Attention to detail is an important aspect of accounting, but not every cost or profit can be calculated down to the second decimal point. There are many times when an accountant has to make an immediate decision based on an estimate of future costs or profits that are subject to variables. These types of decisions are made using subjective judgment. The ability to use subjective judgment effectively, and as accurately as possible, is an indispensable skill for accounting professionals.
An active, thriving business has cash flow that stems from a variety of different revenue streams and many regular expenses. As an accountant, you might be aware of an upcoming profit or expense but unable to record it with the utmost accuracy, either because the money hasn’t actually changed hands yet or because the precise amount is still unknown.
A contingency is a sum of money that may be paid to a contractor depending on the conditions of the contract. For example, some lawyers have a contingency fee that’s agreed upon prior to any legal proceeding. The contingency is paid in the event the case is lost. If the case is won, the lawyer receives a percentage of the client’s settlement, so the contingency isn’t needed.
Contingencies are common in service contracts. A business might be contracted to perform duties to a client that isn’t certain of the exact scope of the labour required. To protect itself, the business might estimate a profit higher than what ends up being received. As an accountant, you may have to use subjective judgment to estimate what the business can expect to be paid.
A write-off is an amount paid for supplies, new equipment, donations, employee wages, or anything else a client is legally allowed to deduct from taxes. If a business is new, recently expanded, or otherwise changed in terms of overall income or structure, there may be a great deal of subjective judgment required on the part of an accountant to factor in potential write-offs.
Accruals and Deferrals
Accruals and deferrals are amounts (either revenues or expenses) reported outside the period in which the actual transaction occurred. An accrual is calculated prior to the transaction, and a deferral is calculated after the transaction. For example, you may be required to account for the accrued cost of a business’ phone bill; the cost is recorded in one month, though the payment will occur in the following month.
Monthly bills are just one example of an accrual. Most businesses have numerous regular payments, costs, and revenues you may need to account for before or after the transactions are recorded. There are many variables that can affect the monetary amounts of such payments upon receipt, so you’ll need to use subjective judgment to account for fluctuations in accruals and deferrals.
Depreciation is the degradation in value of a large piece of equipment purchased by a business. Think of a van or truck for a moving company, or a set of new computer monitors for an office. In Canada, depreciation is accounted for via the capital cost allowance (CCA) system, which dictates what percentage of an item’s value can be claimed annually for its useful lifetime.
The total amount of depreciation that a business can claim at tax time is dependent on a number of factors including the previous year’s depreciation amount and the cost of assets acquired or disposed of during the current tax year.
In business, materiality is the amount of impact that an accounting discrepancy has on periodic financial statements and reports. For example, say that while reviewing a client’s ledgers you notice the client was invoiced for $25,000 by a vendor, but the corresponding debit amounted to $24,995 on a bank statement.
Because the discrepancy is only $5, and a very small percentage of the overall payment, it isn’t considered material. That is, it’s not going to have much of an effect on the client’s taxes or overall finances. By contrast, a discrepancy of $500 is a more significant sum, and would probably be considered material by most businesses.
When you begin working with a client, establish a firm materiality threshold. There’s no set regulation for a materiality threshold, and materiality can vary depending on the type of statement and type of payment or profit. You may have to use your judgment in cases where the materiality of a cost might be disputed.
How to Use Subjective Judgment Effectively
To make subjective accounting judgment work for you and your clients, you need to ensure you’re on the same page when it comes to how much subjective judgment and estimation is expected or necessary to balance the books. Talk to the business owner about how much estimation he is comfortable using, and ask about the practices of previous accountants or in-house bookkeepers.
Try to gain an understanding of the business’ process for implementing subjective judgment, and develop your own system adjacent to it. Whenever an estimate or subjective judgment is required, ask strategic questions about potential points of cash flow, and understand the environmental, economic, and timing fluctuations that can affect the cost of, and revenues from, various business activities.
Don’t be afraid to go to outside sources when determining the extent to which you can implement subjective judgment. Compare your client’s practices to peers and similar businesses. If possible, gather information about previous audits and find out if there were any issues or complaints with past uses of an accountant’s judgment. While it can be difficult to have a completely accurate and up-to-date picture of a business’ accounts and cash flow, effective subjective judgment should provide you and your client with the basic information you need to maintain a healthy financial system.