Those that reflect the entity’s own judgments about what assumptions
marketplace participants would use in pricing the asset or liability developed based on the best information available in the circumstances (sometimes referred to as “unobservable inputs” or equivalent). In practice, however, the distinction between (a) and (b) is not always apparent. Further, it may be necessary for management to select from a number of different assumptions used by different marketplace participants.
A36. The extent of subjectivity, such as whether an assumption or input is observable, influences the degree of estimation uncertainty and thereby the auditor’s assessment of the risks of material misstatement for a particular accounting estimate. Changes in Methods for making Accounting Estimates (Ref: Para. 8(c)(v))
A37. In evaluating how management makes the accounting estimates, the auditor is required to understand whether there has been or ought to have been a change from the prior period in the methods for making the accounting estimates. A specific estimation method may need to be changed in response to changes in the environment or circumstances affecting the entity or in the requirements of the applicable financial reporting framework. If management has changed the method for making an accounting estimate, it is important that management can demonstrate that the new method is more appropriate, or is itself a response to such changes. For example, if management changes the basis of making an accounting estimate from a mark-to-market approach to using a model, the auditor challenges whether management’s assumptions about the marketplace are reasonable in light of economic circumstances.
Estimation Uncertainty (Ref: Para. 8(c)(vi))
A38. Matters that the auditor may consider in obtaining an understanding of whether and, if so, how management has assessed the effect of estimation uncertainty include, for example:
Whether and, if so, how management has considered alternative
assumptions or outcomes by, for example, performing a sensitivity analysis to determine the effect of changes in the assumptions on an accounting estimate.
How management determines the accounting estimate when analysis
indicates a number of outcome scenarios.
Whether management monitors the outcome of accounting estimates
made in the prior period, and whether management has appropriately responded to the outcome of that monitoring procedure.
Reviewing Prior Period Accounting Estimates (Ref: Para. 9)
A39. The outcome of an accounting estimate will often differ from the accounting estimate recognised in the prior period financial statements. By performing risk assessment procedures to identify and understand the reasons for such differences, the auditor may obtain:
Information regarding the effectiveness of management’s prior period
estimation process, from which the auditor can judge the likely effectiveness of management’s current process. Audit evidence that is pertinent to the re-estimation, in the current period, of prior period accounting estimates. Audit evidence of matters, such as estimation uncertainty, that may be required to be disclosed in the financial statements.
A40. The review of prior period accounting estimates may also assist the auditor, in the current period, in identifying circumstances or conditions that increase the susceptibility of accounting estimates to, or indicate the presence of, possible management bias. The auditor’s professional skepticism assists in identifying such circumstances or conditions and in determining the nature, timing and extent of further audit procedures.
A41. A retrospective review of management judgments and assumptions related to significant accounting estimates is also required by SA 240.11 That review is conducted as part of the requirement for the auditor to design and perform procedures to review accounting estimates for biases that could represent a risk of material misstatement due to fraud, in response to the risks of management override of controls. As a practical matter, the auditor’s review of prior period accounting estimates as a risk assessment procedure in accordance with this SA may be carried out in conjunction with the review required by SA 240. 11 SA 240, “The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements”, paragraph 32(b)(ii).
A42. The auditor may judge that a more detailed review is required for those accounting estimates that were identified during the prior period audit as having high estimation uncertainty, or for those accounting estimates that have changed significantly from the prior period. On the other hand, for example, for accounting estimates that arise from the recording of routine and recurring transactions, the auditor may judge that the application of analytical procedures as risk assessment procedures is sufficient for purposes of the review.
A43. For fair value accounting estimates and other accounting estimates based on current conditions at the measurement date, more variation may exist between the fair value amount recognised in the prior period financial statements and the outcome or the amount re-estimated for the purpose of the current period. This is because the measurement objective for such accounting estimates deals with perceptions about value at a point in time, which may change significantly and rapidly as the environment in which the entity operates changes. The auditor may therefore focus the review on obtaining information that would be relevant to identifying and assessing risks of material misstatement. For example, in some cases obtaining an understanding of changes in marketplace participant assumptions which affected the outcome of a prior period fair value accounting estimate may be unlikely to provide relevant information for audit purposes. If so, then the auditor’s consideration of the outcome of prior period fair value accounting estimates may be directed more towards understanding the effectiveness of management’s prior estimation process, that is, management’s track record, from which the auditor can judge the likely effectiveness of management’s current process.
A44. A difference between the outcome of an accounting estimate and the amount recognised in the prior period financial statements does not necessarily represent a misstatement of the prior period financial statements. However, it may do so if, for example, the difference arises from information that was available to management when the prior period’s financial statements were finalised, or that could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements. Many financial reporting frameworks contain guidance on distinguishing between changes in accounting estimates that constitute misstatements and changes that do not, and the accounting treatment required to be followed.
Identifying and Assessing the Risks of Material Misstatement
Estimation Uncertainty (Ref: Para. 10)
A45. The degree of estimation uncertainty associated with an accounting estimate may be influenced by factors such as: The extent to which the accounting estimate depends on judgment. The sensitivity of the accounting estimate to changes in assumptions.
The existence of recognised measurement techniques that may mitigate
the estimation uncertainty (though the subjectivity of the assumptions used as inputs may nevertheless give rise to estimation uncertainty). The length of the forecast period, and the relevance of data drawn from past events to forecast future events. The availability of reliable data from external sources. The extent to which the accounting estimate is based on observable or unobservable inputs. The degree of estimation uncertainty associated with an accounting estimate may influence the estimate’s susceptibility to bias.
A46. Matters that the auditor considers in assessing the risks of material misstatement may also include: The actual or expected magnitude of an accounting estimate.
The recorded amount of the accounting estimate (that is, management’s
point estimate) in relation to the amount expected by the auditor to be recorded.
Whether management has used an expert in making the accounting
estimate. The outcome of the review of prior period accounting estimates.
High Estimation Uncertainty and Significant Risks (Ref: Para. 11)
A47. Examples of accounting estimates that may have high estimation uncertainty include the following:
Accounting estimates that are highly dependent upon judgment, for
example, judgments about the outcome of pending litigation or the amount and timing of future cash flows dependent on uncertain events many years in the future.
Accounting estimates that are not calculated using recognised
measurement techniques. Accounting estimates where the results of the auditor’s review of similar accounting estimates made in the prior period financial statements indicate a substantial difference between the original accounting estimate and the actual outcome.
Fair value accounting estimates for which a highly specialised entity-
developed model is used or for which there are no observable inputs.
A48. A seemingly immaterial accounting estimate may have the potential to result in a material misstatement due to the estimation uncertainty associated with the estimation; that is, the size of the amount recognised or disclosed in the financial statements for an accounting estimate may not be an indicator of its estimation uncertainty.
A49. In some circumstances, the estimation uncertainty is so high that a reasonable accounting estimate cannot be made. The applicable financial reporting framework may, therefore, preclude recognition of the item in the financial statements, or its measurement at fair value. In such cases, the significant risks relate not only to whether an accounting estimate should be recognised, or whether it should be measured at fair value, but also to the adequacy of the disclosures. With respect to such accounting estimates, the applicable financial reporting framework may require disclosure of the accounting estimates and the high estimation uncertainty associated with them (see paragraphs A120-A123).
A50. Where the auditor determines that an accounting estimate gives rise to a significant risk, the auditor is required to obtain an understanding of the entity’s controls, including control activities.12
A51. In some cases, the estimation uncertainty of an accounting estimate may cast significant doubt about the entity’s ability to continue as a going concern. SA 570(Revised)13 establishes requirements and provides guidance in such circumstances. Responses to the Assessed Risks of Material Misstatement (Ref:
A52. SA 330 requires the auditor to design and perform audit procedures whose nature, timing and extent are responsive to the assessed risks of material misstatement in relation to accounting estimates at both the financial statement and assertion levels.14. Paragraphs A53-A115 focus on specific responses at the assertion level only.
Application of the Requirements of the Applicable Financial Reporting
Framework (Ref: Para. 12(a))
A53. Many financial reporting frameworks prescribe certain conditions for the recognition of accounting estimates and specify the methods for making them and required disclosures. Such requirements may be complex and require the 12 SA 315, paragraph 29. 13 SA 570(Revised), “Going Concern”. 14 SA 330, paragraphs 5-6. application of judgment. Based on the understanding obtained in performing risk assessment procedures, the requirements of the applicable financial reporting framework that may be susceptible to misapplication or differing interpretations become the focus of the auditor’s attention.
A54. Determining whether management has appropriately applied the requirements of the applicable financial reporting framework is based, in part, on the auditor’s understanding of the entity and its environment. For example, the measurement of the fair value of some items, such as intangible assets acquired in a business combination, may involve special considerations that are affected by the nature of the entity and its operations.
A55. In some situations, additional audit procedures, such as the inspection by the auditor of the current physical condition of an asset, may be necessary to determine whether management has appropriately applied the requirements of the applicable financial reporting framework.
A56. The application of the requirements of the applicable financial reporting framework requires management to consider changes in the environment or circumstances that affect the entity. For example, the introduction of an active market for a particular class of asset or liability may indicate that the use of discounted cash flows to estimate the fair value of such asset or liability is no longer appropriate.
Consistency in Methods and Basis for Changes (Ref: Para. 12(b))
A57. The auditor’s consideration of a change in an accounting estimate, or in the method for making it from the prior period, is important because a change that is not based on a change in circumstances or new information is considered arbitrary. Arbitrary changes in an accounting estimate result in inconsistent financial statements over time and may give rise to a financial statement misstatement or be an indicator of possible management bias.
A58. Management often is able to demonstrate good reason for a change in an accounting estimate or the method for making an accounting estimate from one period to another based on a change in circumstances. What constitutes a good reason, and the adequacy of support for management’s contention that there has been a change in circumstances that warrants a change in an accounting estimate or the method for making an accounting estimate, are matters of judgment. Responses to the Assessed Risks of Material Misstatements (Ref: Para. 13)
A59. The auditor’s decision as to which response, individually or in combination, in paragraph 13 to undertake to respond to the risks of material misstatement may be influenced by such matters as: The nature of the accounting estimate, including whether it arises from routine or non-routine transactions. Whether the procedure(s) is expected to effectively provide the auditor with sufficient appropriate audit evidence.
The assessed risk of material misstatement, including whether the
assessed risk is a significant risk.
A60. For example, when evaluating the reasonableness of the allowance for doubtful accounts, an effective procedure for the auditor may be to review subsequent cash collections in combination with other procedures. Where the estimation uncertainty associated with an accounting estimate is high, for example, an accounting estimate based on a proprietary model for which there are unobservable inputs, it may be that a combination of the responses to assessed risks in paragraph 13 is necessary in order to obtain sufficient appropriate audit evidence.
A61. Additional guidance explaining the circumstances in which each of the responses may be appropriate is provided in paragraphs A62-A95. Events Occurring Up to the Date of the Auditor’s Report (Ref: Para. 13(a))
A62. Determining whether events occurring up to the date of the auditor’s report provide audit evidence regarding the accounting estimate may be an appropriate response when such events are expected to:
Provide audit evidence that confirms or contradicts the accounting estimate.
A63. Events occurring up to the date of the auditor’s report may sometimes provide sufficient appropriate audit evidence about an accounting estimate. For example, sale of the complete inventory of a superseded product shortly after the period end may provide audit evidence relating to the estimate of its net realisable value. In such cases, there may be no need to perform additional audit procedures on the accounting estimate, provided that sufficient appropriate evidence about the events is obtained.
A64. For some accounting estimates, events occurring up to the date of the auditor’s report are unlikely to provide audit evidence regarding the accounting estimate. For example, the conditions or events relating to some accounting estimates develop only over an extended period. Also, because of the measurement objective of fair value accounting estimates, information after the period-end may not reflect the events or conditions existing at the balance sheet date and therefore may not be relevant to the measurement of the fair value accounting estimate. Paragraph 13 identifies other responses to the risks of material misstatement that the auditor may undertake.
A65. In some cases, events that contradict the accounting estimate may indicate that management has ineffective processes for making accounting estimates, or that there is management bias in the making of accounting estimates.
A66. Even though the auditor may decide not to undertake this approach in respect of specific accounting estimates, the auditor is required to comply with SA 56015. The auditor is required to perform audit procedures designed to obtain sufficient appropriate audit evidence that all events occurring between the date of the financial statements and the date of the auditor’s report that require adjustment of, or disclosure in, the financial statements have been identified16 and appropriately reflected in the financial statements.17 Because the measurement of many accounting estimates, other than fair value accounting estimates, usually depends on the outcome of future conditions, transactions or events, the auditor’s work under SA 560 is particularly relevant.
Considerations Specific to Smaller Entities
A67. When there is a longer period between the balance sheet date and the date of the auditor’s report, the auditor’s review of events in this period may be an effective response for accounting estimates other than fair value accounting estimates. This may particularly be the case in some smaller owner-managed entities, especially when management does not have formalised control procedures over accounting estimates.
Testing how Management made the Accounting Estimate (Ref: Para. 13(b))
A68. Testing how management made the accounting estimate and the data on which it is based may be an appropriate response when the accounting estimate is a fair value accounting estimate developed on a model that uses observable and unobservable inputs. It may also be appropriate when, for example: The accounting estimate is derived from the routine processing of data by the entity’s accounting system. The auditor’s review of similar accounting estimates made in the prior period financial statements suggests that management’s current period process is likely to be effective. The accounting estimate is based on a large population of items of a similar nature that individually are not significant.
A69. Testing how management made the accounting estimate may involve, for example: 15 SA 560, “Subsequent Events”. 16 SA 560, paragraph 6. 17 SA 560, paragraph 7. Testing the extent to which data on which the accounting estimate is based is accurate, complete and relevant, and whether the accounting estimate has been properly determined using such data and management assumptions.
Considering the source, relevance and reliability of external data or
information, including that received from external experts engaged by management to assist in making an accounting estimate. Re-calculating the accounting estimate, and reviewing information about an accounting estimate for internal consistency. Considering management’s review and approval processes.
Considerations Specific to Smaller Entities
A70. In smaller entities, the process for making accounting estimates is likely to be less structured than in larger entities. Smaller entities with active management involvement may not have extensive descriptions of accounting procedures, sophisticated accounting records, or written policies. Even if the entity has no formal established process, it does not mean that management is not able to provide a basis upon which the auditor can test the accounting estimate.
Evaluating the Method of Measurement (Ref: Para. 13(b)(i))
A71. When the applicable financial reporting framework does not prescribe the method of measurement, evaluating whether the method used, including any applicable model, is appropriate in the circumstances is a matter of professional judgment.
A72. For this purpose, matters that the auditor may consider include, for example, whether: Management’s rationale for the method selected is reasonable.
Management has sufficiently evaluated and appropriately applied the
criteria, if any, provided in the applicable financial reporting framework to support the selected method. The method is appropriate in the circumstances given the nature of the asset or liability being estimated and the requirements of the applicable financial reporting framework relevant to accounting estimates. The method is appropriate in relation to the business, industry and environment in which the entity operates.
A73. In some cases, management may have determined that different methods result in a range of significantly different estimates. In such cases, obtaining an understanding of how the entity has investigated the reasons for these differences may assist the auditor in evaluating the appropriateness of the method selected.
Evaluating the use of Models
A74. In some cases, particularly when making fair value accounting estimates, management may use a model. Whether the model used is appropriate in the circumstances may depend on a number of factors, such as the nature of the entity and its environment, including the industry in which it operates, and the specific asset or liability being measured.
A75. The extent to which the following considerations are relevant depends on the circumstances, including whether the model is one that is commercially available for use in a particular sector or industry, or a proprietary model. In some cases, an entity may use an expert to develop and test a model.
A76. Depending on the circumstances, matters that the auditor may also consider in testing the model include, for example, whether: The model is validated prior to usage, with periodic reviews to ensure it is still suitable for its intended use. The entity’s validation process may include evaluation of: o The model’s theoretical soundness and mathematical integrity, including the appropriateness of model parameters. o
The consistency and completeness of the model’s inputs with market
practices. o The model’s output as compared to actual transactions. Appropriate change control policies and procedures exist. The model is periodically calibrated and tested for validity, particularly when inputs are subjective. Adjustments are made to the output of the model, including in the case of fair value accounting estimates, whether such adjustments reflect the assumptions marketplace participants would use in similar circumstances.
The model is adequately documented; including the model’s intended
applications and limitations and its key parameters, required inputs, and results of any validation analysis performed.
Assumptions Used by Management (Ref: Para. 13(b)(ii))
A77. The auditor’s evaluation of the assumptions used by management is based only on information available to the auditor at the time of the audit. Audit procedures dealing with management assumptions are performed in the context of the audit of the entity’s financial statements, and not for the purpose of providing an opinion on assumptions themselves.
A78. Matters that the auditor may consider in evaluating the reasonableness of the assumptions used by management include, for example: Whether individual assumptions appear reasonable. Whether the assumptions are interdependent and internally consistent.
Whether the assumptions appear reasonable when considered collectively
or in conjunction with other assumptions, either for that accounting estimate or for other accounting estimates. In the case of fair value accounting estimates, whether the assumptions appropriately reflect observable marketplace assumptions.
A79. The assumptions on which accounting estimates are based may reflect what management expects will be the outcome of specific objectives and strategies. In such cases, the auditor may perform audit procedures to evaluate the reasonableness of such assumptions by considering, for example, whether the assumptions are consistent with:
The general economic environment and the entity’s economic
circumstances. The plans of the entity. Assumptions made in prior periods, if relevant. Experience of, or previous conditions experienced by, the entity, to the extent this historical information may be considered representative of future conditions or events.
Other assumptions used by management relating to the financial
A80. The reasonableness of the assumptions used may depend on management’s intent and ability to carry out certain courses of action. Management often documents plans and intentions relevant to specific assets or liabilities and the financial reporting framework may require it to do so. Although the extent of audit evidence to be obtained about management’s intent and ability is a matter of professional judgment, the auditor’s procedures may include the following: Review of management’s history of carrying out its stated intentions.
Review of written plans and other documentation, including, where
applicable, formally approved budgets, authorisations or minutes. Inquiry of management about its reasons for a particular course of action. Review of events occurring subsequent to the date of the financial statements and up to the date of the auditor’s report. Evaluation of the entity’s ability to carry out a particular course of action given the entity’s economic circumstances, including the implications of its existing commitments. Certain financial reporting frameworks, however, may not permit management’s intentions or plans to be taken into account when making an accounting estimate. This is often the case for fair value accounting estimates because their measurement objective requires that assumptions reflect those used by marketplace participants.
A81. Matters that the auditor may consider in evaluating the reasonableness of assumptions used by management underlying fair value accounting estimates, in addition to those discussed above where applicable, may include, for example:
Where relevant, whether and, if so, how management has incorporated
market specific inputs into the development of assumptions.
Whether the assumptions are consistent with observable market
conditions, and the characteristics of the asset or liability being measured at fair value.
Whether the sources of market-participant assumptions are relevant and
reliable, and how management has selected the assumptions to use when a number of different market participant assumptions exist.
Where appropriate, whether and, if so, how management considered
assumptions used in, or information about, comparable transactions, assets or liabilities.
A82. Further, fair value accounting estimates may comprise observable inputs as well as unobservable inputs. Where fair value accounting estimates are based on unobservable inputs, matters that the auditor may consider include, for example, how management supports the following:
The identification of the characteristics of marketplace participants
relevant to the accounting estimate. Modifications it has made to its own assumptions to reflect its view of assumptions marketplace participants would use.
Whether it has incorporated the best information available in the
Where applicable, how its assumptions take account of comparable
transactions, assets or liabilities. If there are unobservable inputs, it is more likely that the auditor’s evaluation of the assumptions will need to be combined with other responses to assessed risks in paragraph 13 in order to obtain sufficient appropriate audit evidence. In such cases, it may be necessary for the auditor to perform other audit procedures, for example, examining documentation supporting the review and approval of the accounting estimate by appropriate levels of management and, where appropriate, by those charged with governance.
A83. In evaluating the reasonableness of the assumptions supporting an accounting estimate, the auditor may identify one or more significant assumptions. If so, it may indicate that the accounting estimate has high estimation uncertainty and may, therefore, give rise to a significant risk. Additional responses to significant risks are described in paragraphs A102-
A115. Testing the Operating Effectiveness of Controls (Ref: Para. 13(c))
A84. Testing the operating effectiveness of the controls over how management made the accounting estimate may be an appropriate response when management’s process has been well-designed, implemented and maintained, for example: Controls exist for the review and approval of the accounting estimates by appropriate levels of management and, where appropriate, by those charged with governance. The accounting estimate is derived from the routine processing of data by the entity’s accounting system.
A85. Testing the operating effectiveness of the controls is required when:
