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Free Sample Essay on Estimates and Accounting Policy Judgement

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Estimates and Accounting Policy Judgement

Free Sample Essay on Estimates and Accounting Policy Judgement The Australian Securities & Investments Commission in their review of 2011 financial reports unearth that listed entities in their reporting did not follow or meet expectations of the Australian Accounting Standard Board (AASB) requirement. According to ASIC (2012), the most affected accounting policies that did not meet full disclosure were standards concerned with performance and uncertain economic conditions and useful information for investors. Standards that deal with performance and uncertain economic condition and were not fully disclosed by reporting entities include revenue recognition, expense deferral and other comprehensive income, asset values, off- balance sheet arrangement and going concern. The standards that help disclose useful information to investors and did not meet disclosure requirement include non-IFRS financial information disclosures, operating and financial review, current versus non-current classifications, estimates and accounting policy judgements and financial instruments.

The commission was concerned with non-compliance of estimates and accounting policy judgements. The commission in their investigation observed that some entities did not make material disclosures of sources of estimation uncertainty and significant judgements in applying accounting policies . According to ASIC (2012), non compliance with estimates and accounting policies leads to material misstatement of economic value of transactions of the firm, and therefore, it is important for firms to fully comply with disclosure requirements of the policy to allow users of financial statements evaluate financial performance and position of a reporting entity with all relevant and necessary financial information. The Board of Wesfarmers Limited is concerned about the company’s reputational standing in the market if ASIC found any deviations from AASB requirements in this matter. The Board, therefore, sought review of the relevant disclosures in the company’s annual report undertaken as recommended by ASIC. This business research report seeks to review Wesfarmer Limited’s compliance of estimates and accounting policies to the requirements set by the Australian Accounting Standards Boards in order to meet Australian Securities and Investment Commission guidelines.

Critical Accounting Judgement and Sources of Estimation  Uncertainty

The AASB 101 Accounting Policies, Changes in Accounting Estimates and Errors is the accounting policy standard that outlines how a reporting entity should deal with estimation uncertainty. According to ASIC (2012) the disclosure standard, in part  requires that

“An entity shall disclose information about the assumptions it 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. In respect of those assets and liabilities, the notes shall include details of: a) their nature and b) their carrying amount as at the end of the reporting period. ”

According to Deloitte (2010), disclosure standards require the management and accountants when preparing financial statements to disclose both the critical judgements and estimations used in the process of applying accounting policies. The requirement for the full disclosure of critical judgements emanates from the basis that critical judgement has a huge effect on the amounts recognized in financial reports and statements. The aim of disclosure of sources of estimation uncertainty is because estimates hold a major risk of originating material change to the carrying value of assets and liabilities within the next reporting period. Deloitte (2010) asserts that disclosure requirement are necessary to furnish users of financial statement with the subjective areas of financial statements, and which could have a significant impact on the materiality of financial statements if preparation of financial statement was based on different assumptions or judgements. Therefore, it is important for a reporting entity to identify critical judgements and describe estimation uncertainty on the financial reports and statements. However, according to a survey conducted in New Zealand and whose findings can be generalized to Australia given the recent revelations by the Australian Securities and Investment Commission on critical judgements and estimations, there is continued confusion among reporting entities on what is critical judgements and estimation uncertainty.

One of the requirements for disclosure is that the management and accountants should make disclosure on items that have a major risk of causing material adjustment to carrying amounts within the following reporting period. However, when material changes in the carrying amounts is not as a result of the assumptions and sources of estimation uncertainty, the disclosure requirement does not require the management and accountants to make disclosure on items, such as assets and liabilities, that have been measured at fair values using observed market prices. Deloitte (2010) observes that limiting disclosure to items that pose significant risk of causing material adjustments to carrying values ensures that only relevant information that has material effect of reversing carrying amounts is disclosed, ignoring information that is less specific.

During the preparation of financial statements, the management is required to make critical accounting judgement in applying accounting policies. Some of the critical judgments that the management makes include classification of items into different accounting recognitions, such as assets or liabilities and finance or operating . The management also makes critical judgement on timing of items in recognizing them in financial statements, which include timing of revenue and expense recognition. Accounting estimates and assumptions affect the amounts that are recognized in financial statements. In a survey carried out by Deloitte in the year 2010 on financial reporting systems in New Zealand, it was reported by Deloitte (2010) that there were around 98 key sources of estimation uncertainty, however, companies involved in the survey reported that they only disclosed between one and twelve estimates in their financial statements.  The predominant source of estimation uncertainty lies in estimation of figures for impairment, provisions, fair values, revenue recognition, deferred taxes and  useful lives of assets.

In the preparation of financial statement, the following are the critical judgements that the management makes judgement. They include:

1.    Classification of leases.
2.    Timing of revenue recognition.
3.    Classification of financial instruments into either equity, debt of held to maturity.
4.    Classification of owner occupied premises as an investment.
5.    Evaluation of levels of controls and influence.
6.    Classification of exceptional items.
7.    Recognition of deferred taxes.

Similarly, sources of economic uncertainty arise from the following estimations, and they include:

1.    Measurement of provisions, such as bad debt provisions, contract provisions, restructuring provisions and dilapidation provisions.
2.    Determination of taxable profits that will arise to support recognition of deferred tax assets
3.    Determination of fair value of property, unlisted equities, acquisitions and derivatives.
4.    Determination of future cash flows and discount rates in calculating impairment of goodwill, share based payments, retirement benefits and other intangible assets.
5.    Determination of useful life of an asset
6.    Valuation of intangible assets.

Critical Accounting Judgements and Estimates

According to Wesfarmers (2011), the management and directors of Wesfarmers Limited exercised critical judgement in applying accounting policies in preparation of financial statements. In 2011, one of the judgements they made besides estimation of statements was on income tax. The management in exercising critical judgement in the preparation of financial statements made the decision, which formed part of disclosures, to unrecognise any benefits concerning carried forward capital losses because the management cannot foresee capital gains arising in the future to utilize  the benefits of the tax assets. Besides critical judgement of accounting policies, the management also determined carrying amounts of various assets and liabilities based on estimates and assumptions of prospective events. It is worthy to note, the management only disclosed key estimates and assumptions that pose a major risk of influencing material adjustment to the carrying amounts of specific assets and liabilities within the next reporting year. One of the significant accounting estimates and assumptions that the management of

Wesfarmers Limited made was to determine whether assets such as goodwill and other intangible assets with indefinite useful lives had been impaired. This exercise is done at least in annual basis. The process of determining impairment for this class of assets involves estimation of the recoverable amounts of cash to which intangible assets such as goodwill and other intangible assets are allocated. The recoverable amount is determined using cash flow projections and other information obtained using the appropriate valuation model. The valuation model used in estimating the recoverable amount of cash generating units uses corporate plans that extend for five years. Determination of impairment of intangible assets is influenced by legislations and government policies, like the case of Wesfarmers coal mining business. For example, in 2010, Wesfarmer (2011) reports that on 2 July, the Australian Government proposed a new rent tax regime for the coal and iron ore sectors that were to take effect from 1 July 2012. The new Mineral Resources Rent Tax, which was to reform resource taxation, incorporated the 94 recommendations proposed by the Policy Transition Group. The recommendations as they stand and based on the estimates of 2011 are not expected to impair Wesfarmer’s coal mining business. The Australian Government is spearheading for the use of clean energy in the future, the proposals contained in draft legislation have so far received support, providing a structure for a carbon pricing mechanism. Once both houses of parliament pass the necessary supporting legislative that will put in force a carbon pricing mechanism in Australia, the management of Wesfarmers Group will have to revise assumptions used for the exercise of determination of impairment, deviating from the current estimates.

Estimations and assumptions are also made on inventories. According to calculations by Wesfarmers (2011), the net realizable value of inventories that is obtained during the course of ordinary business is the estimates of selling price less estimated costs incurred during the selling process. The management in valuing the inventory use assumptions and judgement to determine the variables that affect estimates of the selling price and costs to be incurred in the ordinary process of business. Another item in the financial statement that the management exercises their judgement to estimate probable intrinsic value is in determining the useful lives of assets. According to Wesfarmers (2011), Wesfarmers Limited reviews annually the useful lives and residual value of assets like property and plant and equipment. Similarly, the group on an annual basis reviews the useful lives of intangible assets with a finite life.

Judgements and reviews of the useful lives of assets are not done arbitrary, but are done and supported by a team of technical experts. Once revaluation of the useful life and value of property and plant and equipment is carried out, the management effects changes to the material substance of depreciation and amortisation expense. Changes made to depreciation and amortization value affect the material value of the asset from the day of reassessment to the end of the new reassessed useful life for both the current and future years. On the other hand, revaluation of intangible assets with finite lives affects amortisation expense from the reassessment date to the end of the reassessed useful life for both the current and future years. Another item that the management exercises judgement in ascertaining the true value is on employee benefits. The management exercises judgement on key assumptions used in determination of service benefit. The assumptions include future increases in salaries and wages, period of employee service, future on-cost rates and experience of employee turnover. Insurance liabilities and assets arising from reinsurance contracts is another item in the financial statement that is based on judgement, estimates and assumptions. Estimation of outstanding insurance claim is done using actuarial techniques, with the past happenings being used as predictors of the future developments. The projected future claims payments and claims handling costs are discounted to a present value using a risk-free discount rate. Similarly, assets arising from reinsurance contracts are assessed using actuarial techniques, the assets that are recoverable are assessed periodically and reflected in financial statements after adjusting for counterparty risk and credit risk and impairment.

Gap Between Current Practice and Accounting Standard

Wesfarmers Limited accounting policies are by far consistent with accounting policies. However, one area of disclosure of judgement and estimates is not consistent with the accounting policies that deal with accounting judgements and estimates. The highlighted area is on provisions. The management would have given estimations and assumptions they used in assessment of bad debts that would arise in the following year given the prevailing harsh economic conditions, which may cause a significant material change to accounts receivable. The management would have also given more disclosure on long-term provisions. However, only one area of provision, which was on pension liability, did the management give disclosures of judgement and estimates used.

Recommendation

However, compliance levels with accounting policies that deal with critical judgements, estimates and assumption is commendable, there is a need to increase the disclosure level of the judgement and estimates used by the management to recognize provisions in financial statements.

References

ASIC 2012. Attachment to 12-140MR: ASIC’s area of focus for 30 June 2012 financial reports. Australian Securities & Investments Commission.

Deloitte 2010. Where are the judgements. Deloitte Financial Reporting Survey Series, 4, pp. 1-8.

Wesfarmers 2011. Wesfarmers annual report 2011. Ross Barr Associates Pty Limited.

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