Abstract: Some financial statement items can’t be measured precisely and, instead, are based on management’s estimates. This article explains common estimates that appear on companies’ financial statements and how auditors help minimize the risk of error or misstatement related to accounting estimates. A sidebar highlights a recent SEC investigation of a company that allegedly hid its deteriorating financial performance by artificially inflating the fair value of a subsidiary.
Some financial statement items — such as cash, loans and rent expense — are relatively cut-and-dried. But others can’t be measured precisely. The use of judgment can sometimes lead to inadvertent errors or, worse, intentional misstatement. External audits can help minimize the risk of misstatement by evaluating the reasonableness of management’s estimates.
Where estimates show up
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,
- Recoverability provision against the carrying value of investments, and
- Costs arising out of litigation settlements and judgments.
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.
How auditors evaluate estimates
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 evaluate accounting estimates as part of their standard audit procedures. They may inquire about the underlying assumptions (or inputs) that were used to make estimates to determine 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, auditors try to recreate management’s estimate using the same assumptions (or their own). If an auditor’s estimate differs substantially from what’s reported on the financial statements, the auditor will ask management to explain the discrepancy. In some cases, an independent specialist may be called in to estimate complex items, such as fair value and impairment write-offs.
Auditors also may compare past estimates to what happened after the 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 significant differences are found, the auditor may be more skeptical of management’s estimates and conduct additional audit procedures.
Gray area in accounting
There are seldom “right” answers when calculating fair value, writing off bad debts and making other accounting estimates. Two well-informed people could analyze the situation and arrive at somewhat different conclusions. During an audit, the objectives are to evaluate whether the assumptions that underlie an accounting estimate are based on reliable market data and whether management’s analysis of that information results in a reasonable conclusion.
Don’t be surprised if your auditors ask questions related to your accounting estimates. And be prepared to provide additional documentation to support your conclusions for 2021. In today’s uncertain marketplace, accounting estimates may come under increased scrutiny from auditors.
Sidebar: SEC charges company with misstating fair value of subsidiary
The Securities and Exchange Commission (SEC) recently charged Medallion Financial Corp. and its president and chief operating officer (COO) with allegedly carrying out two fraud schemes from 2014 to 2017 to reverse the company’s falling stock price. One of the schemes involved the use of accounting estimates.
Medallion Financial made loans secured by medallions to taxi drivers. A taxi medallion (also known as a Certificate of Public Necessity and Convenience) is a transferable permit that allows a taxi driver to operate in the United States.
In 2014, Medallion Financial’s stock rose to an all-time high of $17 per share. But things changed dramatically by 2015 when ridesharing apps (such as Uber and Lyft) threatened the taxi industry, and the value of taxi medallions dropped significantly. Its stock price dropped to $3 per share, according to the SEC’s complaint filed with the U.S. District Court in the Southern District of New York on December 29, 2021.
As the company’s stock price fell, the president and COO allegedly pressured its valuation firm to inflate the fair value of Medallion Bank (a subsidiary based in New York). When the valuation firm refused to cave to his pressure, the president and COO hired a new expert to value the bank. The SEC’s complaint alleges that the new valuator (an investment bank) was lured with a quid pro quo offer: provide the requested valuation figure in exchange for much more lucrative investment banking work in the future.
The reported fair value of Medallion Bank was $166 million as of the second quarter of 2016. The estimate shot up to $193 million in the third quarter of 2016. Then, it rose to $280 million in the fourth quarter of 2016 and $290 million in the fourth quarter of 2017. Among other things, the SEC claims that Medallion Financial’s internal accounting controls weren’t properly designed to implement appropriate procedures that comply with the U.S. Generally Accepted Accounting Principles.
According to the complaint, the reported fair value for the bank was overstated by at least $110 million in 2016 and by at least $85 million in 2017. Moreover, the portfolios of medallion loans held by Medallion Financial were overvalued by more than $30 million in 2016 and by the same amount in 2017.
In an emailed statement, Medallion Financial announced plans to “vigorously defend against the SEC’s unfounded charges.” Moreover, the company emphasized that the activities in question occurred more than five years ago when short sellers deliberately tried to drive down the company’s stock price for their personal profit by spreading misinformation.
This case is currently ongoing. Although no wrongdoing has been proven, it illustrates how accounting estimates are a gray area in financial reporting that may come under scrutiny from external stakeholders. When making such estimates, the use of reliable market data and unbiased specialists is essential.
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