When the international standard on auditing accounting estimates and related disclosures was revised in 2018, it brought a change in approach and emphasis not just for the auditing of accounting estimates, but also in the way auditors assess risk and evaluate the overall approach taken to their work. 

Phrases such as ‘spectrum of inherent risk’ and ‘stand back’ feel very familiar now, but back in 2018, they were new concepts that needed to be understood. 

Subsequent revised standards continued to follow the same risk assessment and evaluation approach. Hopefully, these are now well embedded in all audit teams and their approaches. But what of the specific requirements in the revised ISA on auditing accounting estimates? It has never been easy to audit this area and audit quality reviews continue to flag weaknesses. 

Let’s remind ourselves of the key requirements from the revised standard and consider how the current economic environment may affect the audit approach.

Risk assessments

Almost all sets of published financial statements will contain an accounting estimate of some kind. The key point is, what is the risk of material misstatement of that estimate? We all know that the higher the risk of material misstatement, the greater the audit response should be. Therefore a robust assessment of the inherent risk factors must be undertaken. 

Across audit files I have seen widely differing approaches. Some assume that every estimate is automatically risky and deserving of an enhanced response, whereas others do not even document certain estimates as they are deemed so unlikely to cause a material misstatement that their existence is ignored completely. Of course, neither approach is correct. 

As part of a good understanding of the entity, the existence of all accounting estimates should initially be documented and then an assessment of estimation uncertainty, subjectivity and complexity undertaken, at which point those estimates more susceptible to misstatement are taken forward, considered in more detail and a specific risk response designed.

For continuing audits, it can be easy to fall into the trap of seeing estimates the same way each year but with current economic conditions, these assessments may need to be reconsidered. 

Consider for example any estimates with a ‘cost of capital’ element. Previously the auditor may have considered this to have low estimation uncertainty due to the stability of finance costs and the risk of material misstatement was therefore low, but this may not be the case currently with higher interest rates leading to increased costs of finance, an error in which could be material.

Management bias must also be considered as part of the risk assessment process. Again, in the current environment, there may be more incentives for bias than in the past and accounting estimates are clearly an area of vulnerability for management override.

Before we move away from risk assessment, remember that there is a specific requirement in the standard to review the outcome of previous accounting estimates to assist in assessing risks for the current engagement. This is again often misunderstood as giving assurance over the method of calculation and hence the quality of the current period estimate. It is not. Any methods should be evaluated in the current period, should that be the selected audit approach.

Risk response

The revised ISA 540 and ISA (UK) 540 are both very explicit on how auditors obtain evidence where there is a risk of material misstatement of an accounting estimate. The auditor’s further audit procedures should include one or more of the three following approaches. Let’s consider each separately.

• Obtaining audit evidence from events occurring up to the date of the auditor’s report. This may seem a simple approach – let’s just see what happened after the year end and then we will know how good the estimate was. This could well work where the estimate concerns a fast-moving item (such as inventory) and there is a reasonable time between the period end and the audit report date. It can fail quite spectacularly though where the reverse timings are true.
  
  If this approach is being used, the auditor must not let the entity rush them into signing the audit report, constraining the time in which the estimate crystallises. In the current climate, management may press for a quick turn-around of the audit to keep the bank or investors happy. But the auditor needs to consider whether this is appropriate in the circumstances. Is there sufficient appropriate audit evidence at that date?

• Testing how management made the accounting estimate. This may seem like an easy task, but it is important to understand that this is not just ‘checking the maths’. This approach requires a robust review of the mechanics and assumptions of the estimate, not just the numbers.
  
  Do not assume that because a model is the same as last year that it is still appropriate for the current year. With the ongoing fast pace of economic change, it is important to stay alert and challenge conventional practices.

• Developing an auditor’s point estimate or range. Developing your own estimate and then comparing it to that of the client is most likely to be the purest form of audit approach but it does rely on the audit team having the necessary knowledge and expertise. This may be an area where the auditor considers using external experts or at least their models. If this is the case, don’t overlook key considerations, such as their independence, objectivity, reliability, and professional scepticism. The audit report will have your firm’s name on it.

Overall evaluation

Identifying and addressing risks of material misstatement emphasises the need to stand back in the current economic climate. In the context of auditing accounting estimates it is particularly important to realise that things may have changed, even in a few days or weeks.

The stand back gives the chance not just to look objectively at the work the audit team has carried out but also to consider the bigger, potentially more up to date picture.

Consider, for example, a review of a goodwill valuation which was considered reasonable, but only marginally. A rise in bank base rates may change that marginal decision. Should that rate change happen between the audit fieldwork and the time of the review/stand back procedure, it should trigger a reassessment.

Use the stand back not just as a chance to look at corroborating and contradictory evidence but also to look at the landscape underpinning the assumptions and any changes in the intervening period.

Andrew Paul, Audit Software and Technical Manager, Baker Tilly International