Risk factors in auditing accounting estimates

The risk that an accounting estimate might be materially misstated is influenced by a number of factors. You can find out more below on risk factors and how they may influence your audit of accounting estimates.

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;
• judgement, including management bias; 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, the more judgement that is involved in making the estimate, the greater the estimation uncertainty is likely to be. The severity and interaction of these factors will therefore 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.

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, Auditing accounting estimates including fair value accounting estimates, and related disclosures (ISA 540). The degree of estimation uncertainty varies depending on:

• the nature of the estimate;
• the variation in the possible methods, data sources and types of assumptions available;
• the extent to which the method/models used to make the estimate are 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, estimation uncertainty cannot be eliminated. 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, an indicator of estimation uncertainty or 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. These may be estimates that are made frequently and that relate to routine transactions with a history of predictable outcomes.

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 and requires limited judgement by the management.

Estimates with higher estimation uncertainty

Other accounting estimates may be subject to higher estimation uncertainty. For these estimates, management may have a number of alternative sources of information from which to determine an amount. There may also be a number of models 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. Likewise, an entity might be facing legal action through the courts, the outcome of which is uncertain and dependent on a number of factors.

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 judgement

Management uses judgement when developing assumptions, interpreting data, selecting measurement methods or interpreting the requirements of the applicable financial reporting framework. 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.

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 sufficiently 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.

As accounting estimates can be influenced by management judgement, 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 judgement required and the estimation uncertainty associated with it.

Estimates involving complexity

Sometimes the determination of accounting estimates can be intrinsically complex. It may require the use of specific methods or models that require specialised skills or knowledge in relation to their valuation concepts and techniques.

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.