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) ***