Although a company’s financial statements may appear to be straightforward and unquestionable, many factors come into play that may throw off the numbers. It’s important to make distinctions between your borrowers’ financial certainties and estimates based on management judgment. You need to be able to ascertain when errors, either intentional or unintentional, may occur — errors that can make a big difference in your borrower’s financial health.
Subjective or objective?
Accounting estimates may be based on subjective or objective information (or both) and involve a level of measurement uncertainty. Some estimates may be easily determinable, but many are inherently subjective or complex. Examples of accounting estimates include allowance for doubtful accounts, inventory obsolescence, warranty obligations, depreciation method or asset useful life, and recoverability provisions against the carrying amount of investments. Long-term contracts and costs arising out of litigation settlements and judgments are also subject to uncertainty.
Fair value measurements are another type of accounting estimate. They’re used to report:
- Share-based payments,
- Goodwill and other intangible assets acquired in business combinations,
- Impairments of long-lived assets, and
- Valuations of financial and nonfinancial assets.
Accounting estimates and fair value measurements often involve a high degree of subjectivity and may be susceptible to misstatement. Therefore, lenders may want to give them more attention when reviewing year-end financial statements.
What are the assumptions?
Managers are champions of a company’s products and strategies and, therefore, may have unrealistic expectations. Understandably, they also don’t want to prematurely worry stakeholders about temporary downturns that they expect to overcome. So, their accounting estimates sometimes paint a rosier picture than reality.
External auditors test accounting estimates as part of their standard audit procedures. But when reviewing unaudited statements, lenders can play devil’s advocate by questioning the reasonableness and consistency of management’s estimates.
To do so, ask your borrowers about the underlying assumptions (or inputs) that were used to make estimates. Evaluate whether the inputs seem complete, accurate and relevant. Estimates based on objective inputs, such as published interest rates or percentages observed in previous reporting periods, are generally less susceptible to bias than those based on speculative, unobservable inputs. This is especially true if management lacks experience making similar estimates in the past.
Whenever possible, try to re-create management’s estimates using the same assumptions (or your own). If your estimates differ substantially from what’s reported on the financial statements, ask the borrower to explain the discrepancy.
You can also compare past estimates to what happened after a financial statement date. The outcome of an estimate is often different from management’s preliminary estimate. Possible explanations include errors, unforeseeable subsequent events and management bias. If management’s estimates are consistently similar to what occurred later, it demonstrates that management makes reliable estimates. But if they aren’t, you may lose confidence in them.
What is the basis?
It’s not necessarily bad for management to make financial estimates about aspects of their financial operations. In fact, it’s inevitably necessary in some instances. The key is to determine whether the estimates are well founded and based on assumptions that hold up over time. While outside auditors and specialists can help, it’s wise for lenders to understand the ins and outs to be able to accurately evaluate, and provide input on, their borrowers’ financial situations.