ISA 540 (Revised) recognises that there is no ‘one size fits all’ response when auditing accounting estimates and that different responses will be needed depending on the assessed risks. To demonstrate scalability, the standard therefore makes it clear that the further audit procedures need to be responsive to the reasons for the assessed risk of material misstatement and that the higher the assessed risk, the more persuasive the audit evidence needs to be. The linkage of the further audit procedures with the assessed risk and the reasons for the assessment needs to be documented.
Alongside this, and highlighting the need for professional scepticism, the auditor is required to design and perform further audit procedures without a bias towards obtaining corroborative or excluding contradictory evidence.
ISA 540 (Revised) requires the auditor to respond in one or more of three ways by:
- obtaining evidence from events up to the date of the audit report;
- testing how management has made the estimate;
- developing the auditor’s own point estimate or range.
For the second and third approaches the requirements are structured around testing the methods, data and assumptions.
How does the auditor determine whether the methods, assumptions or data are appropriate?
The first stage is determining whether management has appropriately applied the requirements of the financial reporting framework in relation to the methods chosen, significant assumptions made and selection of data. The auditor also needs to assess whether any changes from the prior period are appropriate in the circumstances.
The auditor also needs to think about whether:
- the calculations are applied in accordance with the method and are mathematically accurate and if the method involves complex modelling, judgements have been applied consistently and the design of the model meets the measurement objective of the financial reporting framework (and the auditor may need to consider whether there is a need for specialised skills or knowledge here);
- Significant assumptions are consistent with each other and those used in other accounting estimates or with related assumptions used in other areas of the entity’s business activities; and
- The data is relevant and reliable and has been appropriately understood or interpreted by management.
Arbitrary changes in methods, data or inconsistency in significant assumptions not justified by changes in circumstances or new information will need to be discussed with management. What is required in all cases is the use of judgement and professional scepticism. For example, where an impairment calculation is supported by assumptions about future sales, the auditor’s industry knowledge and judgement will be important in considering the reasonableness of sales figures used in discounted cash flow forecasts.
What if management hasn’t taken appropriate steps to address estimation uncertainty?
The auditor needs to consider whether management has taken appropriate steps to understand estimation uncertainty and address it by selecting an appropriate point estimate and by developing related disclosures. If, based on the audit evidence obtained, the auditor doesn’t believe that management has appropriately addressed estimation uncertainty the auditor must
- Request management to do more work – which means either additional procedures, reconsideration of the point estimate or additional disclosures – and evaluate the response;
- If the response does not sufficiently address estimation uncertainty, develop an auditor’s point estimate or range (if practicable); and
- Evaluate whether a deficiency in internal control exists (requiring a communication in accordance with ISA 265).
The audit documentation needs to show how the auditor has responded to this.
How does the auditor develop a point estimate or range?
Developing an auditor’s point estimate or range might be necessary where, for example, there are appropriate alternative assumptions or sources of data that can be used or if the auditor’s review of similar accounting estimates made in the prior period suggests that the current period process is not likely to be effective.
In relation to the use of point and range estimates, the auditor may use management’s or the auditor’s own methods, assumptions and data but either way the further audit procedures should be performed to address the same considerations in relation to methods, assumptions and data as required when testing how management has made the estimate.
If using different assumptions to those used by management, the auditor needs to understand management’s assumptions well enough to establish that they have considered relevant variables and evaluated differences. Different, equally valid assumptions may be used as inputs to a model but if there is little effect on the estimate, it may suggest that management’s estimate is appropriate. If there is a significant difference, it might suggest that management has made an error, or that there is high sensitivity to changes in assumptions which might indicate that the assessed risk should be higher along the spectrum. It will also lead the auditor to consider the reasonableness of disclosures about estimation uncertainty.
If the auditor concludes that it is appropriate to use a range, the range is narrowed based on audit evidence available, until all outcomes within the range are considered reasonable. This should be obvious. The auditor excludes from the range those extremities unlikely to occur and, looking at the remaining reasonable range, compares it with management’s estimate. The size of the “reasonable” range may itself be useful because if it is significant then estimation uncertainty may be a significant risk.
How does the auditor evaluate the reasonableness of estimates and related disclosures?
The auditor must evaluate whether the estimates and related disclosures are reasonable with regard to the financial reporting framework – or are misstated.
This includes considering whether the estimate is reliable enough to be recognised. For example, FRS 102 requires that if a provision cannot be reliably estimated it should not be booked. A contingent liability should be disclosed instead and the need for an emphasis of matter in the auditor’s report should be considered in such circumstances.
When the auditor has determined a point estimate, a difference between that estimate and management’s is a misstatement. Where the auditor’s estimate is a range, the misstatement is no less than the difference between management’s point estimate and the nearest point of the auditor’s range. When the audit evidence supports a wide range (even multiples of materiality for the financial statements as a whole) it may indicate that it is important for the auditor to reconsider whether sufficient appropriate audit evidence has been obtained regarding the reasonableness of the amounts within the range.
The auditor must also document significant judgements relating to their assessment. They must also obtain written representations from management about the appropriateness of the methods, significant assumptions and data used in making the accounting estimates in terms of achieving recognition, measurement and disclosure that is in accordance with the financial reporting framework.