Ask the Auditor: Accounting estimates

In our regular feature, Ask The Auditor, Graham Liddell from Grant Thornton UK LLP discusses the role of the CFO in making accounting estimates.  To ask Graham a technical query, email editor@room151.co.uk

The CIPFA Code on local authority accounting (the Code) recommends that the statement of responsibilities within the financial statements includes a declaration that the Chief Financial Officer (CFO) has made estimates that were reasonable and prudent. We are often asked what this means in practice for CFOs and how auditors go about auditing accounting estimates.

Estimates used in preparing financial statements

The use of accounting estimates is an essential part of the preparation of local authority financial statements and covers key areas of the accounts including:

• property values
• the pension fund liability
• the value of assets and associated liabilities that are recognised under PFI and leasing agreements.

The CFO will need to be satisfied that all the accounting estimates included in the financial statements are reasonable and prudent. This links to professional auditing standards that require auditors to:

• determine whether an authority has identified all estimates in the financial statements
• gain an understanding of how the authority has developed its estimates
• evaluate the related risks of material misstatement in designing their audit approach.

Prudent and reasonable

Estimates include a greater degree of uncertainty and some require authorities to make a significant degree of subjective judgment. This means that CFOs and auditors need to be less concerned about whether an estimate is exactly right and more about whether it is reasonable.

The requirement for CFOs to state that estimates are “prudent” might seem to be a throwback to an earlier age when prudence was sometimes seen as a way of storing away funds for future years. However, the Code sets prudence within the wider concept of reliability which also includes the need for faithful representation and neutrality. So whilst estimates must not be imprudent, this does not mean that they can be overly conservative.

Neutrality (also referred to as freedom from bias) also links to the auditors responsibility to apply professional scepticism. Where auditors encounter estimates that are either imprudent or overly conservative, they will want to understand why. If auditors identify instances of estimates being prepared to achieve a particular outturn, this is likely to set alarm bells ringing and result in additional audit procedures and, potentially, additional costs for the authority.

Audit approach for evaluating the reasonableness of an estimate

The audit approach will depend on the nature of the accounting estimate and the auditor’s assessment of the risk of material misstatement. Professional standards require auditors to apply one or more of the following:

• review and test the process used by the authority to develop the estimate
• develop an independent expectation of the estimate to corroborate the reasonableness of the estimate developed by the authority
• review subsequent events or transactions to evaluate the reasonableness of the estimate or key assumptions used in the preparation of the estimate

Grant Thornton auditors use all three methods in the local authority sector. Typically, however, we find that testing the authority’s process is often the most effective and efficient approach, particularly where estimates are derived from systems with robust processes and effective internal controls. This is one of the reasons why we are so keen to encourage authorities to develop formal processes.

Disclosing estimation uncertainty

The Code requires local authorities to disclose information about estimates that have a significant risk of resulting in a material adjustment within the next financial year. This means that we would expect local authorities to concentrate on amounts where:

• difficult, complex or subjective judgments have been made
• the value of the uncertainty (rather than the whole balance) is material
• the uncertainty is likely to crystallise in the next financial year.

Disclosures must include the nature of the assumption and the carrying amount of the asset/liability at the end of the reporting period. They may also include other information such as the sensitivity of the carrying amount to the assumptions and the range of possible outcomes.

In our experience there is an opportunity for authorities to make an improvement to these disclosures:

• authorities often provide extensive disclosures on estimates where the risk of a material impact is low. These disclosures can be cut out altogether
• conversely, sometimes authorities just provide the bare minimum where the risks are highest. This is an area where we would expect more detailed information to be provided.

Challenge questions for CFOs

In summary, here are some challenge questions for CFOs to consider when declaring that estimates are prudent and reasonable:

• Are you confident that you have identified all estimates that have been used in preparing the financial statements?
• Have you put in place robust procedures for producing estimates? Are you able to provide your auditor with evidence that your procedures and internal controls for producing estimates have been working effectively?
• Are you satisfied that your estimates are neither imprudent nor overly conservative?
• Do your accounts disclose enough information about estimation uncertainty where the risks of material adjustment are highest. Have you removed all unnecessary disclosures?

Graham Liddell is Grant Thornton UK LLP’s national technical lead for the public sector. No responsibility or liability is accepted by Grant Thornton UK LLP towards any person or organisation in respect of the use of, or reliance on, information contained in this column.