Accounting: The Language of Business - Vol. 2 (Intermediate: Part 17)

Nature is an expert in cost-benefit analysis,' she says. 'Although she does her accounting a little differently. As for debts, she always collects in the long run.

Margaret Atwood

Judgment and Applied Financial Accounting Research (Part B)

by 

Charles Lamson

The Role of Assumptions and Estimates

After a manager or accountant determines that a firm should report a business event in the financial statements, he or she often uses assumptions and estimates to answer the questions related to when to recognize the transaction, what accounting method to use, and what amount to record.

Assumptions and Estimates in the Financial Statements

Many amounts reported on the financial statements are based upon assumptions. For example:

1. Property, plant, and equipment are deprecated using a particular method [such as straight-line depreciation (Straight-line depreciation is the simplest method for calculating depreciation over time. Under this method, the same amount of depreciation is deducted from the value of an asset for every year of its useful life.) See part 58 of vol. 1.] that requires managers and accountants to make assumptions about the pattern of use.

2. Investments in another company are accounted for differently depending on how long management intends to hold the investment. Thus, managers and accountants must make assumptions about the duration of the investment.

Many of the balances reported on financial statements are estimates. Consider these two specific examples:

1. The value reported for plant, property, and equipment is net of accumulated depreciation. Depreciation is based upon estimates of the life and pattern of use of the depreciable assets.

2. Accounts receivable are reported on the balance sheet net of an allowance for those receivables that are not likely to be collected. However, the balance in the allowance account is an estimate as to how much of the accounts receivable balance might not be paid by customers.

It is important for financial statement preparers and users to understand the extensive use of assumptions and judgment in the financial statement preparation process.

Judgement-Related Disclosures

How does a financial statement user know where managers used judgment in the financial reporting process? Financial statement disclosures---specifically, the accounting policies footnote provide this information. Generally Accepted Accounting Principles (U.S. GAAP or GAAP) require companies to disclose their significant accounting policies.

Accounting Policies Footnote. The accounting policies footnote outlining the portfolio of accounting choices is typically one of the first notes to the financial statements. In Johnson & Johnson's 2015 annual report, it listed accounting policy choices for 14 different areas: cash equivalents; investments; property, plant, and equipment depreciation; revenue recognition; shipping and handling; inventories; intangible assets and goodwill; financial instruments; product liability; concentration of credit risk; research and development; advertising; income taxes; and net earnings per share. For example, Johnson & Johnson indicated that it reported inventory at the lower of cost or market and valued inventory using the first-in, first-out method ( an easy-to-understand inventory valuation method that assumes that goods purchased or produced first are sold first). As another example, Johnson & Johnson disclosed that it reports property, plant, and equipment at cost, depreciating these assets using the straight-line method [Straight line basis is a method of calculating depreciation and amortization, the process of expensing an asset over a longer period of time than when it was purchased. It is calculated by dividing the difference between an asset's cost and its expected salvage value by the number of years it is expected to be used (Investopedia).], and it also disclosed the lives that it uses to depreciate various groupings of assets. Toward the end of the disclosure, Johnson & Johnson also indicated that it uses estimates extensively in the preparation of financial information.

Industry Comparisons. Financial statement users rely on accounting policies footnote information to compare Johnson & Johnson to other firms in the industry. Johnson & Johnson's competitors include healthcare and pharmaceutical companies such as Pfizer Inc., GlaxoSmithKline plc, and AstraZeneca plc. Exhibit 3.1 illustrates the different methods, estimates, and assumptions that Johnson & Johnson and its competitors use in accounting for common items such as inventory and long-lived tangible assets. Notice that two of the companies Johnson & Johnson and Pfizer---are U.S. GAAP reporters and that two report under IFRS---GlaxoSmithKline and AstraZeneca. Next, two of the four companies use the first-in, first-out (FIFO) inventory cost flow assumption (Johnson & Johnson and GlaxoSmithKline), one uses average cost (Pfizer), and one uses a combination of FIFO and average cost (AstraZeneca). Or depreciation of long-lived tangible assets, all four companies use the straight-line method. However, the asset categories and useful lives vary considerably among the companies and are influenced by management judgment. For example, all four companies have a different range of useful lives for their buildings (Analysts and other financial statement users also employ various statement analysis techniques to understand a company's financial position and performance and compare it to other companies. We will discuss some of these techniques in upcoming posts and apply them where appropriate throughout this text.).

In addition, the accounting policies footnote enables users to determine whether a company employs income-increasing or income-reducing accounting policies or methods. For example, a company using FIFO in a period of inflation will typically report lower cost of sales and higher gross profit than a company using LIFO.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 57-58*

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