Management judgments in financial statements

Kristiine Villemi Kristiine Villemi

Management estimates play a key part on preparation of financial reporting. It’s not something that can be delegated to the accountant.

Management estimates can have a significant bearing on a company's economic results, they are not precise or uniformly measurable in the manner of cash on hand. Although it is natural for some part of accounting estimates not to hold up, the management is obliged to provide such judgments to the best of its knowledge and if necessary, earlier estimates have to be changed. Changes in the estimates are recognized in the current period, not retroactively. It is important to keep in mind that accounting estimates cannot be delegated to accountants; this is the duty of the management. This article deals with some of the more common management estimates that the management of a company can find itself facing on balance sheet date.

Assessment of accounts receivable

On each balance sheet date, accounts receivable recognized in the balance sheet should be assessed as to whether they are likely to be collected. If there are any signs that indicate the value of the receivables has declined, the receivable must be written down to the present value of payments expected to be received in future. Allowances arising from the decline in value are recognized as an expense in the income statement:

Each company should establish principles for assessment of receivables and implement them consistently. The receivables may be assessed individually or by carrying out an age analysis. In a situation where the balance “accounts receivable” consists of a large number of low-value receivables, it is wiser to perform age analysis. For example, all receivables that are 6 months past due are 50% discounted.

It should not be forgotten that all of the receivables recognized in the balance sheet, including loan receivables, must be assessed. In assessing receivables, one should take into account the collection history from previous periods and not proceed from an unjustifiably optimistic assumption. If a payment schedule has been agreed on, the other party's compliance with the schedule must be verified. Merely the existence of a schedule or confirmed balance does not prove that the receivable is likely to be received. Additional collateral can increase certainty. In assessing receivables, one should not neglect to verify the other party’s financial capability.

Assessment of inventories

One goal of annual stock-taking is to identify illiquid inventories and inventory items that are unfit for use, which must be written off for the current period. ASBG 4 stipulates that the management must consider the need for write-down of inventories if the following circumstances exist:

  • inventories have been damaged or their physical condition has deteriorated;
  • the market value of similar inventory items has declined;
  • it has not proved possible to sell or use certain items over the longer term and there is doubt as to whether they could be realized during a reasonable time period.

Although many companies have made the stock-taking the accountant’s obligation, the management is in fact fully responsible for imposing uniform stock-taking rules, including principles pertaining to write-down. The principles of assessing inventories arise from the specifics of each company. For example, if socks consist of goods that have a specific expiration date, it’s important to work out a system where the expired goods are automatically written-down on a running basis based on the established principles. If the expiration of the goods cannot be determined by date, but the management, based on previous periods, has information about how rapidly the products lose their market value, it is possible to lay down the principles for write-down based on age analysis. Solid principles put in place by the management board simplify inventory checking procedure and ensure continuity of financial reporting.

Assessment of non-current assets

An assessment of the value of non-current assets must be performed on balance sheet date, and this is generally united with the year-end inventory check. Non-current assets that are unfit for use must be charged to expenses and a review performed as to whether the useful lives of non-current assets are still relevant. If it becomes evident that the actual useful lifespan of assets is significantly different from the initial estimate, the amortisation period has to be changed. The change in depreciation period is also a change in estimation and is recognized pursuant to ASBG 1 (Estonian Accounting Board guidelines) rules in the reporting period in which the change was made.

Assessment of investment property recognized at fair value

Pursuant to ASBG 6, investment property may be recognized at acquisition cost (i.e. investment property is depreciated on a current basis) or at fair value. If the accounting policy chosen is recognition at fair value, the management will decide whether reliable appraisal of the fair value of the investment property is possible with reasonable expenses and effort. To evaluate whether it can be appraised reliably at reasonable cost and effort, the monetary and time expense should be considered in the form of a ratio to the benefit received by doing so. The reliability of the appraisal should be considered as well, because the lower the reliability of the fair value appraisal, the lower the benefit received from the information for readers of the report. The expense and effort made to conduct the appraisal are thus less justified. It is also important who are the consumers of the report. In a company with one owner, the appraisal may not be justified but if there are many consumers of the report the appraisal of fair value is definitely more important.

The fair value of assets is the amount paid for the assets in the case of an ordinary market transaction. The best indicator of fair value is the present value of the asset on an active market. If actual market transactions cannot be used as a guide, the discounted cash flow method can be used. That means the present value of the future net cash flows generated by the asset are calculated. The greater the unreliability and indirectness of the method used, the more doubtful the reliability of the fair value, as a result of which the assistance of professional appraisers should generally be used to appraise fair value, unless the company itself has specialists with the corresponding qualifications. The final decision regarding the appraisal is, of course, always made by the management.

Testing the value of assets

Pursuant to the provisions of ASBG 5, an impairment test is carried out on each balance sheet date regarding assets or asset groups with regard to which there are possible signs of impairment of value. The same principle applies not only with regard to non-current assets (which in turn are divided into intangible and tangible non-current assets) but also with regard to investments recognized at acquisition cost. In the course of the test, the recoverable amount of an assets is found, which is the higher of the two indicators – fair value (less sales costs) and the asset’s value in use. Assets need to be written-down only if both the asset’s fair value and the asset’s value in use are lower than its carrying amount. The write-downs of assets are charged to expenses of the accounting period.

How to ascertain whether there are signs of impairment? One important indication could be if the company is operating at a loss. If assets have not brought in the budgeted revenue, this may constitute a situation where assets need to be written down. In accordance with ASBG 5, a poorer economic situation or market situation, deterioration of the physical condition of assets or discontinuation of some areas of operation may signal a possible impairment of an asset. It may be sufficient even if only one such condition is met.

Evaluation of the completeness of obligations

As to liabilities, the management should be sure to evaluate whether any provision has not been formed. ASBG 8 says that provisions should be formed on the balance sheet if:

  • companies have a present obligation (legal or constructive) as a result of a past event.
  • it is likely that the liability will be realized and
  • the amount of the liability can be reliably measured.

Most commonly provisions are formed with regard to a guarantee given to sold goods, bonuses not decided as of the balance sheet date, court disputes in progress, collateral provided to secure other persons’ obligations, harmful contracts, and provisions for layoffs and for environmental damage.

The management must also make certain that all off-balance-sheet liabilities are correctly disclosed in the notes to the financial statements.