A reasonably objective basis for financial forecasts. (Statements of Position 92-2 of the Task Force on Forecasts and Projections of the American Institute of Certified Public Accountants)(includes related article)by Dirkes, Kenneth J.
A Task Force on Forecasts and Projections was formed by the AICPA's Auditing Standards Board in 1987 to consider implementation issues resulting from the 1986 Guide for Prospective Financial Statements (the Guide). Since that time, the Task Force has issued Statements of Position (SOP) 89-3, Questions Concerning Accountants' Services on Prospective Financial Statements, and 90-1, Accountants' Services on Prospective Financial statements for Internal Use Only and Partial Presentations. SOP 89-3 responded to a number of specific implementation issues raised by practitioners. Sop 90-1 was issued to respond to certain changes in the Code of Professional Conduct and to provide additional guidance on partial presentations.
Sec. 210.07 of the Guide requires that "the responsible party have a reasonably objective basis to present a financial forecast for it to be appropriate for general use." The Guide defines the responsible party as the person or persons who are responsible for the financial forecast assumptions, usually management. As the Task Force studied various implementation issues raised by practitioners, it soon became clear that many of the issues could be more easily resolved if guidance was available to preparers and their independent accountants that would assist them ill gaining a better understanding of the term "reasonably objective basis."
As a result, the Task Force prepared an Exposure Draft of a proposed SOP, Questions and Answers on the Term Reasonably, objective Basis and Other Issues Affecting Prospective Financial Statements, issued February 1990. Almost all the commentators supported issuance of the proposed SOP. The resulting SOP 92-2 was issued in early 1992, with an effective date six months after issuance.
This new pronouncement describes the purpose of the term reasonably objective basis and provides guidance on factors that should be considered in evaluating whether such a basis exists to present a financial forecast. Because existence of a reasonably objective basis is affected by the length of the forecast periods, the SOP also provides guidance for evaluating whether that period is appropriate.
Further, SOP 92-2 provides guidance for disclosures that may be necessary for periods beyond the forecast period. That guidance was deemed necessary because of the SOP's emphasis on tie use of shorter forecast periods. As a result, responsible parties may need to refocus on the Guide's requirement that forecasts include a description of the potential effects of long-term results where short-term financial forecasts may not be meaningful, e.g., in situations where disclosure of long-term results are necessary to evaluate investment consequences. Finally, SOP 92-2 discusses the reporting accountant's responsibilities for evaluating 1) whether a responsible party has a reasonably objective basis to present a financial forecast, and 2) the responsible party's disclosure of long-term results.
Accountants, both preparers and attesters, are familiar with each component word in the term "reasonably objective basis." Thus, the Task Force concluded that it could best provide guidance by explaining the purpose of the term and discussing the factors to be considered when evaluating whether such a basis exists, Accordingly, SOP 92-2 states that:
"Because users expect financial forecasts to present the responsible party's best estimate,' the term reasonably objective basis was included in the Guide to communicate to responsible parties a measure of the quality of information necessary to present a forecast."
That new SOP makes it clear that the term reasonably objective basis is a preparer concept. The responsible party should conclude that such a basis exists; otherwise, a financial forecast should not be presented.
The guidance in the SOP 92-2 applies only to financial forecasts. However, the SOP points out that it should be useful in evaluating whether other assumptions provide a reasonable basis for a projection, given the hypothetical assumptions.
EVALUATING WHETHER A
When evaluating whether a reasonably objective basis exists to present a financial forecast, there is no substitute for the responsible party's knowledge of the reporting entity's business and industry. That is true even if another party such as an independent accountant assembles the presentation because a financial forecast is simply a quantification of the responsible party's plans and only the responsible party (usually management) has the authority to carry out those plans.
In a somewhat over-simplification, SOP 92-2 indicates that the responsible party has a reasonably objective basis for presenting a financial forecast if sufficiently objective assumptions can be developed for each key factor. The Guide defines key factors as the significant matters on which the entity's future results are expected to depend. Such factors are basic to the entity's operations and, thus encompass matters that affect, among other things, its sales, production, service, and financing activities. However, important guidance is provided to assist the responsible party in evaluating whether such assumptions can be developed:
* Can facts be obtained and informed judgments made about past and future events in support of the underlying assumptions?
* Are any of the significant assumptions so subjective that no reasonably objective basis could exist to present a financial forecast?
* Would people knowledgeable in the entity's business and industry select materially similar assumptions?
* Is the length of the forecast period appropriate? (This factor is discussed later.)
All of these factors are important, but perhaps the most basic is the first. To have a reasonably objective basis to present a financial forecast, the responsible party must be able to point to data or other information including informed judgments (e.g., opinions from experts) about past or future events in support of significant assumptions. Sec. 316.03 of the Guide states that the "level of support should be persuasive, although there are times when a number of assumptions in a narrow range of possibilities may appear equally likely."
The second factor is a good old fashion smell test, and the third is a test of the guideline that the responsible party prepares financial forecasts in good faith given the facts and informed judgments available and his or her knowledge of the entity's business and industry. Although highly judgmental, this factor more often than not is critical in deciding when a presentation of prospective financial information may be labeled a financial forecast. Other matters the responsible party should consider when evaluating whether sufficient objective assumptions can be developed are illustrated in an exhibit to SOP 92-2, and examples are provided to illustrate the Task Force's views on how the guidance provided may be applied.
ASSUMPTIONS USED ARE
The new SOP makes a distinction between the responsible party's evaluation of whether he or she has a reasonably objective basis to present a financial forecast and whether the assumptions used are appropriate. That distinction is intended to convey the message that even though a reasonably objective basis may exist to present a financial forecast, the responsible party may develop inappropriate assumptions from the facts and informed judgments available. For example, data may be available to estimate an occupancy rate for a real estate development; however, incorrect analysis of that data could lead to the selection of inappropriate assumptions. In practice, the responsible party's evaluation of whether a reasonably objective basis exists to present a financial forecast and his or her evaluation of whether assumptions used are appropriate often will not be clearly separate. Rather, some responsible parties gather information to develop and support assumptions for their financial forecasts and concurrently evaluate whether a reasonably objective basis exists and the assumptions selected are appropriate.
SOP 92-2 indicates that there are several factors that should be considered by the responsible party when evaluating whether assumptions underlying a financial forecast are appropriate including whether:
* There appears to be a rational relationship between the assumptions and the underlying facts and circumstances, i.e., the assumptions are consistent with past or current conditions.
* The assumptions are complete, i.e., assumptions have been developed for each key factor.
* It appears that the assumptions were developed without undue optimism or pessimism.
* The assumptions are consistent with the entity's plans and expectations.
* The assumptions are consistent with each other. B The assumptions, in the aggregate, make sense in the context of the forecast taken as a whole.
When a financial forecast is subjected to challenge by a third party, that challenge may often be based on a contention that sufficient facts and informed judgments did not exist to present a financial forecast, i.e., a reasonably objective basis did not exist. Or, if a reasonably objective basis did exist the information available was incorrectly analyzed indicating that a rational relationship did not exist between the assumptions and the underlying facts and circumstances.
As to the later issue, it is important that the selection of assumptions not be overly biased. Undue optimism at the time of selection can haunt a preparer and his or her independent accountants when a financial forecast is challenged by those with the benefit of hindsight. For example, historical trends are important indicators of the future, but they require careful consideration of current economic or other indicators of impending changes.
LENGTH OF THE
A major issue in evaluating whether a reasonably objective basis exists to present a financial forecast is the length of the forecast period. As the time span covered by a forecast increases, uncertainty as to the basis for the forecast increases, and at some point underlying assumptions may no longer be sufficiently objective to present a financial forecast. As a result of the recent recession in the U.S., even the most optimistic preparers, independent accountants, and users of forecasts have become painfully re of the inability to predict the future over long periods. Further, since each year of a financial forecast presented must have a reasonably objective basis, most people believe that the "running out" of financial forecasts using assumed inflation rates for revenues and expenses ordinarily do not provide for sufficiently objective assumptions, particularly if different inflation rates are used for revenues and variable expenses. The following statement in SOP 92-2 sets forth the Task Force's view on the length of a forecast period and represents a major change in practice:
"It ordinarily would be difficult to establish that a reasonably objective basis exists for a financial forecast extending beyond three to five years, and depending on the circumstances, a shorter period may be appropriate. For example, in the case of certain start-up or high- tech companies, it may be difficult to support an assertion that a reasonably objective basis exists to present a financial forecast and, if so, for more than one year."
The AICPA's Guide does not prohibit the presentation of a financial forecast accompanied by financial projections for periods extending beyond the forecast period, however, such presentations would be limited to use by the responsible party alone or by persons with whom the responsible party is negotiating directly.
There may be some exceptions to this guidance. For example, it may be possible to present a financial forecast for longer periods when long- term contracts exist specifying revenues to be received, including their timing, and when costs can be controlled within reasonable limits.
Disclosure of Long-term Results
The Guide provides and SOP 89-3 expands on guidance about the disclosures that may be necessary to enable users to evaluate long-term investment consequences of a project or entity when a short-term financial forecast may not be meaningful. That guidance relates primarily to disclosures that assume the circumstances or events expected in periods beyond the forecast period take place at the end of the forecast period. SOP 92-2 expands the disclosure guidance about the investment consequences of long-term results to encompass information for periods beyond the forecast where such disclosures do not assume the circumstances or events take place at the end of the forecast period.
The disclosures provided for in SOP 92-2 may be limited to narrative descriptions or they may include estimated effects of future transactions or events; they are intended to be part of the summary of significant assumptions and accounting policies. Accordingly, they are not to be presented comparative to forecasted results on the face of the financial forecast or in related summaries of results. Nor should they be presented as separate financial projections. Examples of the disclosures are provided using the following criteria described in the new SOP. In all cases, the disclosures should be based on the responsible party's plans and knowledge of specific events or circumstances, at the date of the forecast, that are expected to have a material effect on results beyond the forecast period. The disclosures should:
* Include a title indicating that information is presented about periods beyond the financial forecast period.
* Include an introduction indicating that the information presented does not constitute a financial forecast but does indicate its purpose.
* Disclose significant assumptions and identify those that are hypothetical as well as specific plans, events, or circumstances that are expected to have a material effect on results beyond the forecast period.
* State that 1) the information is presented for analysis purposes only, 2) there is no assurance that the events and circumstances described will occur, and 3) if applicable, that the information is less reliable than that presented in the financial forecast.
An example of a disclosure about plans and events expected after the forecast period is included in a sidebar to this article.
The procedures in Secs. 600 (Compilation Procedures) and 700 (Examination Procedures) of the Guide contemplate consideration of whether the responsible party has a reasonably objective basis for presentation of a financial forecast. For example, in an examination engagement, the independent accountant considers the existence of that basis when he or she evaluates the support for the forecast assumptions.
To provide accountants with guidance about their responsibility for disclosures of long-term results, SOP 92-2 states that in applying procedures to provide assurance that the forecast conforms to AICPA presentation guidelines in an examination, or in reading the forecast for conformity with the guidelines in a compilation, the accountant should consider whether such disclosures are required and, if so, whether they are made. The accountant is not required to design specific procedures to identify conditions and events that might occur beyond die forecast period. Rather, the accountant's consideration is based on information about management's existing plans, future events, and circumstances obtained during the engagement
Since disclosures of long-term results are included in notes to the financial forecast, they are covered by the independent accountant's report. Procedures applied to the disclosure will depend on whether the accountant is compiling or examining the financial forecast. The accountant should also consider whether:
* Disclosures are consistent with management's existing plans and its knowledge of future events and circumstances; and
* Disclosures are presented in conformity with the guidelines for presentation of such information.
In today's world of electronic spreadsheets and other sophisticated software, it is not difficult to prepare impressive-looking prospective financial statements indicating what the future results of an activity may or could be. However, such statements are not financial forecasts unless a reasonably objective basis exists to present the prospective information therein.
Kenneth J. Dirkes, CPA is a Partner of KPMG Peat Marwick, and is a member of the AICPA and NJSCPA He is Chairman of the AICPA's Task Force on Forecasts and Projections and participated in preparations of SOP 92- 2.
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