative impact on the results of their operations, which will show up in their financial reporting – and it should be explained through facts and figures in management accounting.