The COVID-19 pandemic has made financial estimates, which involve assumptions that rely on experience and trends, more difficult to calculate.
Because the last pandemic occurred over 100 years ago, organizations are lacking the history necessary to calculate reliable financial estimates, conditions that affect the tax provision — itself an estimate.
Auditing Standard 2501.02 describes an accounting estimate as a measurement or recognition in the financial statements of (or a decision not to recognize) an account, disclosure, transaction, or event that generally involves subjective assumptions and measurement uncertainty.
The subjectiveness and uncertainty inherent in accounting estimates are heightened by today’s unprecedented environment.
Examples of accounting estimates include bad debt and asset impairment reserves, net realizable values of inventory and accounts receivable, property and casualty insurance loss reserves, revenues from contracts accounted for by the percentage of completion method, and pension and warranty expenses.
A tax provision is the estimated amount of income tax that a company is expected to pay for the current year — that is, a reserve set aside to cover a probable future expense.
Businesses attempting to calculate the pandemic’s impact on financial estimates are pricing several unprecedented and interconnected events. No one expected to analyze COVID-related pent-up consumer demand, supply chain disruption, cryptocurrency and real estate volatility, labor shortages, and the Russian invasion of Ukraine at the same time.
All that has made it difficult to analyze trends, expectations, and history that typically drive the estimate analysis. If the estimates themselves are inaccurate, so are the conclusions from analysis of the financial statements.
For example, companies calculate their reserves for bad debt by relying on economic conditions and historical data to arrive at an estimate of a percentage of receivables that are uncollectable.
The pandemic-related business closures and consumer cash shortages support increasing that percentage and the bad debt reserve. That has an unfavorable effect on the company’s current ratio (current assets to current liabilities) and quick ratio (cash to current liabilities). Analysts use those two ratios to assess a company’s short-term liquidity and could reach the wrong conclusions if the reserve is too low (or high).
Impairment estimates are often based on historical data adjusted to reflect estimates of future conditions. Changes in consumer demand and purchasing habits are taken into account when estimating finished goods inventory values.
Disruptions in the global supply chain that decrease manufacturers’ ability to procure components may decrease the value of their unfinished inventories. Idle capacity may decrease the estimated future cash flows of long-lived assets, and decreases in asset values may warrant impairment reserves.
The uncertain and subjective nature of the estimate process facilitates a covert bias toward favorable estimates. Accountants and auditors might exercise transparency and good faith only to discover that they based their estimates on honest assumptions that were overly optimistic.
Auditing standards require auditors to second-guess the reasonableness of management assumptions, and auditors will often be evaluating the assumptions with the same uncertainty that burdened management.
AS 2501.16 requires an auditor to evaluate the reasonableness of the significant assumptions used by the company to develop estimates individually and in combination.
An auditor must evaluate whether the company has a reasonable basis for the significant assumptions used and for its selection of assumptions from a potential range. Auditors must also evaluate whether the significant assumptions are consistent with:
- relevant industry; regulatory; and other external factors, including economic conditions;
- the company’s objectives, strategies, and related business risks;
- existing market information;
- historical or recent experience, taking into account changes in conditions and events affecting the company; and
- other significant assumptions used by the company in other estimates tested.
For critical accounting estimates, AS 2501.18 requires the auditor to understand how management analyzed the degree to which its significant assumptions were sensitive to change based on other reasonably likely outcomes that would have a material effect on the company’s financial condition or operating performance.
The auditor must take that sensitivity understanding into account when evaluating the reasonableness of the significant assumptions and potential management bias.
Based on that criteria, auditors and management might start with reasonable assumptions based on experience, history, and industry performance and still calculate an estimate driven by faulty projections and forecasts.
The forecasting difficulties that complicate estimates for bad debt and impairment reserves also complicate the tax provision estimate. The effects of the COVID economy on current financial results and the projection of future performance have income tax accounting implications. Moreover, companies must take into account their receipt of COVID-related government benefits.
Those developments will affect the estimated effective tax rate, the realizability of deferred tax assets, the tax effect of losses in continuing operations, assertions about reinvestment of foreign earnings, the tax effect of any impairments, and any other components of the tax provision that are estimates.