Insights > Navigating Gray Areas in Accounting: Applying Your Best Judgment to Impairment, CECL, and More

Navigating Gray Areas in Accounting: Applying Your Best Judgment to Impairment, CECL, and More

When facing areas of accounting that require a high degree of judgment, companies rely heavily on the Office of the CFO to get it right. By rethinking initial approaches and learning from hindsight, accounting professionals can ensure accuracy, enable audit readiness, and support a stronger path forward.

For corporate accounting professionals, navigating the complexities of financial reporting requires not only a firm grasp of technical accounting standards but also the ability to exercise sound judgment in situations where specific guidance may be limited. Some timely topics that accounting professionals may find challenging to navigate include impairment testing and new or recently implemented accounting standards such as CECL. Accurately accounting for new standards not only impacts a company’s audit readiness—it also plays an essential role in accurate budgeting, forecasting, and strategic decision-making.

Navigating Gray Areas in Accounting: Applying Your Best Judgment to Impairment, CECL, and More

A guide to judgment in impairment testing

Amongst the various complexities of technical accounting, impairment testing often presents unique challenges due to its reliance on estimates and subjective assessments. Annual impairment testing, as well as assessing impairment triggers for finite-lived assets, is sometimes overlooked but is important for most organizations, including private companies preparing for their annual audits. Accounting leaders should understand the intricacies of goodwill impairment, potential impairment scenarios, and how to tackle the “gray areas” with informed judgment.

Goodwill impairment and indefinite-lived intangible asset impairment each require sound judgment

Goodwill, an intangible asset representing the premium paid in an acquisition over the fair value of identifiable net assets, is particularly susceptible to both impairment and a significant amount of judgment. Similarly, indefinite-lived assets which typically represent intangible assets with useful lives that are assumed to exist in perpetuity, such as a tradename, represent a challenge when applying the guidance in ASC 350 regarding evaluation for impairment. While annual goodwill and indefinite-lived intangible assets may seem run-of-the-mill, significant judgment is required to determine the inputs utilized in the impairment test. Determining fair value often depends on forecasted cash flows, which like any estimates are inherently susceptible to unforeseen changes in the business environment. This inherent subjectivity calls for sound judgment by company management and invites scrutiny from auditors.

Poor performance in a reporting unit can indicate potential goodwill or indefinite-lived intangible asset impairment. The future cash flows used in the impairment test will require a detailed build of budgeted figures and an analysis of potential scenarios. A sensitivity analysis is a great way to determine the strength of the reporting unit in various scenarios and identify significant inputs that require further analysis. A sensitivity analysis such as a most-like scenario accompanied by a worst-case scenario and an upside scenario can help make clear the potential range of business outcomes and how they impact the impairment analysis.

What about finite-lived assets?

While often overlooked, assessing finite-lived intangible assets for potential triggering events should be the first step preceding the required annual impairment tests for goodwill and indefinite-lived intangible assets. A significant decline in a business unit’s performance can indicate potential impairment in other groups of assets. Finite-lived assets are tested in asset groups, defined as the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of the other assets and liabilities. Potential triggering events indicated by ASC 360 include:

  • A significant decrease in the market price of a long-lived asset (asset group)
  • A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition
  • A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator
  • An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group); A current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group)
  • A current expectation is that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. The term more likely than not refers to a level of likelihood that is more than 50 percent.

How cash flow forecasting factors into impairment testing

As noted earlier, the fair value of goodwill and indefinite-lived intangible assets heavily relies on forecasted cash flows. If management has determined there is a triggering event for finite-lived assets, forecasted cash flows will be utilized in the recoverability test.  Determining these cash flows involves making assumptions about future economic conditions, market dynamics, and the company’s competitive landscape. The ability to exercise sound judgment in selecting these assumptions and ensuring their reasonableness is crucial in determining the impairment loss, if any.

For example, if a software company acquires a competitor, the fair value of the acquired goodwill will depend heavily on forecasted cash flows. The accounting team will consider various factors: a potential economic downturn could decrease future sales, while the company’s recent innovative product launch might boost market share. Ultimately, they will exercise sound judgment by incorporating both optimistic and pessimistic economic forecasts, and factor in the launch’s potential impact, resulting in a balanced and reasonable estimate of future cash flows, which in turn will help determine the appropriate level of potential goodwill impairment.

This highlights the importance of professional skepticism and a critical evaluation of the underlying assumptions and methodologies used in the cash flow forecasting process. Collaboration between management and external auditors becomes critical in ensuring that the chosen assumptions are sufficiently supported and represent a realistic view of the company’s future prospects.

Challenging the assumptions of third-party valuation specialists

When accounting for goodwill impairment, it can often be difficult to understand the methodology used by third-party valuation specialists. Sometimes these communications can be full of jargon or arranged in a way that isn’t intuitive, so company accounting leaders should be proactive and get clarity wherever needed. It can help to look at the prior-year analysis and inputs and compare what has changed year-over-year.

If the numbers don’t seem accurate (for example, if the cash flows are too heavily discounted), company accounting leaders can—and should—challenge the valuation specialists because the in-house team knows the business. This deep knowledge of the business supports a clear understanding of the relevant risks, cash flows, and other critical factors. A valuation specialist might not know the business as intimately as accounting management, so it’s important to use judgment to work in partnership with these professionals in order to support the findings with the most accurate assumptions.

Other impairment considerations beyond goodwill

While goodwill impairment may be a prominent example, it’s crucial to remember that the principles of impairment testing apply to various other asset classes. For instance, if a company experiences a significant and sustained decline in its market value, it might trigger an impairment test for long-term investments. Additionally, inventory obsolescence and deterioration can necessitate impairment tests for inventory assets.

Exercising accounting judgment with confidence

Impairment testing, particularly for goodwill, presents unique challenges due to its reliance on estimates and subjective assessments. By exercising sound judgment, leveraging professional skepticism, and fostering collaboration with auditors, corporate accounting professionals can navigate this area with confidence and ensure that their financial statements reflect a faithful representation of the company’s financial health.

Mastering CECL: honing judgment and approaches to this dynamic accounting standard

The Current Expected Credit Loss (CECL) standard brought a significant shift in credit loss recognition and measurement. While many accounting teams initially perceived the standard as a straightforward calculation, reporting for CECL relies on estimates and subjective assessments, which introduces complexities that demand informed judgment. Plus, accounting teams can benefit from revisiting their initial approaches to CECL to strengthen accuracy and ultimately support better decisions in the future.

CECL affects most companies, not just the financial services sector

While the financial services industry experienced the most significant impact from CECL, its reach extends far beyond. Any company extending credit, from retailers offering store credit cards to manufacturers providing financing options, even companies simply holding accounts receivable balances, must grapple with the standard’s implications. Applying CECL to these diverse scenarios requires tailoring the standard’s framework to specific business models and credit risk profiles, further emphasizing the role of judgment in navigating its nuances.

Beyond the numbers: The role of judgment in accounting for CECL

Unlike earlier standards focused on incurred losses, CECL requires companies to estimate expected credit losses over the entire life of the financial instrument. This inherently forward-looking approach necessitates the application of sound judgment across various aspects of the standard.

Accounting for CECL is complex because it requires incorporating qualitative factors alongside quantitative data. Factors like economic forecasts, industry trends, and historical loss patterns must be considered and weighed against each other, demanding professional skepticism and a critical evaluation of underlying assumptions.

For instance, when faced with implementing CECL for the first time, a furniture manufacturer’s accounting team might debate how to segment their customer base for loss estimation. Option A would involve grouping all customers together, leading to simpler calculations but potentially masking risks in specific segments and may not meet the standards requirements around risk pooling. Option B would involve segmenting customers by creditworthiness, offering a more nuanced view but requiring additional data analysis. Ultimately, the accounting team could benefit from choosing Option B, acknowledging the complexity but recognizing the importance of accurately reflecting the varying credit risks associated with different customer segments. This decision allows the company to tailor its loss estimates and better assess potential future losses within specific customer groups.

Embracing the “best guess” and learning from hindsight

Determining the precise value of current expected credit losses can be akin to peering into a crystal ball. The inherent uncertainty requires CFOs and accounting professionals to use their best judgment, supported by historical data, industry benchmarks, and expert insights.

Hindsight can be a valuable tool in refining future estimates. Regularly reviewing the accuracy of past estimates allows for identifying any significant discrepancies between predicted and actual losses. This retrospective analysis helps in calibrating future assumptions and improving the reliability of estimates over time but may require a significant effort to understand historical trends, especially when receivables have only been reserved and not fully written off.

For example, during an annual review, a retail company’s accounting team will likely identify discrepancies between the previous year’s CECL estimates for bad debt on store credit cards and the actual losses experienced. Upon further analysis, they might attribute any underestimation to a misjudgment of the economic impact on consumer spending within their target demographic. Consequently, the accounting and finance team will be able to recalibrate their assumptions for the upcoming year. They can factor in a more conservative outlook on consumer spending patterns based on updated economic forecasts and industry trends. This revised approach will aim to improve the accuracy of their CECL estimates and provide a more reliable picture of the company’s expected credit losses.

By looking back and recalibrating the approach, the office of the CFO can enable the company to more accurately account for expected credit losses going forward.

The value of revisiting your company’s initial assumptions

As with any newly implemented accounting standard or evolving business practice, it’s crucial to remember that the initial application of CECL and the selection of key assumptions should not be considered an endpoint.

As the business environment evolves and new information becomes available, continuously revisiting and refining assumptions becomes critical. This dynamic approach ensures that the company’s CECL implementation remains audit-ready and reflects the most accurate representation of its expected credit losses.

Accounting for CECL accurately by learning from public companies

Private companies currently implementing the CECL standard can benefit from the experiences of public companies that have already done so. Many public companies implementing CECL have encountered challenges like ensuring the completeness of financial assets, gathering auditable data, and coordinating across departments. These experiences highlight the importance for private companies to:

  1. Dedicate sufficient resources to gather necessary data and prepare for implementation.
  2. Establish clear communication channels across departments involved in the CECL process.
  3. Focus on data quality and auditability throughout the process.
  4. Seek professional guidance when navigating complex aspects of the standard.
  5. Continuously monitor and refine their application of CECL accounting standards as needed.

By learning from their successes and pitfalls, private companies can streamline their CECL process and minimize potential challenges. This collaborative approach fosters the application of CECL best practices and allows private companies to leverage the collective knowledge within the industry.

CECL can be a catalyst for informed decision-making

Beyond accurately reflecting credit losses, CECL offers a valuable perspective into the underlying health of a company’s credit portfolio. By estimating expected losses, CECL empowers businesses to identify potential risks associated with substandard customer segments and optimize credit risk management strategies. This forward-looking insight facilitates informed decision-making regarding customer acquisition and portfolio composition, ultimately contributing to a more sustainable financial future.

By embracing the essential role of judgment, actively seeking learning opportunities, and fostering a culture of continuous improvement, corporate accounting professionals can navigate the complexities of CECL with confidence, ensuring accurate financial reporting and informed decision-making for their organizations.

In accounting, getting it right can elevate your impact

In the world of accounting, exercising sound judgment doesn’t just ensure accuracy – it has the power to elevate accounting leaders’ impact within the organization. Beyond ensuring audit-readiness, financial insights can empower proactive problem-solving and support strategic changes.

Making numbers count: Does the business budget and forecast accurately?

One key area where good judgment shines is in assessing the accuracy of budgets and forecasts. This information provides invaluable insights for CFOs and accounting leaders, allowing them to determine if a company is consistently hitting its financial targets or falling short.

Management’s role in a budgetary assessment

While the financial planning and analysis (FP&A) team plays a crucial role in budget creation, it’s vital for management to actively participate in the budget assessment process. This two-pronged approach fosters a culture of ownership and accountability, ensuring everyone is aligned with the company’s financial goals.

Here’s how management can contribute:

  • Conducting an analysis that looks at historical data: Compare past budget forecasts to actual performance over an extended period. This historical analysis reveals if there’s a consistent pattern of under- or overestimating certain factors, such as revenue or expenses. By identifying these discrepancies, management can determine if their budget expectations are realistic or require adjustments. For instance, by looking at past data and evaluating budgetary accuracy, a business might identify that it underestimates third-party costs every year. This could trigger a more realistic budget or a more rigorous third-party selection process.
  • Understanding the budget’s foundation: Gaining a solid understanding of the underlying assumptions and accounting methodologies used to build the budget is crucial. This allows management to assess the logic and rationale behind the numbers, fostering better comprehension and facilitating informed decision-making.
  • Guiding a collaborative approach: Combining the expertise of the FP&A team with management’s insightful perspective creates a robust system for evaluating budget accuracy and improving performance. This collaborative approach doesn’t just validate forecasts; it fosters a shared understanding of the company’s financial health and paves the way for strategic adjustments. By proactively identifying areas for improvement, your organization can refine its budgeting and forecasting processes, ultimately setting the stage for future success.

Explore more insights about transforming the FP&A function.

Anticipating changes within a business—and the accounting impacts

The role of CFOs or accounting leaders extends beyond historical analysis and current operations. When navigating the ever-changing landscape of the business and anticipating its impact on financial reporting, it’s critical to apply accounting expertise and use sound judgment. This can include:

  • Considering the accounting implications of organizational changes: Business is rarely static. Mergers, acquisitions, product line extensions, and even changes in leadership can all trigger the need for adjustments in accounting practices. Proactive consideration of these potential shifts ensures preparedness to address their impact on financial reporting. Imagine a scenario where a CEO restructures the leadership team, dissolving a department and dispersing its responsibilities across other divisions. What seems like an operational change also has accounting implications. For instance, the company’s segment reporting might require adjustments to reflect the new departmental structure. By proactively considering the accounting ramifications of potential business changes, financial reporting remains accurate, transparent, and reflects the true picture of an evolving organization. This foresight empowers anticipation of challenges, maintenance of investor confidence, and ultimately, support for informed decision-making throughout the company’s journey.
  • Knowing when to refine accounting practices: Adopting an accounting standard or guidance doesn’t mark the end of the journey. It’s crucial to revisit these approaches periodically to ensure they accurately reflect the current state of the business. This ongoing evaluation helps ensure accounting practices remain relevant and capture the nuances of an evolving business model. For instance, a company experiencing rapid growth through acquisitions might need to re-evaluate its consolidation methods to accurately represent its financial position.

While the above insights explore general considerations for CECL, impairment, and other matters, accounting professionals must apply the relevant accounting standards and regulations to specific situations. Work with qualified advisors to determine the best approach for your organization’s individual circumstances.

Related topics: Accounting Consulting Group | Technical Accounting Matters

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