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) *** 

Why Bearer Plants was taken out from the scope of IAS 41 ?

Prior to the 2014 amendments, IAS 41 required all biological assets related to agricultural activity to be measured at fair value less costs to sell (read also : Biological Assets and Bearer Plants, what is the difference between them ?).

Later, in June 2014 the IASB board issued Agriculture : Bearer Plants (Amendments to IAS 16 and IAS 41) which amended the scope of IAS 16 to include bearer plants. While IAS 41 Agriculture applies to the produce growing on the bearer plants. The amendments define a bearer plant and require bearer plants to be accounted for as property, plant and equipment in accordance with IAS 16.

As discussed in the amendments to the Basis for Conclusions on IAS 16 Property, Plant and Equipment, stakeholders told the Board that they think the fair value measurement is not appropriate for mature bearer biological assets such as oil palms and rubber trees because they are no longer undergoing significant biological transformation as defined in IAS 41 for the biological assets in relation to the agricultural activity. The use of mature bearer biological assets such as those is seen by many as similar to that of manufacturing. Consequently, they said that a cost model should be permitted for those bearer biological assets (bearer plants such as oil palms and rubber trees), because it is permitted for property, plant and equipment. Further, they also said that they had concerns about the cost, complexity and practical difficulties of fair value measurements of bearer biological assets in the absence of markets for those assets, and about the volatility from recognising  changes in the fair value less costs to sell in profit or loss. Furthermore, they asserted that investors, analysts and other users of financial statements adjust the reported profit or loss to eliminate the effects of changes in the fair values of these bearer biological assets.

Most respondents who cited agriculture in their responses to the Board’s 2011 Agenda Consultation raised concerns in relation to fair value measurement of plantations, for example oil palm and rubber trees plantation, and favoured a limited-scope project for these bearer biological assets to address the concerns as mentioned above. Only a small number of respondents favoured a broader consideration of IAS 41 or a Post-implementation Review, or said that there is no need to amend IAS 41.

Before the limited-scope project for bearer biological assets was added to its work programme, the Board was monitoring the work undertaken by the Asian-Oceanian Standard-Setters Group (AOSSG), primarily by the Malaysian Accounting Standards Board (MASB), on a proposal to remove some bearer biological assets from the scope of IAS 41 and account for them in accordance with IAS 16. Those proposals were discussed several times by national standard-setters, the Board’s Emerging Economies Group (EEG) and the IFRS Advisory Council. Feedback from these meetings indicated strong support for the AOSSG/MASB proposals and for the Board to start a limited-scope project for bearer biological assets.

In September 2012, the Board decided to add to its agenda a limited-scope project for bearer biological assets, with the aim of considering whether the account for some or all of them as property, plant and equipment, thereby permitting use of  a cost model.  Later, the Board decided that it had received sufficient information to develop an ED from work performed by the MASB, meetings of national standard-setters, feedback from preparers on the 2011 Agenda Consultation and user outreach performed by staff. Furthermore, the project was expected to result in limited changes that were sought by both users and preparers of financial statements. Consequently, the Board decided that the project could proceed without a Discussion Paper and developed and ED that was issued in June 2013, and finally, in June 2014 the accounting standard of Agriculture : Bearer Plants (Amendments to IAS 16 and IAS 41) was published by the IASB. Entities are required to apply the amendments for annual periods beginning on or after 1 January 2016. Earlier application is permitted (HRD).

Definition of Agricultural Activity based on IAS 41

IAS 41 Agriculture governs the accounting treatment, financial statement presentation and disclosures related to AGRICULTURE ACTIVITY.

IAS 41 defines Agriculture Activity as the management by an entity of the BIOLOGICAL TRANSFORMATION and harvest of biological assets for sale or for conversion into agricultural produce or into additional biological assets.

Biological Transformation comprises the process of growth, degeneration, production, and procreation that cause qualitative or quantitative changes in a biological asset. A biological asset is a living animal or plant.

Agriculture activity covers a diverse range of activities; for example, raising livestock, forestry, annual or perennial cropping, cultivating orchards and plantations, floriculture and aquaculture (including fish farming)

The above stated agriculture activities have certain common features :

1. Capability to change. Living animals and plants are capable of biological transformation;
2. Management of change. Management facilities biological transformation by enhancing, or at least stabilising, conditions necessary for the process to take place (for example, nutrient levels, moisture, temperature, fertility, and light). Such management distinguishes agricultural activity from other activities. For example, harvesting from unmanaged sources (such as ocean fishing and deforestation) is not agricultural activity; and
3. Measurement of change. The change in quality (for example, genetic merit, density, ripeness, fat cover, protein content, and fibre strength) or quantity (for example, progeny, weight, cubic metres, fibre length or diameter, and number of buds) brought about by biological transformation or harvest is measured and monitored as a routine management function.

Biological transformation results in the following types of outcomes :

1. asset changes through (i) growth (an increase in quantity or improvement in quality of an animal or plant), (ii) degeneration (a decrease in the quantity or deterioration in quality of an animal or plant), or (iii) procreation (creation of additional living animals or plants); or
2. production of agricultural produce such as latex, tea leaf, wool, and milk.

Agriculture activities are distinguished by the fact that management facilitates and manages biological transformation and is capable of measuring the change in the quality and quantity of biological assets (HRD).

Biological Assets and Bearer Plants, what is the difference between them ?

IAS 41 Agriculture regulates the accounting treatment for biological assets, except for bearer plants, and for agricultural produce at the point of harvest.

Based on IAS 41, a biological asset is a living animal or plant controlled by the entity as a result of past events. Control may be through ownership or through another type of legal arrangement. Further, IAS 41 also defines biological transformation as the processes of growth, degeneration, production, and procreation that cause qualitative or quantitative changes in a biological asset.

Biological assets are the principal assets of agricultural activities, and they are held for their transformative potential. This results in two major types of outcomes; the first may involve asset changes – as through growth or quality improvement, degeneration or procreation. The second involves the creation of separable products initially qualifying as agricultural produce.

A biological asset shall be measured on initial recognition and at the end of each reporting period at its FAIR VALUE LESS COSTS TO SELL. Agricultural produce harvested from an entity’s biological assets shall be measured at its FAIR VALUE LESS COSTS TO SELL AT THE POINT OF HARVEST. Such measurements is the cost at that date when applying IAS 2 Inventories or another applicable standard. A gain or loss arising on initial recognition of a biological asset at fair value less costs to sell and from a change in fair value less costs to sell of a biological asset shall be included in profit or loss for the period in which it arises.

On 30 June 2014, the IASB issued Agriculture : Bearer Plants (Amendments to IAS 16 and IAS 41) which changed the accounting treatment for biological assets that meet the definition of BEARER PLANTS. Based on the amendments, bearer plants will now be within the scope of the IAS 16 and will be subject to all of the requirements therein. This includes the ability to choose between the COST MODEL and the REVALUATION MODEL for the subsequent measurement. Agricultural produce growing on bearer plants will remain within the scope of the IAS 41 Agriculture, i.e as a biological asset.

All of the following criteria as defined in the standard need to be met for a biological asset to be considered as a bearer plant. A bearer plant is defined as a living plant that : (a) is used in the production or supply of agricultural produce; (b) is expected to bear produce for more than one period; and (c) has a remote likelihood of being sold as agricultural produce, except for incidental scrap sales.

The following are not bearer plants :

• plants cultivated to be harvested as agricultural produce (for example, trees grown for use as lumber);
• plants cultivated to produce agricultural produce when there is more than a remote likelihood that the entity will also harvest and sell the plant as agricultural produce, other than as incidental scrap sales (for example, trees that are cultivated both for their fruit and their lumber); and
• annual crops (for example, maize and wheat)

When bearer plants are no longer used to bear produce they might be cut down and sold as scrap, for example, for use as firewood. Such incidental scrap would not prevent the plant from satisfying the definition of a bearer plant.

The measurement requirements for bearer plants should be as follows :

• before maturity, bearer plants must be measured at their accumulated cost, similar to the accounting treatment for a self-constructed item of plant and equipment before it is available for use; and
• after the bearer plant is mature, entities have a policy choice to measure the bearer plants using either the cost model or the revaluation model

(HRD)