Standards Working Group. Making Good Accounting and Reporting Judgments - A Process. December 21, 2011

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1 Standards Working Group Making Good Accounting and Reporting Judgments - A Process December 21, 2011 Background and purpose Business is often complex. Today's financial reporting framework reflects that complexity. To report financial results of their business activities companies must navigate a multitude of accounting requirements to appropriately record and report numerous types of transactions. Sometimes this is a simple exercise; but often it is not, requiring management to exercise judgment in a variety of decisions related to the selection and application of appropriate accounting principles and other financial reporting matters. This paper describes a process to help management make and document these judgments. The process described in this paper is not the only process that would result in good accounting and reporting judgments. Many differing approaches are possible. This is just one that can be considered a good practice to follow. The process described is more appropriate for significant, complex or material transactions. Though many of the same concepts apply the thought process for determining the policies and accounting judgments for routine transactions have often already been determined and are effectively embedded in the existing control processes of a company. Thus, the level of detail in the analysis and documentation that is needed should be adjusted depending on the significance, complexity, nature, and materiality of transactions. Using this process for significant transactions should benefit both companies and financial statement users by enhancing the quality, relevance and information value of financial reporting. A secondary benefit of applying a robust judgment process is that it enhances a company's ability to support accounting and reporting judgments when questions arise from auditors, regulators, plaintiffs' counsels, or other parties. The main focus of this paper is on judgments made in the selection of the accounting standards and policies. However, it also addresses other financial reporting related judgments used in the application of those accounting standards and the related financial reporting. Introduction The accounting literature requires transactions to be categorized, summarized, and reported to inform users of the effect of transactions on a company's financial position, results of operations, and cash flows. These tasks fall to management, who are responsible for ensuring that the company follows the financial reporting framework and appropriately communicates with investors and other financial statement users. Many transactions are specifically addressed in the accounting standards; however others are not, requiring management to interpret and make judgments regarding the appropriate selection and application of the accounting principles to be applied to particular transactions to reflect the economic substance of those transactions. Accounting standards have been developed over many years by many standard setting bodies and regulators with differing views on how the economics of transactions should be reflected in financial reporting. These views may reflect legal requirements or cultural considerations in particular jurisdictions that can vary territory to territory. Some of the requirements are grounded in conceptual accounting theory and some are more influenced by pragmatic considerations. Further, the explanations accompanying the conclusions can vary significantly in extent and insight depending on who wrote them and when they were written. Page 1 of 7

2 Accounting and reporting judgments range from evaluating which accounting standards are relevant, to identifying the components of transactions and whether those components should be accounted for separately or together, to determining amounts to record, to evaluating the sufficiency of evidence supporting the application of a particular accounting standard or policy, and to deciding on appropriate and relevant disclosures. Because use of judgment is such an important and integral part of preparing financial statements and judgments can and will differ among knowledgeable, experienced, and objective people presented with the same facts, a consistent and robust approach to making and supporting judgments should enhance the quality, consistency and reliability of financial reporting. The Process The process includes seven steps that, when effectively applied, will aid management in delivering timely, transparent, and meaningful information to investors and other users of financial statements. These steps when applied to a transaction are: Understand and evaluate the facts and economics of the transaction Determine the boundaries of the transaction for accounting purposes Consider the relevant accounting guidance and identify alternative treatments Consider the alternatives and select a policy Evaluate the requirements of the selected alternative and determine amounts to record Evaluate disclosure objectives and requirements to develop responsive disclosures Document the process followed, considerations addressed, and conclusion reached. In practice, these steps may not be performed sequentially and are often combined due to the iterative nature of the decision process. For the purpose of this paper, they have been separated for ease of presentation and discussion. Having a robust process to make good accounting judgments is the responsibility of management. However, that process should include steps to assess transactions to determine which are significant and warrant additional consideration compared to those that are more typical and are addressed through a company's routine internal control processes. Management should also consider the level of oversight that may be needed by the audit committee to review and challenge the appropriateness of the process followed, and judgments made, for significant decisions. Understand and evaluate the facts and economics of the transaction Understanding and evaluating the facts is the essential first step in the process. All of the following steps build on the specific facts and circumstances. An objective of accounting and reporting is to faithfully reflect economic events. To meet this objective, an understanding of the context, substance, and business purpose of a transaction is required. For example, transactions with related parties may be substantially different from those with independent parties. The process should be undertaken by an individual who has the appropriate level of knowledge, expertise, and objectivity to ensure that all relevant facts and circumstances related to the transaction are identified, understood and considered. Obtaining this understanding generally involves: Reading the transaction documentation. This includes relevant contracts, agreements, and related correspondence. Discussing the matter with others who have knowledge of the transaction. Often this adds clarity to the understanding of the business purpose of the transaction and any unique terms and conditions. Page 2 of 7

3 Evaluating and comparing the circumstances of the current transaction with those from the past. Look for similarities and differences in the fact patterns as this helps to achieve consistent treatment for transactions with similar fact patterns. Comparing the transaction with similar transactions, e.g., those of peers or others within the same industry. Identify any factual differences that may affect the analysis. For similar transactions consider whether there is a common accounting method being used in practice or a precedent that has been set. This will help enhance comparability and highlight feasible alternative accounting treatments. Considering whether the terms and conditions make economic sense when considered alone or whether they are part of one or more integrated transactions that involves other agreements usually entered into contemporaneously. Also consider whether the transaction includes multiple elements that should be separated and accounted for individually. Determining whether subject matter expertise is important to understanding the transaction and developing views. If so, engage subject matter experts. Such experts (e.g., actuaries, valuation specialists, legal counsel, accounting specialists, etc.) can provide additional insights and help analyze situations for which technical or specialized expertise is needed. The use of third parties can add further objective data and/or support for the conclusions reached. Gathering the above information provides relevant information to support developing an appropriate accounting policy and its application to the transaction. A timely assessment is important because it helps take into account all the facts known at the time of the transaction and only those facts, avoiding the use of hindsight. Determine the boundaries of the transaction for accounting purposes Early in the process of considering how to account for a transaction, a company should consider what are the boundaries of the individual transaction. Often transactions are accounted for on a contract-by-contract basis. However, financial reporting frameworks require consideration of the substance of a transaction and often require linked transactions to be accounted for on a combined basis if the terms of one contract are impacted by those of another and the economics would not be portrayed faithfully if accounted for separately. Conversely, a single legal agreement may include several transactions that should be accounted for separately. Sometimes accounting literature specifies when separation is permitted or required. Examples are sales agreements that include more than one product or service and when certain derivatives are embedded in the terms of borrowings or investments. Identifying and applying relevant separation requirements to these types of transactions may require judgment. Judgment may be required even if consideration of combining or separating transactions is explicitly specified in the accounting literature for the type of transaction being considered. This "step" is often done in conjunction with considering the relevant accounting guidance. Consider the relevant accounting guidance and identify alternative treatments The next step is to analyze the accounting literature to determine relevant guidance. Accounting guidance will vary depending on the financial reporting framework being used. Most frameworks have various sources of information to consider. These sources include authoritative pronouncements and may also include relevant appropriate supplemental non-authoritative guidance. Each may assist in selecting and applying an appropriate accounting policy. Take as an example a listed company that reports under U.S. accounting standards. Management will need to look to U.S. accounting standards, other related guidance and guidance issued by the relevant regulator(s). Once the guidance is identified it should be considered with the knowledge of the transaction as a backdrop. As the guidance is read, other guidance may be identified or referenced that will prompt further research and consideration to gain a comprehensive view of which literature is relevant. As research is conducted to identify the accounting guidance relevant to the transaction, it is important to consider if certain financial reporting principles or applications of principles are required or prohibited. Doing so helps narrow possible alternatives to those that are permitted and to ascertain if there is more than one. In Page 3 of 7

4 many cases there will be a single set of specific requirements that apply to the transaction. This will reduce the judgment required to select an appropriate accounting policy to apply. In other cases, situations may be encountered which will increase the need for a company s management to use their judgment. For example, the literature may not contain a specific requirement or sufficiently detailed guidance for the transaction at hand. Management will need to consider how general principles in relevant or related standards or other guidance should be applied to account for the transaction. A second example is when the literature reflects differing views on how the economics of transactions should be reflected in financial reporting. This occurs sometimes because accounting standards were developed over a number of years by different individuals. Judgment may be needed to evaluate conflicting guidance in order to reflect the substance of the transaction. Still another situation encountered is when there is no specific guidance on point, but there is more than one piece of potentially relevant guidance to apply by analogy. Judgment is required to determine which analogy should be made. And last, sometimes the scope of various pieces of literature may overlap or conflict which creates challenges deciding which literature to follow. All of these circumstances can result in more than one acceptable alternative that may apply to a particular transaction. It is these alternatives that require consideration as discussed below. Companies may also consider consulting with their auditors at this point to obtain additional insight as to which accounting guidance may be relevant and should be considered by management in their evaluation. Consider the alternatives and select a policy Once the transaction has been evaluated and understood and the accounting guidance has been analyzed, if possible alternatives have been identified each alternative should be considered in light of the circumstances and underlying facts of the transaction to determine whether it is acceptable. Discussion with subject matter experts is often helpful at this stage to gain further insight and perspective in identifying and evaluating alternatives. An accounting standard's basis for conclusions often provides useful background and information to help with this assessment. If more than one accounting alternative is permitted under the relevant guidance, the decision about which alternative to use should be assessed based on multiple factors including, but not limited to: How well each alternative portrays the underlying substance and economics of the transaction Whether each alternative results in providing users with transparent and meaningful information How faithful each alternative is to the spirit of the accounting requirements Whether an alternative is preferred by the standard setters or relevant regulator The benefits and drawbacks of each alternative Self-awareness of any inherent bias because of underlying incentives or financial reporting pressures Past practice, industry trends, and input from subject matter experts The data, assumptions, and estimates needed to apply the alternatives. The availability and reliability of underlying data can be an important factor when selecting an alternative. After considering the above (and other) factors a tentative decision as to which accounting treatment to follow can be made. It also may be helpful to review the tentative policy selection with others in the organization who are knowledgeable about the transaction. As different people will weigh factors differently, additional levels of review add rigor to the process, enabling others to challenge the views taken and ensuring that all relevant information has been considered appropriately before concluding and applying a finalized accounting policy. As a best practice, for complex transactions and judgments the company might involve its auditor throughout the process; however, if this approach has not been followed, this would also be a good time to review the Page 4 of 7

5 preliminary conclusion with the company's auditor. Also depending upon the regulatory environment in which the company operates, if the judgment is particularly difficult and the transaction has a significant impact on the financial statements, management may wish to consider consulting with their local regulator on the specifics of the transaction and judgments made. Evaluate the requirements of the selected alternative and determine amounts to record Determining the accounting principle to apply is only part of the job. Once the alternative is selected, the requirements of that alternative need to be applied within the context of the specific facts and circumstances of the transaction to determine the proper amounts to record. The guidance and its application should be applied in a manner consistent with the intent of the standard setters and in line with the decision logic in selecting the alternative. Often there are additional judgments and estimates that are required to apply the relevant accounting guidance. And additional data may be needed to make these estimates and judgments. For each additional judgment and estimate, a best practice would be to follow a similar thought process to that set out above. As with deciding on the accounting principle, some accounting standards include detailed guidance on how these estimates should be derived while other standards provide little or no additional guidance. When specified, that guidance is followed. For example this is often the case when addressing measurement amounts under fair value measurement guidance. When not specified, select the guidance that will yield estimates that are consistent with the overall objective of the standard and the economics of the transaction, and are reliable and verifiable. For example, when estimating bad debt reserves, companies may consider a number of methodologies or approaches. Judgments and estimates within a selected accounting alternative should be based on the same understanding of the facts and circumstances and factors that were used to select the accounting alternative itself. Subject matter experts, past practice, and industry practice should be considered. Also, consider whether any key elements or assumptions are susceptible to change and weigh the possible range of assumptions and the potential impact on the analysis to ensure it is appropriately balanced. Evaluate disclosure objectives and requirements to develop responsive disclosures Judgment also is required to determine what disclosures should be made. Transparent disclosure helps to convey the economic substance of transactions to users. It also puts transactions into context which improves the relevance in relation to the overall financial information being reported. Reporting guidance requires certain disclosures regarding the key judgments made in preparing the financial statements. Required disclosures often include items such as accounting policies selected, judgments used when estimating amounts to record, and the underlying logic for decisions made. Complying with the minimum disclosure requirements is important; however, more information about the specific facts and circumstances of a transaction is often helpful for users. Evaluating additional disclosures beyond those specifically required is another area that requires judgment. These judgments involve considering what additional disclosures are appropriate to give users an understanding of the accounting policy applied and any key estimates and assumptions used in applying that policy without obscuring key points with excess discussion of less relevant items. Financial statement disclosures are not limited to detailed analyses of individual line items; describing the business purpose of significant transactions and providing transparency into the judgments made in accounting for the transaction, sensitivity of key assumptions and possible impact of changing assumptions often serve to enhance the user's understanding of how those transactions impact the financial statements. Financial statement disclosures can be further supplemented with information that may be contained in other parts of an annual report. Good disclosure does not cure financial statements that include inappropriate estimates or selections and applications of inappropriate accounting principles. However, good disclosure can provide evidence that the company has been forthright and transparent in informing users of the transaction and its associated accounting. Page 5 of 7

6 Document the process followed, considerations addressed, and conclusion reached An important part of the process is documentation of the selection and application of accounting principles and the underlying logic for decisions. Ideally, documentation should be done as part of the judgment process. Contemporaneous documentation promotes a timely and thorough assessment of the specific facts and circumstances considered at the time the judgment was made. By documenting the decision process in a timely manner, management can better respond to any "second guessing," and the use of hindsight that could call into question the judgment made. Documentation should be clear, concise and in plain language such that a person with appropriate expertise but no knowledge of the transaction or decision process can read and understand the points considered, logic and conclusions reached. It should describe management's view of the economics of the transaction, the accounting (and any other) guidance followed, and how the two correlate such that the accounting principles applied and related disclosures achieve transparency for financial statement users. To meet these objectives it is useful for the documentation to contain the following: Overview of the transaction The overview provides a summary of the transaction in enough detail to understand the key business terms, substance, economics, and business purpose of the transaction. The information gathered will provide the basis for this overview. A description of the documents reviewed and the discussions held with others provides useful background. Assessment of the accounting literature Identify and provide an assessment of the accounting literature reviewed and considered including the specific guidance reviewed and factors considered when selecting that guidance. A discussion of whether any required or prohibited accounting principles or applications were identified and the supporting logic should be included. If alternative acceptable accounting principles or applications exist, include a balanced assessment of the pros and cons of each given the specific facts of the transaction. Consideration of the assessment of past company treatments and industry practice should be documented. A discussion of any preferred treatments as well as any rejected alternatives is useful to demonstrate the robust thought process used to reach the decision. Discussion of key judgments and estimates in the application of the accounting literature As the various alternatives likely require estimates and other related judgments, these considerations should also be documented. The rationale for the selection of underlying assumptions as well as consideration of other factors, such as the reliability and precision of the data, and the possible range of outcomes for the assumptions also should be documented. Other factors considered Other facts or information considered in the decision process should be documented. For example, document the input provided by subject matter experts, their findings, and how those findings were considered in the overall assessment. Discussion of disclosures The documentation should discuss disclosure considerations, including disclosures that are required and additional disclosures deemed appropriate to enhance the users' understanding of the relevant facts and circumstances. Consider discussing factors weighed in determining the extent of additional disclosures. Often it is helpful to document these considerations at the time of the transaction, or draft the specific intended disclosures at this time, to avoid inadvertent omissions when it is time to prepare the full financial statements. Page 6 of 7

7 Conclusion Document Conclusion Finally, summarize the conclusion reached. This includes the logic for any rejected alternatives, examples or amounts to be recorded, and the concurrence of others who were involved with or reviewed the decision. Complex and significant accounting and reporting judgments are made by companies every day. However, as transactions and their related fact patterns vary widely, so can the conclusions as to reasonable and acceptable alternatives for recording them. Judgments can and will differ among knowledgeable, experienced, and objective people presented with the same facts. It is this complexity and the possibility of alternative accounting treatments and applications within those principles that necessitate a robust thought process followed by clear and contemporaneous supporting documentation. We have presented a process that can be followed to support good and well-reasoned judgments. We hope this process contributes to efforts to strengthen financial reporting by articulating steps to consider to support good sound judgments through thoughtful and thorough consideration of the relevant facts and circumstances, a balanced assessment of alternative treatments to appropriately represent the transaction, and the involvement of appropriate people to gain insights. This process will support the presentation of financial statements to investors and other financial statement users that increase their understanding of the company by presenting relevant information supported by transparent disclosures. Following this process should help demonstrate the judgments made are the outcome of a robust and logical thought process. And this, in turn, should give investors greater confidence in the judgments made by management. Page 7 of 7