The revised ISA 540 is effective for periods beginning on or after 15 December 2019. It has introduced a number of new and enhanced requirements, with significant changes and challenges for auditors to get to grips with. These include enhanced risk assessment procedures, separate inherent and control risk assessments, and the introduction of the spectrum of inherent risk.
ICAEW’s Audit and Assurance Faculty has been looking at some of the challenges of auditing accounting estimates when implementing the revised standard. It has produced a series of webcasts that use practical illustrations to consider key issues in common audit areas. The first of a series of four webcasts tackles an often-overlooked area of accounting estimates, fixed assets and depreciation.
“Estimates tend to be thought of in terms of complex areas of accounts,” says Matt Howells, Partner and Head of the National Assurance Technical Group at Smith and Williamson, talking in the first of a series of webcasts on ISA 540 (Revised). “If you ask people: ‘what are some of the accounting estimates that you might come across?’ people often identify things like provisions for litigation, valuation of share options, those quite complex areas. It's the same when you're thinking about fixed assets and depreciation.”
A fairly obvious accounting estimate within fixed assets and depreciation is impairment losses, particularly in the context of the COVID-19 pandemic. That has been at the forefront of a lot of audit teams’ minds, says Howells, because of the impact that COVID-19 has had on business performance. “Other estimates include assets carried at a revalued amount or at fair value, like investment property, for example.”
Depreciation, on the other hand, is often treated as quite a straightforward area of the accounts, with the same calculation year on year. But there are actually two accounting estimates within depreciation, Howells explains: the useful economic life of the asset, and the residual value of the asset.
“The residual value is often ignored; it's just assumed by the directors to be zero,” says Howells. “But it's important that we as auditors actually think about that and ask ourselves: ‘Is this a fair assumption to make?’ Have we actually questioned whether there might be a material residual value?”
It's also important that auditors consider evidence, for example from past sales, says Howells, to judge whether the useful economic life is appropriate. Another indicator to look for would be if there are a lot of fully depreciated assets that the business is still using, which would suggest that the useful life of those assets is too short.
Early understanding of how these estimates are made is crucial. “Make sure that you understand at the planning stage what estimates you're dealing with and how management makes those estimates,” says Howells. How does management factor in economic life and material residual value when it's making its depreciation calculations, for example?
If you're looking at an impairment calculation, you need to think about how management has calculated the impairment loss, ie, whether they’ve used net realisable value or value in use, says Howells. “If it's value in use, there might be some quite complex cash flow assumptions. So again, what assumptions have been used? How has management calculated the amount of the impairment loss?”
Performing a retrospective review of accounting estimates is also important and while this isn't a change from the old standard, it is frequently misunderstood by audit teams, says Howells. It’s not a matter of just saying that last year’s depreciation is correct: “The idea is to check how good management is at making estimates by comparing previous estimates with actual outturn. For example, if there are significant sales of assets post year end, this will help to assess previous estimates of useful life and residual value.”
To help support firms in addressing some of these challenges, ICAEW’s Audit and Assurance Faculty has designed a new accounting estimates hub, which brings together a range of articles, guides and webinars to help firms navigate the requirements of the revised standard. The new resource hub highlights the key changes for auditors, discusses what is meant by the spectrum of inherent risk, considers how to demonstrate professional scepticism and looks at what documentation might be needed on audit files.
For more information, resources and support tools about ISA 540 (Revised), visit the new auditing accounting estimates hub here.
Further webcasts in the auditing accounting estimates series consider how to identify specific risks in relation to estimates and look at some trickier audit areas, including provisions and property valuations. View the first of the series of four ICAEW Audit and Assurance Faculty webcasts here.