How to determine high estimation uncertainty
In determining whether an accounting estimate has high estimation uncertainty, the auditor needs to consider the risk factors that influence the likelihood and magnitude of a potential misstatement.
Under ISA 540, Auditing accounting estimates including fair value accounting estimates, and related disclosures (ISA 540), the following are examples of indicators of high estimation uncertainty:
- high dependency on judgement;
- no recognised basis or technique for measurement;
- evidence of historic differences in estimates compared to subsequent actual outcomes; and
- application of fair value measurement using a complex model or with no observable inputs.
Following the assessment of indicators of estimation uncertainty, including those highlighted above, the auditor should be in a position to conclude whether the accounting estimate has a high estimation uncertainty that gives rise to a significant risk.
The illustrations below are intended to demonstrate the assessments that the auditor might make in order to reach this conclusion.
High dependency on judgement
An accounting estimate may have a high dependency on judgement when the estimate is driven by uncertainty.
Uncertainty may arise when management has limited or no influence on the outcome, such as outstanding litigation. Alternatively, uncertainty may also arise when the timing of future cash flows is dependent on uncertain events many years into the future.
| Example: An entity operates as a travel agency, specialising in travel between Portugal and the UK. Following the acquisition of a group tour business in prior years, the entity’s business is split equally between group tours and family holidays. Due to a poor trading performance, the entity’s management has determined that there is an indicator of impairment of the goodwill and intangible assets within the group tour business. As a result, management performed an impairment review, based on the future cash flow forecasts of the group tour business only. With uncertainty over Brexit, the impact on border controls and the economy of the UK, there is significant uncertainty over management’s forecasts. In particular, it is questionable whether the forecast growth in the number of holiday travellers will be achieved, a key assumption within the estimation. |
| In this example, the auditor determines that there is high estimation uncertainty over the accounting estimate due to the potential impact of Brexit on future cash flows. The auditor’s assessment of risk considers the value of the goodwill and intangible assets, which are material, in combination with the magnitude of a potential misstatement, resulting in the identification of a significant risk within the audit. |
No recognised basis or technique for measurement
For certain accounting estimates, the applicable financial reporting framework may indicate the estimation basis or technique on which management should base its accounting estimate, eg, fair value or value in use. There may also be established estimation techniques that can be used. Some examples include Black-Scholes option pricing models to value share-based payments or mathematical approaches, such as Monte Carlo, to value options.
Where there is no financial reporting framework guidance, or a recognised measurement technique in the market, this may result in an increase in the estimation uncertainty. In turn, that might lead to a significant risk. The increased estimation uncertainty arises from the nature of the model used by management as a basis for the estimate. This may not consider all the potential factors impacting the outcome of the estimate.
It is anticipated that in most circumstances there will be a recognised measurement technique for an accounting estimate in the market. Where management does not have sufficient skills or knowledge in the estimation basis or technique, management should engage an expert with these skills and knowledge to aid the preparation of the accounting estimate.
Evidence of historic differences in estimates compared to subsequent actual outcomes
When considering whether an estimate has a high level of estimation uncertainty that may give rise to a significant risk, the auditor should reflect on management’s estimation ability over similar accounting estimates. While the outcome of a previous accounting estimate is expected to be higher or lower than the estimate, that this outcome varies widely to the original estimate may call into question management’s ability to estimate. In turn, this may result in a higher estimation uncertainty.
| Example: An architecture business works on fixed fee projects that may take a number of months to complete. Revenue for these projects is recognised over time based on the applicable financial reporting framework. Through a review of completed projects in the prior year, the auditor identified that the forecast costs at the start of each project were, on the whole, understated by 20%, resulting in a significantly higher than actual forecast profit. This impacted the prior year end revenue recognition. |
| In this example, based on the prior year experience, the auditor determines that there is high estimation uncertainty over management’s ability to forecast the total costs, and thus appropriately recognise revenue. The assessment of estimation uncertainty considers the magnitude of a potential misstatement. This includes the impact on the key performance indicators of the business (revenue and profit), which may have a significant impact on the judgement of the status of the company by a user of the financial statements. The auditor considers the magnitude of a potential misstatement to be high and, combined with the high assessment of estimation uncertainty, decides to raise a significant risk in the audit file in respect of this estimation. |
Application of fair value measurement using a complex model or with no observable inputs
Accounting estimates often involve highly complex calculations, such as fair value models used for acquisition accounting, impairments and financial assets. This complexity can present a number of challenges to the auditor. These include:
- tracing the formulae within the calculation through to input data to check the validity of the calculation;
- understanding the key inputs/assumptions that impact the outcome and drive the estimate, when there are numerous inputs/assumptions within the model;
- seeking support for key inputs/assumptions where evidence is not readily available; and
- benchmarking key inputs/assumptions that are not sufficiently comparable.
With so many different factors in the basis for estimation that can impact the outcome, there is often an increased risk over the uncertainty of the estimate. The increased risk arises from the impact of a small change, or combination of small changes, to any of these factors (eg, inputs/assumption, formulae) on the outcome of the estimate. This can create a wide range of possible outcomes. The auditor will need to consider where management’s estimate sits within the range and whether this is within the acceptable range, hence the higher level of uncertainty over the accounting estimate.
Where management does not have sufficient skills or knowledge in the estimation basis or technique, they should look to engage an expert with these skills and knowledge to aid the preparation of the accounting estimate.
Impact of identifying significant risk due to high estimation uncertainty
When assessing an accounting estimate with high estimation uncertainty as a significant risk, it is important for an auditor to remember the requirement of ISA 315 to obtain an understanding of the entity’s controls, including the control activities. This also includes whether and how management responds to the risks. For judgemental areas, such as accounting estimates, these responses may include:
- control activities in place over the accounting estimate, such as the review of assumptions by an expert or senior management;
- documented processes in place for estimates; and
- approval by those charged with governance of the estimation, including an understanding of the approach applied and the resulting balance.
It is also important to consider whether the accounting estimate with high uncertainty may also cast significant doubt on the entity’s ability to continue as a going concern. Examples of when this may be relevant include:
- the impairment of a significant asset (which could, for example, result in a loan covenant being breached); or
- litigation (where, for example, the estimated cost of settling the litigation is significant compared to the entity’s potential available cash resources).
Finally, in response to a significant risk, an auditor should be mindful of the further substantive procedures that are required under ISA 540. These include an evaluation of:
- management’s consideration of alternative assumptions or outcomes (eg, sensitivity analysis);
- the reasonableness of assumptions; and
- the intent and ability of management to proceed with a course of action.
In circumstances where the auditor believes that management has not adequately addressed the effects of estimation uncertainty giving rise to significant risks (and where the auditor has not already elected to test the estimate by developing an auditor’s range), ISA 540 explains that the auditor needs to consider whether to develop a range to evaluate the reasonableness of the accounting estimate.