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How incorrect assumptions increase risk

Aug 18, 2022
By: Alison J. Herrick

I was recently talking to my daughter about how making assumptions can hinder us from developing new or deeper relationships. The conversation brought to mind an awkward but teachable moment from my own childhood that arose from a silly and unnecessary assumption.

It also ties to accounting. I promise.

I met a new friend in school, and after a bit of time, she invited me over for a sleepover. (I was still too shy to make such a bold move). Once at her house, we experienced that awkward moment in a new friendship of “now what do we do,” so we decided to order pizza. Not knowing much about each other, she asked what kind of pizza I wanted. Up to that point, I had been conditioned to think pepperoni was the default topping that everyone liked but me. I didn’t want to be difficult, so I said, “Whatever, pepperoni is fine.”

The pizza arrived and we both took a slice, and in unison, we peeled off the pepperoni. While our mutual gesture turned out to be a funny icebreaker, the main lesson learned was don’t make unnecessary assumptions. Had we communicated our pizza preferences, we would have ended up with a more delicious pizza experience and less waste.

Communication is key

So what does this story have to do with accounting? Well, when we have to make estimates, we need to make assumptions. A number of components of the balance sheet are made up of estimates, which require assumptions to be made. Those assumptions require varying levels of information and thought, which includes communicating and understanding what is going on within the institution.

The newly effective ASC 842 lease standard brings another estimate to the mix. Though the quantitative data needed to determine the right-to-use asset amount takes out a lot of the guess work, if the lease has renewal extensions, management must make some level of assumptions to predict the future.

If the assumptions are made on prior history alone, assuming the lease will be extended as it always has, the financial institution may be adding more to the balance sheet than is needed. It’s important to communicate with those involved in strategic planning to help ensure assumptions are aligned.

For example, the strategic plan could be to focus on reducing brick-and-mortar branches and increasing digital presence; this plan could lessen the likelihood of extending the leases in the future. If we make assumptions without communicating first to get as much information as we can to make good assumptions, we could find ourselves with estimates that don’t truly reflect the eventual outcomes.

Another example where good communication is needed when developing assumptions is the allowance for loan and lease losses. Factors used to estimate the allowance are based on external and internal information and assumptions. If the assumptions aren’t aligned with lending strategies, the financial institution could be carrying a reserve that doesn’t represent the expected losses. Understanding the loan products and strategies will help the institution better predict the allowance by developing solid and supported assumptions.

As auditors we rely heavily on professional judgment, with that comes the need to maintain a level of professional skepticism and the mindset to trust but verify. This type of mentality should also be used when making assumptions that could significantly impact your accounting estimates.

The more communication and data obtained, the more refined the estimates can be. When you avoid making assumptions about what another party wants, you get a better professional outcome. And you may also end up with your preferred pizza.

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Alison J. Herrick, CPA
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