Board Matters Quarterly - Issue 14: December 2012

Year-end issues the audit committee should consider

1. Financial reporting and disclosures

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While economic conditions have generally improved, uncertainties remain. The challenging economic environment requires more management judgments, and estimates in financial reporting. The AC needs to understand and assess the quality, not just the acceptability, of critical accounting policies, judgments, and estimates. The AC should also bear in mind that there continues to be an increased focus on transparency in financial reporting.

Use of assumptions and estimates

Assumptions, estimates, and judgments have taken on an increasingly important role in preparing financial statements. The AC may want to focus on how sensitive accounts are to variations in the assumptions, and whether there were any significant changes in assumptions during the period. The volatile market conditions mean that many companies will need to consider a wider range of reasonably possible outcomes when performing sensitivity analysis on their cash flow projections that support asset valuations, and asset impairment assessments.

Given recent events, the AC may want to understand the process management used to develop its judgments, and whether key assumptions and estimates used have been appropriately documented. A number of areas are more likely to be more heavily affected by the current economic conditions, notably impairment of tangible and intangible assets, working capital allowances such as allowance for doubtful debts and inventory reserves, and recognition of deferred tax.

Estimating fair value

Estimating fair value continues to be challenging, particularly for illiquid or complex securities, and non-financial assets and liabilities. The AC should understand the methodologies used by management to determine fair value, and any significant changes to those methodologies. Furthermore, understanding the assumptions used to determine fair value, particularly those that are not based on observable market transactions (for example, fair valuation of unquoted equity investment) helps the AC understand how management has applied its own judgment in developing these estimates.

Significant unusual transactions

Significant unusual transactions can raise a number of financial reporting issues that often are addressed outside the company’s routine internal control processes. The AC should understand the business purpose, the underlying economics of the transaction (including related and interested person transaction), and how management has evaluated it for financial reporting purposes. The AC should also focus on the transaction’s financial statements disclosure.

Abuse of the materiality concept

Accounting errors may be intentionally recorded under the assertion that their impact on the bottom line is not significant. Even if materiality or significance is sometimes hard to define, the AC needs to consider whether any identified error represents a threat to investor protection, and therefore a reputational risk for the company.

Capitalization and deferral of expenses

Costs that should be accounted for as a cost of the period may be capitalized or deferred. The capitalizing and deferring of such costs can occur through, for instance, ambiguously defined capitalization criteria for property, plant and equipment and intangible assets, unreasonable amortization periods, or the capitalization of costs for which future economic benefits are not reasonably assured.

Reference library:

Questions the AC should consider:

  • What methodologies did management use in its fair value determinations?
  • Has the AC considered setting processes in place to ensure that appropriate procedures and controls have been applied to the group’s use of models to generate cash flow and valuation information, including the choice and consistent use of key assumptions?
  • Is the AC satisfied that key models have been subject to independent analysis and verification, for instance, by internal audit?
  • Where models have been used to estimate the value of assets which must be tested for impairment, is the AC satisfied by the procedures adopted to estimate cash flows, and the appropriate adjustments made for risks?
  • Is the AC satisfied that appropriate sensitivity analysis has been conducted to flex assumptions to identify how robust the model outputs are in practice, and that the assumptions are free from bias? Has management considered appropriately the potential impact of reasonably possible events? For instance, have relationships with third parties been reviewed? Has the potential of third party defaults been taken into account?
  • Where assets are not traded, perhaps because markets are no longer active, has the AC satisfied itself that appropriate additional procedures have been undertaken to estimate fair values through the selection of market‐based variables, and the use of appropriate assumptions?
  • Has the company entered into a significant unusual transaction? What are the financial reporting implications? Has this been appropriately disclosed?
  • Is the entity’s description of its operating results, liquidity, capital resources, and how it develops critical accounting estimates sufficiently transparent?
  • What are the other comparable entities in similar circumstances doing based on publicly available information?

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