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ASA 540 - Audit of Accounting Estimates - April 2006
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ASA 540 - Audit of Accounting Estimates - April 2006
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8 The determination of an accounting estimate may be simple or complex depending upon the nature of the item. For example, accruing a charge for rent may be a simple calculation, whereas estimating a provision for slow-moving or surplus inventory may involve considerable analysis of current data and a forecast of future sales. In complex estimates, there may be a high degree of special knowledge and judgement required. For example, the following elements are reflected in calculating an asset’s future economic value:
(a) an estimate of the future cash flows the entity expects to derive from the asset;
(b) expected variations in the amount and timing of those cash flows;
(c) the time value of money, represented by the current market risk-free interest rate;
(d) the price of bearing the uncertainty inherent in the asset; and
(e) other factors, such as illiquidity, that market participants would reflect in the pricing of future cash flows the entity expects to derive from the asset.
9 Accounting estimates may be determined as part of the routine information system relevant to financial reporting, operating on a continuing basis, or may be non-routine, operating only at period end. In many cases, accounting estimates are made by management using a formula based on experience, such as the use of standard rates for depreciating each category of non-current assets or a standard percentage of sales revenue for computing a warranty provision. In such cases, the formula needs to be reviewed regularly by management, for example, by reassessing the remaining useful lives of assets or by comparing actual results with the estimate and adjusting the formula when necessary.
10 The uncertainty associated with an item, or the lack of objective data may make it incapable of reasonable estimation, in which case under ASA 701 Modifications to the Auditor’s Report, the auditor needs to consider whether the auditor’s report needs to be modified.