Inherent risk factors and risk of material misstatement
Accounting estimates are subject to, or affected by, risk factors that influence the likelihood and magnitude of a potential misstatement. These factors include:
- estimation uncertainty;
- subjectivity; and
- complexity.
The degree to which these inherent risk factors affect the likelihood or extent of misstatement varies on a scale which ISA 540 (Revised) refers to as the spectrum of inherent risk. Where the assessed risk sits on this spectrum will determine what the audit response needs to be.
What is estimation uncertainty?
The measurement of an accounting estimate is intrinsically less precise the more it is affected by risk factors. This inherent lack of precision is defined as estimation uncertainty in ISA 540 (Revised). Estimation uncertainty arises when a monetary amount that is recognised in the financial statements cannot be measured with precision through direct observation of the cost or price. The degree of estimation uncertainty varies depending on:
- the nature of the estimate;
- the variation in the possible valuation methods, sources from which relevant data is obtained and types of assumptions available;
- the extent to which the method/model used to make the estimate is generally accepted; and
- the subjectivity of the assumptions used to make the accounting estimate.
Because there are inherent limitations associated with information and methods used to determine the amount of an accounting estimate, there will always be some level of estimation uncertainty. Further, an accounting estimate that might appear immaterial has the potential to result in a material misstatement if it is subject to high estimation uncertainty. This is because of a concern that the estimate may be materially understated. This means that the amount included in the financial statements is not, in and of itself, always an indicator of the risk of material misstatement.
Estimates with lower estimation uncertainty
Some accounting estimates involve a low degree of estimation uncertainty that results in a lower risk of material misstatement. Examples include estimates:
- that are made frequently;
- that relate to routine transactions;
- with a history of predictable outcomes; and
- that can be measured through direct observation of the cost or price.
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Example: An entity operates items of machinery that are replaced at regular intervals. The technology has evolved over time while their operating life has not substantially changed in recent history. When repairing the machines becomes uneconomic, they are part-exchanged for new ones. In these circumstances, the estimation of the useful life of the machines and of their residual value for the purpose of measuring depreciation may involve a low level of estimation uncertainty. This is because it is based on reliable internal historical data that requires limited judgement to be made by management. |
Estimates with higher estimation uncertainty
Other accounting estimates may be subject to higher estimation uncertainty that results in a higher risk of material misstatement. Examples include estimates where:
- a number of alternative sources of information from which to determine an amount are available;
- a number of different models exist that are all equally accepted in the industry in which the entity operates;.
- the choice of the information source and the model may produce widely different values;
- the outcome of future events or actions is uncertain and dependent on a number of factors, for example, the outcome of legal action against the entity; and
- constraints on the availability of information or knowledge exist.
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Example: An entity has a litigation provision relating to the outcome of a lawsuit. The amount of this provision may rely heavily on the opinion provided by the entity’s legal counsel about the likelihood of a settlement and its expected size. There may also be limited (or no) direct historical precedent to its calculation. The size of an expected settlement may also be significantly sensitive to changes in the key assumptions made by the counsel, thereby increasing estimation uncertainty. |
Estimates involving subjectivity
Subjectivity reflects the inherent limitations in the knowledge or data reasonably available about valuation attributes. Although financial reporting frameworks may reduce the degree of subjectivity by providing a basis for certain judgments, management generally uses judgement when:
- interpreting the requirements of the applicable financial reporting framework;
- Identifying the appropriate sources of data to use;
- developing assumptions based on the best available data;
- selecting measurement methods; or
- interpreting data, such as selecting the most appropriate point estimate from a range of possible outcomes.
Certain estimates are highly dependent on judgement and there may be few relevant information sources to rely on. Observable information derived from external sources (such as published interest rates or statistical data) or from internal sources (such as historical information or previous experience) can help to inform such judgements. However, this is not always available.
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Whenever management has a choice or has to make interpretations, subjectivity will exist. |
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Example: An entity selling products with warranties introduces a radically new product. The estimation of the related warranty obligations is likely to have high uncertainty. In practice, the entity will have no experience of the level of repairs and replacements required by the new product. The historical data relating to its existing conventional products is unlikely to be relevant for the estimate. The assumptions relating to the estimate of the warranty obligations will be more subjective as there will be relatively little internal or external information from which to draw. |
Estimates involving complexity
Sometimes the determination of accounting estimates can be intrinsically complex. Inherent complexity may arise when:
- there are many valuation attributes with many or non-linear relationships between them;
- determining appropriate values for one or more valuation attributes requires multiple data sets;
- more assumptions are required in making the accounting estimate, or when there are correlations between the required assumptions; or
- the data used is inherently difficult to identify, capture, access or understand.
Complexity can arise from the method itself, from the computational process or model used to apply it. It may require the use of specific methods or models that require specialised skills or knowledge in relation to their valuation concepts and techniques.
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Example: An entity has entered into a derivative financial instrument contract that needs to be measured at fair value. The instrument is not publicly traded and requires the use of a particular specialised model to determine its fair value. The model needs data from a number of internal and external sources and requires specialised knowledge to select the most appropriate data source and to interpret the results. |
Other inherent risk factors
As accounting estimates can be influenced by subjectivity resulting from judgements made by management, they may also be subject to management bias. Management bias may be intentional, for example, as a result of a desire to meet profit targets, or unintentional. The latter might be demonstrated by an established pattern of behaviour. The susceptibility of an accounting estimate to management bias increases with the level of subjectivity and the estimation uncertainty associated with it.
Relationship of estimation uncertainty to subjectivity and complexity
These factors often do not exist in isolation, are often inextricably linked and are affected by the relevance and reliability of available information sources. For example, estimation uncertainty impacts the possible methods, data sources and assumption that could be used to make an accounting estimate and this gives rise to subjectivity, ie, the need to use more judgement in making the estimate. Subjectivity, in turn, presents the opportunity for management bias, whether intentional or unintentional. Alternatively, an estimate that requires the use of a complex model will often necessitate judgement by management in selecting the model, determining the most appropriate assumptions and the resulting point estimate. All of which give rise to subjectivity and estimation uncertainty.
The severity and interaction of these factors will impact the assessment of risk of material misstatement. For instance, those accounting estimates that are susceptible to a higher degree of uncertainty are also subject to a higher risk of material misstatement. These estimates may give rise to significant risks.
