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The Bruce Column — Judgements - application or estimation: the question remains

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13 Oct 2017

Regulators care about the difference between judgements that relate to applying accounting policies and judgements involving estimations. As Robert Bruce, our regular columnist reports, they are not the only ones.

It is often argued that the problem with economics is that it is neither an art nor a science. And when it comes to some areas of accounting and financial reporting the same dilemma becomes apparent. Quite what is the difference between judgement in determining what accounting policy applies to a transaction (and how to apply it) and what has been estimated in applying that policy?

Information about the key judgements and estimates provides very useful insights. It helps investors understand the choices and judgements management has had to make in preparing the financial statements.

It also allows investors to better assess the quality of the accounting policy decisions management makes and to identify those areas that rely on greater estimation. It enables people to think about what might happen and what may affect the outcomes being estimated. It throws light into a thought process that the blunt disclosure of a bald fact does not.

Application and estimation both involve judgement. For example, judgement may lead a company to choose fair value for an area of its business. And judgement is required to estimate that fair value.

To go back to the detail, the starting point here is IAS 1 on the presentation of financial statements. It lays down disclosure requirements surrounding the judgements management make in applying accounting policies and the assumptions and other sorts of estimation that underlie the amounts set out in the financial statements.

Policies provide the general shape of the financial statements. And IFRS provides management with certain choices when it comes to policies. Their selection shows how they see transactions. Once the accounting for a transaction has been selected, its consequences should be reasonably well understood. IAS 1 requires disclosure of the judgements that management has made in the process of applying the entity’s accounting policies that have the most significant effect on the amounts recognised in the financial statements.

On the other hand, estimates reflect the inherent uncertainties of the transaction and the associated amounts.   The uncertainties mean that the reported numbers could very well change in the near future as those uncertainties are resolved. IAS 1 requires 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.

It is the sort of thing that capital markets regulators focus on. They want detail. They don’t want a list of the policies or numbers that required the exercise of judgement, they want to know what was in the minds of management and how they exercised their judgement. They want detail of how both are produced, but not boiler-plate, unhelpful statements about estimates and uncertainties. When entities do the latter, the result is clutter.

But the importance of distinguishing judgements about policies from judgements about estimates is not only about disclosure. The accounting for each has a very different impact on the financial statements. When an entity changes its accounting policy it reshapes the current figures and the comparatives as if it had always applied the new policy. Some might say they are re-writing history. An accounting policy change generally changes the timing of income-expense recognition over the life of the asset, liability (contract) being accounted for, but not the cash flows. A change in estimate normally indicates that the timing or amount of future cash flows has changed. And it generally has an impact in profit or loss as it arises.

So it is important to make sure that estimation uncertainty is not treated as an accounting policy judgement with the consequences pushed back into the past.

The IASB has published an exposure draft seeking to provide more clarity over whether a change should be accounted for as a change in estimate vs a change in accounting policy. This may bring some science to the art of determining the kind of judgement an entity is dealing with. But to get guidance on clear and meaningful disclosure, one will have to see how the IASB progresses with the project on principles of disclosure.  

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