Disclosing estimation uncertainty

Disclosure of estimation uncertainty is required for a key reason: to provide users of a financial statement with the best information available.

Financial reporting is filled with estimates. Estimation uncertainty occurs when, in following a specific accounting policy, the measurement of an asset or liability requires significant assumptions about the future. Management is expected to use its professional judgment in such cases and to provide a neutral, unbiased estimate — but there may still be a range of reasonable estimates. Examples of where this occurs include provisions for doubtful accounts, restructuring charges, asset retirement obligations and legal claims, as well as an asset’s useful life for calculations of depreciation, amortization and depletion and the fair value or value in use of an asset used in impairment assessments.

Falling commodity prices, currency volatility and concerns about global growth prospects have added to current economic uncertainties, causing companies to reassess their expectations and business plans, with obvious consequences for their determination of accounting estimates and related disclosures. In these circumstances, it may be particularly challenging to convey the degree of uncertainty associated with significant estimates, the sensitivity of significant accounting estimates to changes in assumptions and to convey how these might evolve in subsequent periods.

Lucy Durocher, partner, national accounting consulting services at PwC, explains why judgment is important. “A significant amount of professional judgment is involved because management is trying to judge today whether there is a good chance that assumptions about the future will not come to pass and lead to a material adjustment within the next financial year,” she says. “If you had asked real estate investors in Alberta before the oil price crash whether there would be a significant change in commercial real estate prices the following year, the answer might have been no. Of course, since then falling oil prices have burst their real estate bubble, showing there was significant estimation uncertainty. Estimation uncertainty is really about looking forward.”

There are two main factors to consider in assessing the adequacy of estimation uncertainty disclosures:

Do financial statements describe major sources of estimation uncertainty?

“Generally, companies do a reasonable job of identifying areas where estimation uncertainty comes into play: the most difficult, complex or subjective judgments,” says Durocher. “Where there is room for improvement is explaining the sources or reasons for that uncertainty. Often, companies don’t disclose enough information or the information they are sharing isn’t specific enough to capture what the standard is trying to elicit — namely, what about that estimate has significant risk that could lead to a material adjustment within the next financial year?”

Is the extent of disclosure appropriate?

For example, sticking with real estate, under IFRS companies are required to carry their investment properties at fair value on their balance sheets. “That valuation is often comprised of two key components: stabilized future cash flow and the capitalization rate. Economic volatility makes it much harder to know if you have the right capitalization rate or the right future cash flow assumptions, creating measurement uncertainty,” says Durocher. “Although you have a value on your balance sheet to get to the source of the estimation uncertainty, you have to focus on the elements that drive the uncertainty.”

Disclosure of estimation uncertainty is required for a key reason: to provide users of the financial statement with the best information available. Today’s estimates are based on expectations of the future, which is why it’s so important to disclose how you arrived at your numbers. “Preparers have made their best guess but others might arrive at different best guesses,” says Durocher. “The objective is to give users of the financial statements more insight into management’s thought process so they can make more informed investment decisions.”

For more information about estimation uncertainty and disclosure requirements, see CPA Canada’s Corporate Reporting Briefing “What should be disclosed about estimation uncertainty?” at www.cpacanada.ca/mag-estimation.