How to audit accounting estimates?

 

Accounting estimate is a monetary amount for which the measurement, in accordance with the requirements of the applicable financial reporting framework, is subject to estimation uncertainty.

Estimation involves judgements based on the latest available, reliable information. For example, estimates may be required of:

(a) bad debts

(b) inventory obsolescence.

(c) the fair value of financial assets or financial liabilities

(d) the useful lives of, or expected pattern of consumption of the future economic benefits embodied in, depreciable assets; and

(e) warranty obligations

 (f) outcome of long-term contracts

(g) costs arising from litigation settlements and judgements.

(h) Provision against the carrying amount of an investment where there is uncertainty regarding its recoverability.

The use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. But the process of making accounting estimates involves selecting and applying a method using assumptions and data, which requires judgment by management and can give rise to complexity in measurement. Balances and transactions related to accounting estimates are therefore more susceptible to management bias, especially where management has an incentive to manipulate financial results (for example, their remuneration is linked to the profit for the year)

 The auditor's objective is to obtain sufficient appropriate audit evidence about whether accounting estimates are reasonable and related disclosures are adequate.

Audit stages of accounting estimates.

The following stages of the audit of accounting estimates could be distinguished:

(a) Performing the risk assessment procedures and related activities.

Risk assessment procedures are performed by obtaining an understanding of the entity and its environment, including the entity’s internal control. These procedures will help the auditor to obtain an understanding of matters relating to accounting estimates.

(b) Identifying and assessing the risks of material misstatement.

The auditor should evaluate the degree of estimation uncertainty associated with an accounting estimate. If the estimation uncertainty is assessed as high, the auditor shall determine whether any of the risks of material misstatement identified and assessed in the auditor’s judgment, a significant risk.

(c) Responding to the identified risks of material misstatement (performing further audit procedures).

The auditor’s further audit procedures shall include one or more of the following approaches: 1. Obtaining audit evidence from events occurring up to the date of the auditor’s, 2. Testing how management made the accounting estimate or 3. Developing an auditor’s point estimate or range.

(d) Performing other audit procedures.

Other audit procedures include evaluation whether the accounting estimates are reasonable or misstated; obtaining sufficient appropriate audit evidence about whether disclosures related to an accounting estimate, other than those related to estimation uncertainty are correct; identifying if there are indications of possible management bias; obtaining written representations from management about the methods, significant assumptions and the data used in making the accounting estimates.

Responses to the assessed risks of material misstatement relating to an accounting estimate.

The responses to the assessed risks of material misstatement relating to an accounting estimate and related disclosures is one of the stages of the audit of accounting estimates and related disclosures.

Actually, the responses are further audit procedures used by auditors to test accounting estimates. They include one or more of the following approaches:

(a) Obtaining audit evidence from events occurring up to the date of the auditor’s report.

(b) Testing how management made the accounting estimate or

(c) Developing an auditor’s point estimate or range.

For a significant risk relating to an accounting estimate, the auditor’s further audit procedures shall include tests of controls in the current period if the auditor plans to rely on those controls. When the approach to a significant risk consists only of substantive procedures, those procedures shall include tests of details.

(a) Obtaining Audit Evidence from Events Occurring up to the Date of the Auditor’s Report

In some circumstances, obtaining audit evidence from events occurring up to the date of the auditor’s report may provide sufficient appropriate audit evidence to address the risks of material misstatement. For example, sale of the inventory shortly after the period end may provide sufficient appropriate audit evidence relating to the estimate of its net realizable of this inventory.

(b) Testing How Management Made the Accounting Estimate

Testing how management made the accounting estimate may be an appropriate approach when, for example:

• The auditor’s review of similar accounting estimates made in the prior period financial statements suggests that management’s current period process is appropriate.

• The accounting estimate is based on a large population of items of a similar nature that individually are not significant.

• The applicable financial reporting framework specifies how management is expected to make the accounting estimate. For example, this may be the case for an expected credit loss provision.

• The accounting estimate is derived from the routine processing of data.

When testing how management made the accounting estimate the auditor obtains sufficient appropriate audit evidence regarding the following matters:

1. The selection and application of the methods, significant assumptions and the data used by management.

Methods. A method is a measurement technique used by management to make an accounting estimate in accordance with the required measurement basis (for example, determination of a theoretical option call price using the Black-Scholes option pricing formula). If applied method uses a computational tool or process, it is sometimes referred to as a model.

Assumptions. Assumptions involve judgments based on available information about matters such as the choice of an interest rate, a discount rate, or judgments about future conditions or events.

Data. Examples of data include market transactions prices, historical prices or other terms included in contracts, economic or earnings forecasts, a future interest rate determined using interpolation techniques.

2. How management selected the point estimate and developed related disclosures about estimation uncertainty.

(c) Developing an Auditor’s Point Estimate or Using an Auditor’s Range

This approach may be an appropriate when, for example:

• The auditor’s review of similar accounting estimates made in the prior period financial statements suggests that management’s current period process is not expected to be effective.

• The entity’s controls within and over management’s process for making accounting estimates are not well designed or properly implemented.

• Events or transactions between the period end and the date of the auditor’s report have not been properly taken into account, when it is appropriate for management to do so, and such events or transactions appear to contradict management’s point estimate.

. • There are appropriate alternative assumptions or sources of relevant data that can be used in developing an auditor’s point estimate or a range.

• Management has not taken appropriate steps to understand or address the estimation uncertainty.

The auditor may develop a point estimate or a range in a number of ways, for example, by:

• Using a different model than the one used by management, for example, one that is commercially available for use in a particular sector or industry, or a proprietary or auditor-developed model.

• Using management’s model but developing alternative assumptions or data sources to those used by management.

• Using the auditor’s own method but developing alternative assumptions to those used by management.

• Employing or engaging a person with specialized expertise to develop or execute a model, or to provide relevant assumptions.

• Consideration of other comparable conditions, transactions or events, or, where relevant, markets for comparable assets or liabilities.

Testing how management made the accounting estimate.

Testing how management made the accounting estimate one of the further audit procedures used by an auditor to test accounting estimates and related disclosures.

When testing how management made the accounting estimate, the auditor obtains sufficient appropriate audit evidence regarding the risks of material misstatement relating to:

(a) The choice and application of the methods, significant assumptions and the data used by management in making the accounting estimate; and

(b) How management selected the point estimate and developed related disclosures about estimation uncertainty

In evaluating the management’s selection of the point estimate and development of the related disclosures about estimation uncertainty the auditor performs further audit procedures to address whether, management has taken appropriate steps to:

1. Understand estimation uncertainty. This step includes:

· Management understanding the estimation uncertainty through identifying the sources and assessing the degree of inherent variability in the measurement outcomes and the resulting range of reasonably possible measurement outcomes.

· Application by management appropriate skills, knowledge, and professional judgment in in making accounting estimates.

· Determination whether management has addressed the estimation uncertainty through appropriately selecting management’s point estimate and related disclosures that describe the estimation uncertainty.

2. Address estimation uncertainty by selecting an appropriate point estimate and by developing related disclosures about estimation uncertainty.

Matters regarding the selection of management’s point estimate and the development of related disclosures about estimation uncertainty include whether:

· The methods and data used were selected appropriately.

· The assumptions used were selected from a range of reasonably possible amounts and were supported by appropriate data.

· The data used was appropriate, relevant and reliable.

· The calculations were mathematically correct.

· Management’s point estimate is appropriately chosen from the reasonably possible measurement outcomes.

· The related disclosures appropriately describe the amount as an estimate and explain the variability of the reasonably possible measurement outcomes.

If the auditor’s consideration of estimation uncertainty associated with an accounting estimate, and its related disclosure, is a matter that required significant auditor attention, then this may be presented as a key audit matter in the audit report.

When management has not taken appropriate steps to understand and address estimation uncertainty the auditor may:

· Request management to perform additional procedures to understand estimation uncertainty,

· Develop an auditor’s point estimate, or

· Modify the audit report

Indicators of Possible Management Bias

 

The auditor shall evaluate whether judgments and decisions made by management in making the accounting estimates are indicators of possible management bias.

Management bias is a lack of neutrality by management in the preparation of information.

Estimation uncertainty gives rise to subjectivity in making an accounting estimate. The presence of subjectivity gives rise to the need for judgment by management and the susceptibility to unintentional or intentional management bias.

The auditor shall evaluate whether judgments and decisions made by management in making the accounting estimates are indicators of possible management bias.

Management bias may be difficult to detect at an account level and may only be identified by the auditor when considering groups of accounting estimates, all accounting estimates in aggregate, or when observed over a number of accounting periods.

Examples of indicators of possible management bias with respect to accounting estimates include:

· Changes in an accounting estimate, or the method for making it, when management has made a subjective assessment that there has been a change in circumstances.

· Selection or development of significant assumptions or the data that yield a point estimate favorable for management objectives.

· Selection of a point estimate that may indicate a pattern of optimism or pessimism.

When such indicators are found, there may be a risk of material misstatement either at the assertion or financial statement level. Indicators of possible management bias may affect the auditor’s conclusion as to whether the financial statements as a whole are free from material misstatement. Additionally, the auditor is required to evaluate whether management’s judgments in making the accounting estimates indicate a possible bias that may represent a material misstatement due to fraud.

 

 

Documenting the audit process of accounting estimates.

 

The auditor includes in the audit documentation the following matters related to accounting estimates:

(a) Key elements of the auditor’s understanding of the entity and its environment, including the entity’s internal control related to the entity’s accounting estimates.

(b) The linkage of the auditor’s further audit procedures with the assessed risks of material misstatement at the assertion level. The audit should consider the reasons given to the risks of material misstatement at the assertion level. Those reasons may relate to one or more inherent risk factors or the auditor’s assessment of control risk.

(c) The auditor’s response(s) when management has not taken appropriate steps to understand and address estimation uncertainty.

(d) Indicators of possible management bias related to accounting estimates.

(e) Significant judgments relating to the auditor’s determination of whether the accounting estimates and related disclosures are reasonable in the context of the applicable financial reporting framework.

 ISA 540