When accounting judgments may lead to legal liability

As featured in Accounting Today

At first glance, accounting judgements may, appropriately, be viewed as routine accounting practices done in the normal course of business: estimates required due to business uncertainty, and assumptions necessary to complete financial reporting obligations. But when such judgements are overly optimistic, unsupported, or poorly documented, they can tip into the territory of accounting errors or fraud, leading to restatements, public scrutiny and even regulatory enforcement. And in the current U.S. enforcement climate, the stakes remain as high as ever.

SEC Focus: Cutting Through the Noise

While the U.S. Securities and Exchange Commission (SEC) has, under the new Administration, indicated publicly that it may reduce its enforcement focus in areas of ESG and crypto disclosures, its scrutiny of accounting and auditing practices will remain robust. In 2024 alone, the SEC brought more than 45 enforcement actions involving financial misreporting. This pattern suggests that, even amid a broader shift towards deregulation, financial reporting integrity is still very much in the crosshairs, due primarily to concerns that inaccurate financial reporting erodes investor confidence and the market as a whole.

Given the significance of accounting estimates in financial reporting it is no surprise that many enforcement actions cite a registrant’s failure to appropriately consider, or intentionally ignore, all relevant facts and circumstances that could materially impact key assumptions that form the basis of accounting estimates. A prime example: In late 2024, United Parcel Service (UPS) was fined $45 million by the SEC for materially misrepresenting its earnings. The company relied on an external valuation of one of its business units but withheld key information from the consultant. As a result, the unit was grossly overvalued, and UPS avoided recording a goodwill impairment. This case illustrates how selective disclosure, even without overt intent to deceive, can result in significant enforcement and reputational damage.

The Judgement-Fraud Continuum

Management accounting judgements are not inherently problematic – after all, no standard can prescribe treatment for every unique transaction. But it’s when those judgements lack a sound basis, are inconsistently applied from one reporting period to the next, ignore contradictory evidence, or aren’t clearly documented that problems arise.

Case in Point 1: Percentage of Completion Accounting

Consider revenue recognition in long-term contracts, a recurring hotspot in SEC enforcement. U.S. GAAP and IFRS both permit revenue to be recognized based on progress toward completion. This requires assumptions about future costs, contract modifications, and the likelihood of contingent income. These assumptions should be reasonable and evidence-based – but our investigations often reveal overly optimistic revenue forecasts or misreporting of costs that can artificially boost profits.

A recent example relates to A.I. enabled robotic company Symbotic Inc. that reported errors related to its revenue recognition practices in 2024 due to material weaknesses in its internal controls that prematurely recognized expenses related to good and services it was providing to customers under milestone achievements. In addition, the Company failed to recognize cost overruns that could not be recovered, and should have, therefore, been written off. Due to Symbotic recognizing revenue under a percentage of completion basis, the recognition of expenses prior to the satisfaction of key milestones, resulted in the early recognition of revenue. Symbotic was sued for securities fraud in a class action lawsuit, following a 35%+ decline in the share price, and has announced an ongoing investigation by the SEC.

This issue also crosses industries and geographies. The UK’s oilfield services and engineering company, Wood Group plc, experienced a 68%+ decrease in its share price since it announced in November 2024 that it had identified “inappropriate management pressure and override to maintain previously reported positions” leading to information being withheld from internal auditors. Reports have suggested the company engaged in over-optimistic accounting judgement and a lack of evidence to support assumptions made and positions taken.

Case in Point 2: Straightforward accounting estimates

While fraud may be easier to conceal in complex areas of accounting, it can also manifest itself in more straightforward recurring practices. At each reporting period end companies are required to estimate, and record accruals for expenses that have been incurred but for which an invoice has not yet been received. US high street retailer, Macy’s reported that a single employee had made unsupported/unjustified adjustments to the accrual entries to conceal $151m of small-package delivery expenses over a two year period from Q4, 2022 through Q3, 2024. While the SEC has not announced a formal investigation, a securities class action was filed against the company, and the company announced it had initiated a $600k+ clawback in executive bonuses.

A Company’s response: Getting Ahead of the Risk

The key takeaway? Judgement-related risks aren’t going away – and neither is regulatory scrutiny. U.S. enforcement bodies may be shifting their focus, but accounting misstatements remain a primary concern. And with the SEC’s emphasis on financial transparency and accurate reporting, businesses can no longer afford to treat accounting judgements as mere technicalities.

Key areas that a company can consider to address the risk of inaccurate or unsupported accounting estimates include:

• Identify those accounting estimates that are most significant to the business from both a qualitative and quantitative perspective: what estimates and key assumptions have a) the most significant impact on reported results, and/or b) have the greatest element of uncertainty and, therefore, highest probability of being incorrect.
• Understand the methodology for developing accounting estimates including the availability and reliability of data sources, how such sources are generated, whether there have been adjustments to how the data is compiled from period to period, and whether there are alternative or supplementary sources that can better inform the facts.
• Stress-test the estimates by assessing the impact of applying alternative assumptions or weightings of information sources. Similarly, conduct regular retrospective testing of historical assumptions relative to actual results to identify how accurate prior estimates were, what factors/assumptions contributed to the accuracy and inaccuracy of prior estimates, and identify amendments and modifications to future estimation processes.
• Ensure that all significant judgements are clearly documented and evidence-based.  Regulators, and litigation plaintiffs use hindsight to “reaudit” or “recreate” accounting estimates so it is critical that companies document a complete account of the information available to them at the time, and the assumptions, thoughts and alternatives that were considered when generating accounting estimates. Estimates project future events and will inevitably be incorrect. However, a well documented record that demonstrates that the company made a balanced, thorough and good-faith approach to developing its estimates provides a strong mechanism to defend any scrutiny that may be levied in the future.
• Ensure that estimates, the processes followed, and assumptions made are done in a clear and transparent manner with the company being open to the thoughts, ideas and comments from others within the business, including those outside of the accounting function.

Ultimately, sound accounting judgement is not just a matter of technical compliance – it’s central to maintaining stakeholder trust and avoiding costly regulatory action.