Nature of Accounting Estimates and its Risk to an Audit

ISA 540 (Revised) describes that accounting estimates vary widely in nature and are required to be made by management when the monetary amounts cannot be directly observed. The measurement of these monetary amounts is subject to estimation uncertainty, which reflects inherent limitations in knowledge or data. These limitations give rise to inherent subjectivity and variation in the measurement outcomes. The process of making accounting estimates involves selecting and applying a method using assumptions and data, which requires judgment by management and can give rise to complexity in measurement. The effects of complexity, subjectivity or other inherent risk factors on the measurement of these monetary amounts effects their susceptibility to misstatement.

Followings are the examples of accounting estimates related to classes of transactions, account balances and disclosures :

• Inventory obsolescence
• Depreciation of property and equipment
• Valuation of infrastructure assets
• Valuation of financial instruments
• Outcome of pending litigation
• Provision for expected credit losses
• Valuation of insurance contract liabilities
• Warranty obligations
• Employee retirement benefits liabilities
• Share-based payments
• Fair value of assets or liabilities acquired in a business combination, including the determination of goodwill and intangible assets
• Impairment of long-lived assets or property or equipment held for disposal
• Non-monetary exchanges of assets or liabilities between independent parties
• Revenue recognized for long-term contracts

Although ISA 540 (Revised) applies to all accounting estimates, the degree to which an accounting estimate is subject to estimation uncertainty will vary substantially. The nature, timing and extent of the risk assessment and further audit procedures required by ISA 540 (Revised) will vary in relation to the estimation uncertainty and the assessment of the related risks of material misstatement. For certain accounting estimates, estimation uncertainty may be very low, based on their nature, and the complexity and subjectivity involved in making them may also be very low. For such accounting estimates, the risk assessment procedures and further audit procedures required by ISA 540 (Revised) would not be expected to be extensive. When estimation uncertainty, complexity or subjectivity are very high, such procedures would be expected to be much more extensive. ISA 540 (Revised) provides guidance on how the requirements of ISA 540 (Revised) can be scaled (HRD) ***

WHY was the change of ISA 540, Auditing Accounting Estimates ?

The International Standard on Auditing (ISA) 540 deals with the auditor's responsibilities relating to accounting estimates and related disclosures in an audit of financial statements. Specifically, it includes requirements and guidance that refer to, or expand on, how ISA 315 (Revised), ISA 330, ISA 450, ISA 500 and other relevant ISAs are to be applied in relation to accounting estimates and related disclosures. It also includes requirements and guidance on the evaluation of misstatements of accounting estimates and related disclosures, and indicators of possible management bias.

In its At a Glance publication in October 2018 prepared by the staff, IAASB announced the revised version of ISA 540 which effective for the audit of financial statements for periods beginning on or after December 15, 2019.

Concerning the requirement to revise ISA 540, the IAASB explains that,

Changes to financial reporting standards have increased the importance and visibility of accounting estimates to users of financial statements. The previous version of ISA 540 was written before recent changes in accounting for expected credit losses and revised standards dealing with insurance contracts, revenue recognition and leases. These changes, along with recurring audit inspection findings criticizing the quality of audits of accounting estimates, led to the need for the IAASB to address this challenging area to improve audit quality.

The increasingly complex business environment and change in accounting practices means that auditors need a more robust approach to identifying, assessing and responding to risks of material misstatement for accounting estimates and related disclosures. The enhancements in ISA 540 (Revised) are aimed at keeping pace with the changing market.

Further, the IAASB assesses that the risk assessment is a critical part of every audit. ISA 540 (Revised) includes an enhanced risk assessment specifically tailored to accounting estimates that builds on the risk assessment required by ISA 315 (Revised). The inherent risk factors of estimation uncertainty, complexity and subjectivity play a central role in the revised risk assessment and throughout ISA 540 (Revised).

ISA 540 (Revised) also notes that there may be other inherent risk factors, including susceptibility to misstatement due to management bias or fraud (HRD) ***