Why disclosure of judgements and estimates matter

When preparing an entity’s financial statements, management will inevitably have to make many judgements and estimates, some of which will have a significant effect on the entity’s reported performance and financial position. Appropriate disclosure of these judgements and estimates enables investors to understand how they impact on an entity’s reported results and how sensitive the entity’s performance is to changes in assumptions, thereby helping investors make appropriate investment decisions based on their risk appetite.

Providing high quality disclosures in this area is particularly important in the light of the ongoing economic and geopolitical uncertainty, as making judgements and estimates is more difficult in such an environment. Against this backdrop, it is not surprising to see that judgements and estimates is consistently in the FRC’s top ten list of the most common topics on which it raises substantive questions during its monitoring work. It is likely to be a subject that will continue to be a focus of investors and regulators for the foreseeable future.

IFRS Accounting Standards

Requirements relating to judgements and estimates are set out in IAS 1 Presentation of Financial Statements, which includes separate requirements relating to the disclosure of judgements and of sources of estimation uncertainty.

IAS 1 paragraph 122 requires an entity to disclose the judgements, apart from those involving estimates, that management has made in the process of applying the entity’s accounting policies that have the most significant effect on the amounts recognised in the financial statements.

IAS 1 paragraph 125 requires an entity to disclose information about the assumptions it makes about the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. Entities are also required to disclose details of the nature of such assets and liabilities together with their carrying amount as at the end of the reporting period.

These disclosures are often provided in the accounting policies note but may be provided in a separate note. Where appropriate, cross references should be made to other notes where further details can be found. The FRC expects judgements and estimates to be separately identified, with judgements clearly distinguished from estimates, and the relevant disclosures to be provided for each.

It is important to note that not all judgements and sources of estimation uncertainty need to be disclosed. Many judgements and estimates will not be considered significant enough to warrant disclosure and some simple businesses may find they do not have any issues that are within scope of these requirements.

UK GAAP

For UK GAAP reporters, paragraphs 8.6 and 8.7 in Section 8 of FRS 102 contain requirements consistent with those outlined above. While FRS 102 does not contain all of the detailed guidance included in IAS 1, and which is referred to below, it is nonetheless useful to UK GAAP preparers and represents best practice.

What are judgements?

Management will often need to use their judgement when applying an entity’s accounting policies. Typically, those judgements that have the most significant effect on amounts recognised in the financial statements are those where exercising judgement in a different way may have led to a significantly different outcome.

Tip: Judgements are often applied when deciding whether, and how, to recognise a transaction. Judgement might also be required when choosing between possible measurement bases.

Examples of significant accounting judgements

IAS 1 gives the following examples of situations where judgement is applied, in determining:

• when substantially all the significant risks and rewards of ownership of financial assets and, for lessors, assets subject to leases are transferred to other entities;
• whether, in substance, particular sales of goods are financing arrangements and therefore do not give rise to revenue; and
• whether the contractual terms of a financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

There are many other instances where judgement is needed when applying accounting policies, including in determining:

• when and how revenue should be recognised;
• the appropriate treatment of leases by a lessee eg, determining the lease term for renewable or cancellable leases;
• whether an unconditional right to a refund exists when determining the limit on a defined benefit pension asset;
• whether a transaction is a business combination or the purchase of a group of assets;
• who is the acquirer and what is the acquisition date in a business combination;
• whether an investee is a subsidiary; and
• whether a joint arrangement is a joint venture or a joint operation.

There may not always be an accounting standard that specifically applies to a transaction, event or condition. In such instances, management should use its judgement to develop and apply an appropriate accounting policy by applying the requirements set out in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors or the equivalent requirements of Section 10 of FRS 102. This judgement will need to be disclosed where it has a significant effect on the amounts recognised in the financial statements.

What to disclose

As noted above, disclosure is only required of those judgements that have the most significant effect on the amounts recognised in the financial statements – so disclosures are not automatically needed merely because judgement is used when applying an accounting policy. For example, no disclosure would be necessary where it is easy to determine how revenue should be recognised or where there is no doubt about who the acquirer is in a business combination.

While there is no detailed guidance on what needs to be disclosed, high quality disclosures should not only explain how and why management have concluded that the judgements identified are considered significant but should also enable users of the financial statements to understand the impact of those judgements. It may be helpful, for example, to explain the differences in accounting that would have arisen if an alternative judgement had been reached. Generic statements that simply say that judgement has been exercised add little or no value and should therefore be avoided.

Judgement disclosures specifically do not include judgements involving estimates, which are covered by the separate requirements discussed below.

What are sources of estimation uncertainty?

IAS 8 defines accounting estimates as ‘monetary amounts in financial statements that are subject to measurement uncertainty’.

Determining the carrying amounts of some assets and liabilities will require the use of accounting estimates to reflect the effects of uncertain future events on their carrying amount at the end of the reporting period. Such estimates may involve making assumptions, for example, about items such as discount rates and future cash flows. Significant estimation uncertainty arises where there is a significant risk of a material adjustment being made to the carrying amounts of assets and liabilities within the next financial year.

Tip: Estimation uncertainty often relates to the measurement of assets and liabilities.

Examples of sources of estimation uncertainty

IAS 1 gives the following examples of estimation uncertainties:

• determining the recoverable amount of property, plant and equipment;
• the effect of technological obsolescence on the net realisable value of inventories;
• provisions subject to the future outcome of litigation in progress; and
• long-term employee benefit liabilities such as pension obligations.

There are many other examples of estimation uncertainties including:

• fair value measurements that rely on significant unobservable inputs;
• forecast future profits used to determine the recoverability of a deferred tax asset; and
• making forward looking assumptions when measuring expected credit losses.

It should also be remembered that sources of estimation uncertainty may vary from year to year. Companies should reassess whether disclosures made in a previous year need to be revised. Simply carrying forward information from prior years will not necessarily ensure compliance with the relevant disclosure requirements.

What to disclose

IAS 1 provides relatively detailed guidance on what should be disclosed in relation to estimation uncertainties.

As noted above, disclosure is only needed where there is a significant risk of a material adjustment to the carrying amounts of assets and liabilities within the next financial year. So, for example, no disclosure would be needed in relation to an impairment review if the recoverable amount calculated was significantly higher than the asset’s carrying amount; in such circumstances it is unlikely that reasonably possible changes in assumptions would change the outcome of the impairment test.

Paragraph 127 of IAS 1 explains that disclosure should only be made of those estimates that require management’s most difficult, subjective or complex judgements. It goes on to explain that as the number of variables and assumptions affecting the possible future resolution of the uncertainties increases, those judgements become more subjective and complex, and the potential for a consequential material adjustment to the carrying amounts of assets and liabilities normally increases accordingly. The Basis for Conclusions to IAS 1 indicates that the disclosures in relation to estimates are expected to be required in respect of relatively few assets and liabilities, though the increased use of estimates required by more recent accounting standards means this may not always be the case.

Paragraph 129 of IAS 1 requires entities to present the required disclosures in a manner that helps users of financial statements to understand the judgements that management makes about the future and about other sources of estimation uncertainty. The nature and extent of the information provided will vary according to the nature of the assumption and other circumstances.

The same paragraph of the standard gives the following examples of the types of disclosures to be made:

• the nature of the assumption or other estimation uncertainty;
• the sensitivity of the carrying amounts to the methods, assumptions and estimates underlying their calculation, including the reasons for the sensitivity;
• the expected resolution of an uncertainty and the range of reasonably possible outcomes within the next financial year in respect of the carrying amounts of the assets and liabilities affected; and
• an explanation of changes made to past assumptions concerning those assets and liabilities if the uncertainty remains unresolved.

Depending on the facts and circumstances, it might not always be necessary to make all of these disclosures but, in most cases, some of this information is likely to be needed if readers are to fully understand the estimates made. Sometimes it may also be necessary to make additional disclosures over and above those listed in order to enable users to fully understand the key sources of estimation uncertainty. While information about longer term uncertainties may be useful for users of financial statements, any additional disclosures about such uncertainties should be clearly identified and explained.

Paragraph 131 of IAS 1 acknowledges that it will sometimes be impracticable to disclose the extent of the possible effects of an assumption or another source of estimation uncertainty at the end of the reporting period. In such cases, the entity should disclose that it is reasonably possible, on the basis of existing knowledge, that outcomes within the next financial year that are different from the assumption could require a material adjustment to the carrying amount of the asset or liability affected. In all cases, the entity must disclose the nature and carrying amount of the specific asset or liability affected by the assumption.

Paragraph 128 of IAS 1 explains that the above disclosures are not required for assets and liabilities with a significant risk that their carrying amounts might change materially within the next financial year if, at the end of the reporting period, they are measured at fair value based on a quoted price in an active market for an identical asset or liability. While such fair values might change materially within the next financial year, these changes would not arise from assumptions or other sources of estimation uncertainty at the end of the reporting period.

Examples of good and bad practice

The FRC published a thematic review on judgements and estimates in 2017 and a follow up report in 2022. Both include helpful hints and real-life examples of good practice.

Examples of good practice identified or encouraged included:

• Clearly distinguishing between judgements and estimates.
• Identifying a smaller number of judgements and estimates but providing much richer and more granular information about the supporting assumptions and sensitivities so that users can fully understand them.
• Explicitly identifying significant estimates (ie, those estimates that may genuinely have a material effect on the following year’s accounts) and focussing on them.
• Providing disclosures about estimates that are clear, specific and pinpoint the precise sources of uncertainty.
• Providing disclosures about the specific amounts at risk of material adjustment, rather than just identifying the financial statement line item within which these are contained.
• Including meaningful sensitivity analysis and providing quantified information about the range of reasonably possible outcomes in the next financial year to enhance investors’ understanding of the assumptions underlying estimates.
• Explaining where management’s view sits within a range of possible outcomes so that investors can evaluate the possible effects of estimates on future accounts.
• Explaining why past assumptions have changed, particularly where the past uncertainty remains unresolved.
• Explaining the reasons for changes in the list of judgements and estimates considered to be key from those disclosed in the previous year.
  Clearly identifying any additional estimate disclosures provided beyond those required, such as those carrying lower risk, having smaller impact or crystallising over a longer timeframe.

Examples of poor practice identified included:

• Making disclosures about estimates that do not have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next year.
• Using ‘boilerplate’ text which could apply to any company and that gives no additional
  useful information to users of the accounts.

Climate change

The FRC’s 2022 thematic review specifically looked at disclosures about the impact of climate change. IFRS Practice Statement 2: Making Materiality Judgements, explains that qualitative external factors – such as the industry in which the company operates and investor expectations – may make some risks ‘material’ regardless of their numerical impact. The current focus on climate-related risks by investors and others means that companies may need to consider such risks in the context of their financial statements, possibly as part of their disclosure of judgements and estimates.

The thematic review noted that many of the companies the FRC looked at as part of their research mentioned climate change within their estimate disclosures, with several explaining that the impact was factored into significant estimates.

The FRC noted that better disclosure clearly articulated the timing of any impact, providing specific clarification that climate either had a risk of a material adjustment to carrying values on assets and liabilities in the next financial year or did not but could have medium or longer-term impact.

The report also noted that some companies presented additional illustrative climate sensitivities relating to the potential longer-term impacts. The report explained that, where such information is provided, it is important to make a clear distinction between these sensitivities and any shorter-term sensitivities disclosed in accordance with IAS 1.

Interaction with other disclosures in the annual report

Information relating to risks and uncertainties will also be included in an entity’s strategic report (when prepared). There should be consistency between the various elements of the annual report. However, it should be noted that just because something is identified in the strategic report as a principal risk or uncertainty, it does not necessarily mean that it is something that is within the scope of the disclosure requirements relating to key judgements and sources of estimation uncertainty.

Any sensitivity disclosures provided in the strategic report should be consistent with disclosures elsewhere in the annual report.

Avoiding disclosure overload

It is important that the disclosures required by IAS 1 are not obscured by irrelevant material that detracts from what is important. Producing an extensive list of all judgements that were taken and estimates used when preparing the financial statements is neither desirable nor helpful to users of the financial statements.

Links to further resources

• IAS 1 Presentation of Financial Statements
• FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland
• FRC’s Annual Review of Corporate Reporting 2022/23
  
• FRC Thematic Review – Judgements and Estimates - Update (2022)
• FRC Thematic Review – Judgements and Estimates (2017)