Accounting estimates have become an increasingly challenging and important part of the audit process as they are often susceptible to material misstatement.
1. Goodwill is a “key audit matter”
The audit reports of public companies list the key audit matters which the auditors have focused on each year. We reviewed the most recent audit reports of the top ten Irish businesses and noted that a common key audit matter identified in almost every audit report is the valuation of goodwill. This is usually also a key area of focus for audit committees. This comes as no surprise. Goodwill valuation has been implicated in a number of high profile financial scandals. Goodwill is often a significant number on the balance sheet and is subject to accounting estimation and judgement.
As a reminder, under IFRS companies are required to test goodwill for impairment annually but this doesn’t have to be at year-end. FRS 102 mandates goodwill impairment testing where circumstances indicate that its value is not recoverable.
Goodwill impairment testing involves complex judgements. For example, How should goodwill be allocated to different parts of the business? What forecasts should be used? What discount rates or growth rates should be used?
2. Goodwill valuation and COVID-19
The COVID-19 pandemic and related market conditions have created many new uncertainties for companies, their boards, auditors, and investors. These include falling stock and commodity prices, manufacturing plant shutdowns, shop closures, reduced demand and selling prices for goods and services, etc. These external and internal conditions may indicate that assets like goodwill are impaired.
While there are now grounds for cautious optimism, many business and finance leaders are still struggling with the uncertainties that the pandemic has created. Impairment is likely to remain topical even as normality returns. Here are just three question that finance leaders are asking about COVID-19 and goodwill valuation:
- Estimates and assumptions: Goodwill is often tested using forecasted cash flows. These cash flows are typically one of the key accounting estimates in a goodwill impairment model. Would an expected cash flow approach based on probability-weighted scenarios be more appropriate than the traditional single best estimate approach?
- Government grants: Many companies are receiving government grants, such as the EWSS, as a result of the pandemic. Is it reasonable to include these cash flows in forecasts used for impairment testing? Do the terms and conditions of the grants, for example the duration of assistance support their inclusion?
- Disclosure: How do finance leaders address the expectations of stakeholders who want more information about key assumptions and judgements in the goodwill disclosure note?
3. ISA 540, Auditing Accounting Estimates and Related Disclosures - Why should management pay attention to ISA 540?
The International Auditing and Assurance Standards Board, IAASB, has overhauled ISA 540, Auditing Accounting Estimates and Related Disclosures for financial statement audits for periods starting after December 15, 2019 as part of an effort to improve auditing standards globally.
Preparing accounting estimates can be a difficult task. The changes to this standard will have significant implications for finance leaders who determine key accounting estimates. The audit of accounting estimates spans the entire audit process and is important to key audit matters – notably goodwill impairment testing.
Finance leaders may need to improve the quality of processes and controls around deriving accounting estimates and also their disclosures. Auditors are more likely to challenge, exercise scepticism and focus on management bias. The nature and extent of information that auditors request to support processes and controls around estimates will change. This is not a one-time change. Accounting estimates must be revisited in each accounting period as changes may occur in the business that require new accounting estimates not required in the previous period.
