Auditing accounting estimates in an ISA audit

Why is it important?

Years ago, bad debt and inventory provisions might have been the key estimates in financial statements. Today, estimates and fair values creep into many other places including pension liabilities, provisions for legal claims and financial instruments.

As with the other ISAs, ISA 540 is split between objectives, requirements and application material.

Requirements and challenges

How are accounting estimates picked up in risk assessment?

The first step in applying the standard is to obtain an understanding of the following in order to provide a basis for the identification and assessment of the risks of material misstatement:

• the requirements of the financial reporting framework relating to accounting estimates, including related disclosures;
• how management identifies transactions, events and conditions which give rise to accounting estimates being recorded or disclosed; and
• how management makes estimates and the data on which they are based, including:
  – the method or model used;
  – relevant controls;
  – any use of experts;
  – underlying assumptions;
  – changes from prior periods; and
  – management’s assessment of estimation uncertainty.

Having considered these factors, the auditor ought to have an understanding of the risks that estimates and fair values might be materially misstated. The requirements of the standard prompt the auditor to be professionally sceptical and challenge the basis on which management produces estimates. For example, the requirement to consider changes from prior periods includes not only whether the estimation technique used has changed, but also whether it ought to have done. An entity selling goods in new markets might need to revisit the way in which it determines the bad debt provision, for example.

The final step in risk assessment is to revisit estimates used in the prior period or, where applicable, their subsequent re-estimation in the current period. This is not designed to call into question previous judgements; rather, it assists in identifying current period risks. For example, an entity traditionally applies a sliding scale of percentages to provide for old inventory. If, in the current year, some types of inventory turn out to have been sold for both significantly higher and lower prices, this may indicate that the auditor needs to do more work to challenge management on whether such a simple technique is appropriate.

Conversely, if almost all old inventory is sold for an amount higher than the written down amount, it might indicate management bias and, at the very least, call into question whether the assumed percentages were the best estimates. At worst, it could indicate a deliberate attempt to defraud.

Are all estimates equal?

In assessing the risks of material misstatement, the auditor needs to understand the degree of estimation uncertainty and whether estimates subject to a high degree of uncertainty give rise to significant risks.

Just because an estimated number is large does not mean the degree of estimation uncertainty is high or vice versa. Consider an entity for which materiality has been determined as €10,000.

The entity has an investment property, revalued each year to open market value. At the year end, the property is under offer for a price of €2m and conveyancing is progressing smoothly. While the value is significant, the degree of uncertainty is low given a firm indication of price from the offer made.

The same entity has a tax liability of €5,000, being tax on profits of €100,000 less group relief of €95,000. The allowability of group relief is disputed and the tax advisors believe it could go either way. With a 50:50 chance of success, the estimation uncertainty is €95,000, which is very significant.

How do auditors determine whether estimates and methods are appropriate?

The first stage in responding to risks is determining whether management has appropriately applied the requirements of the financial reporting framework. This may be relatively straightforward. The auditor also needs to assess whether the methods used are appropriate and consistently applied, and whether any changes in estimates or methods from the prior period are appropriate in the circumstances.

Arbitrary changes in estimates not justified by changes in circumstances or new information may lead to inconsistent accounting, inappropriate smoothing of profit and may indicate management bias. What is required in all cases is the use of professional 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.

How do auditors respond to assessed risks?

Just as the requirements to obtain an understanding in ISA 540 are really a guide to applying ISA 315, the requirements to respond to risks in ISA 540 are really a guide to applying ISA 330 to estimates. In common with ISA 330, ISA 540 recognises that there is no “one size fits all” response and that different responses will be needed depending on the nature of the estimate (including whether or not it is routine), the significance of the risks identified and the effectiveness of the planned procedures. Instead, ISA 540 requires the auditor to respond in one or more of four ways:

• whether post balance sheet events provide evidence regarding the estimate;
• if management has used a model to value an asset, the auditor is likely to understand the model, and evaluate how it has been used and the appropriateness of underlying assumptions, particularly if a significant risk is involved;
• if there is a well-designed and implemented process, it may be appropriate to test the operating effectiveness of the controls over that process, such as looking at how an entity makes sure that changes to the demographics of the workforce are fed through to the actuary calculating a defined benefit pension liability; or
• the auditor develops an estimate and compares it with management’s estimate.

In relation to the use of point and range estimates, if the auditor is 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 a significant risk. It might also lead the auditor to consider whether disclosure is needed in order to comply with the applicable financial reporting framework.

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.

What about significant risks?

For those risks that are not significant, the standard suggests a range of responses. For significant risks, the standard requires one of the responses above and explicit consideration of:

• how management has considered alternative assumptions or outcomes and rejected them, or otherwise considered uncertainty;
• the reasonableness of significant assumptions; and
• where an estimate depends on management’s intent, evidence of that intent and management’s ability to follow it through.

For example, an entity that has bought a building in a falling property market is considering if there is a permanent diminution in value. If management concludes that there is no diminution, because they expect the market to recover in a year, the auditor will need to challenge the judgement if the entity has a loan repayment due in six months that can only be met by selling the property.

How should auditors evaluate the reasonableness of estimates?

At the end of the estimation process, the auditor needs to evaluate whether estimates are reasonable with regard to the financial reporting framework. This may include considering if the estimate is reliable enough to be recognised, and whether there are appropriate disclosures. For example, IAS 37  Provisions, contingent liabilities and contingent assets 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 audit report should be considered in such circumstances.

When the auditor has determined a point estimate, a material 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. The auditor also considers indicators of possible management bias such as arbitrary changes in estimates or methods, or overly optimistic or pessimistic assumptions. This is particularly the case where these changes or assumptions help management achieve an objective such as maximising a bonus or minimising tax which, in extreme circumstances, may indicate fraud.

Finally, the auditor needs to focus on the adequacy of disclosures, particularly those on estimation uncertainty. They must obtain written representations about the reasonableness of significant assumptions made by management. They should also document the basis for the conclusions about the reasonableness of accounting estimates that give rise to significant risks, their disclosure and any indicators of possible management bias.

Hasn’t ISA 540 been revised?

In October 2018, the IAASB issued ISA 540 (Revised) Auditing accounting estimates and related disclosures and this is applicable for audits of financial statements for periods beginning on or after 15 December 2019. The FRC is also consulting on equivalent changes to the ISA (UK). 

Access an overview of key changes in ISA 540 (Revised) and potential challenges for auditors: Introducting ISA 540 (Revised) on auditing estimates