ASA 540 - Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures - October 2009
Events Occurring Up to the Date of the AEvents Occurring Up to the Date of the Auditor’s Report (Ref: Para. 13(a))
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Events Occurring Up to the Date of the Auditor’s Report (Ref: Para. 13(a))
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:
Occur; and
Provide audit evidence that confirms or contradicts the accounting estimate.
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 For example, sale of the complete inventory of a superseded product shortly after the period end may provide audit evidence relating to the estimate of its net realisable value.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.
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.
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.
Even though the auditor may decide not to undertake this approach in respect of specific accounting estimates, the auditor is required to comply with ASA 560.[16] 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 report and the date of the auditor’s report that require adjustment of, or disclosure in, the financial report have been identified[17] and appropriately reflected in the financial report.[18] 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 ASA 560 is particularly relevant.
Considerations specific to smaller entities
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.
Section Events Occurring Up to the Date of the A - ASA 540 - Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures - October 2009 - Events Occurring Up to the Date of the Auditor’s Report (Ref: Para. 13(a)) | Zoe
Testing How Management Made the Accounting Estimate (Ref: Para. 13(b))
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 report 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.
Testing how management made the accounting estimate may involve, for example:
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.
Recalculating 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
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))
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 judgement.
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.
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
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.
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.
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:
The model’s theoretical soundness and mathematical integrity, including the appropriateness of model parameters.
The consistency and completeness of the model’s inputs with market practices.
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))
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 report, and not for the purpose of providing an opinion on assumptions themselves.
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.
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 report.
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 judgement, 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.
Enquiry of management about its reasons for a particular course of action.
Review of events occurring subsequent to the date of the financial report 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.
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.
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 circumstances.
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.
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))
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.
Testing the operating effectiveness of the controls is required when:
The auditor’s assessment of risks of material misstatement at the assertion level includes an expectation that controls over the process are operating effectively; or
Substantive procedures alone do not provide sufficient appropriate audit evidence at the assertion level.[19]
Considerations specific to smaller entities
Controls over the process to make an accounting estimate may exist in smaller entities, but the formality with which they operate varies. Further, smaller entities may determine that certain types of controls are not necessary because of active management involvement in the financial reporting process. In the case of very small entities, however, there may not be many controls that the auditor can identify. For this reason, the auditor’s response to the assessed risks is likely to be substantive in nature, with the auditor performing one or more of the other responses in paragraph 13.
Developing a Point Estimate or Range (Ref: Para. 13(d))
Developing a point estimate or a range to evaluate management’s point estimate may be an appropriate response where, for example:
An accounting estimate is not derived from the routine processing of data by the accounting system.
The auditor’s review of similar accounting estimates made in the prior period financial report suggests that management’s current period process is unlikely to be effective.
The entity’s controls within and over management’s processes for determining accounting estimates are not well designed or properly implemented.
Events or transactions between the period end and the date of the auditor’s report contradict management’s point estimate.
There are alternative sources of relevant data available to the auditor which can be used in making a point estimate or a range.
Even where the entity’s controls are well designed and properly implemented, developing a point estimate or a range may be an effective or efficient response to the assessed risks. In other situations, the auditor may consider this approach as part of determining whether further procedures are necessary and, if so, their nature and extent.
The approach taken by the auditor in developing either a point estimate or a range may vary based on what is considered most effective in the circumstances. For example, the auditor may initially develop a preliminary point estimate, and then assess its sensitivity to changes in assumptions to ascertain a range with which to evaluate management’s point estimate. Alternatively, the auditor may begin by developing a range for purposes of determining, where possible, a point estimate.
The ability of the auditor to make a point estimate, as opposed to a range, depends on several factors, including the model used, the nature and extent of data available and the estimation uncertainty involved with the accounting estimate. Further, the decision to develop a point estimate or range may be influenced by the applicable financial reporting framework, which may prescribe the point estimate that is to be used after consideration of the alternative outcomes and assumptions, or prescribe a specific measurement method (for example, the use of a discounted probability‑weighted expected value).
The auditor may develop a point estimate or a range in a number of ways, for example, by:
Using a model, for example, one that is commercially available for use in a particular sector or industry, or a proprietary or auditor‑developed model.
Further developing management’s consideration of alternative assumptions or outcomes, for example, by introducing a different set of assumptions.
Employing or engaging a person with specialised expertise to develop or execute the model, or to provide relevant assumptions.
Making reference to other comparable conditions, transactions or events, or, where relevant, markets for comparable assets or liabilities.
Understanding Management’s Assumptions or Method (Ref: Para. 13(d)(i))
When the auditor makes a point estimate or a range and uses assumptions or a method different from those used by management, paragraph 13(d)(i) requires the auditor to obtain a sufficient understanding of the assumptions or method used by management in making the accounting estimate. This understanding provides the auditor with information that may be relevant to the auditor’s development of an appropriate point estimate or range. Further, it assists the auditor to understand and evaluate any significant differences from management’s point estimate. For example, a difference may arise because the auditor used different, but equally valid, assumptions as compared with those used by management. This may reveal that the accounting estimate is highly sensitive to certain assumptions and therefore subject to high estimation uncertainty, indicating that the accounting estimate may be a significant risk. Alternatively, a difference may arise as a result of a factual error made by management. Depending on the circumstances, the auditor may find it helpful in drawing conclusions to discuss with management the basis for the assumptions used and their validity, and the difference, if any, in the approach taken to making the accounting estimate.
Narrowing a Range (Ref: Para. 13(d)(ii))
When the auditor concludes that it is appropriate to use a range to evaluate the reasonableness of management’s point estimate (the auditor’s range), paragraph 13(d)(ii) requires that range to encompass all “reasonable outcomes” rather than all possible outcomes. The range cannot be one that comprises all possible outcomes if it is to be useful, as such a range would be too wide to be effective for purposes of the audit. The auditor’s range is useful and effective when it is sufficiently narrow to enable the auditor to conclude whether the accounting estimate is misstated.
Ordinarily, a range that has been narrowed to be equal to or less than performance materiality is adequate for the purposes of evaluating the reasonableness of management’s point estimate. However, particularly in certain industries, it may not be possible to narrow the range to below such an amount. This does not necessarily preclude recognition of the accounting estimate. It may indicate, however, that the estimation uncertainty associated with the accounting estimate is such that it gives rise to a significant risk. Additional responses to significant risks are described in paragraphs A102‑A115.
Narrowing the range to a position where all outcomes within the range are considered reasonable may be achieved by:
Eliminating from the range those outcomes at the extremities of the range judged by the auditor to be unlikely to occur; and
Continuing to narrow the range, based on audit evidence available, until the auditor concludes that all outcomes within the range are considered reasonable. In some rare cases, the auditor may be able to narrow the range until the audit evidence indicates a point estimate.
Considering whether Specialised Skills or Knowledge Are Required (Ref: Para. 14)
In planning the audit, the auditor is required to ascertain the nature, timing and extent of resources necessary to perform the audit engagement.[20] This may include, as necessary, the involvement of those with specialised skills or knowledge. In addition, ASA 220 requires the engagement partner to be satisfied that the engagement team, and any auditor’s external experts who are not part of the engagement team, collectively have the appropriate competence and capabilities to perform the audit engagement.[21] During the course of the audit of accounting estimates the auditor may identify, in light of the experience of the auditor and the circumstances of the engagement, the need for specialised skills or knowledge to be applied in relation to one or more aspects of the accounting estimates.
Matters that may affect the auditor’s consideration of whether specialised skills or knowledge is required include, for example:
The nature of the underlying asset, liability or component of equity in a particular business or industry (for example, mineral deposits, agricultural assets, complex financial instruments).
A high degree of estimation uncertainty.
Complex calculations or specialised models are involved, for example, when estimating fair values when there is no observable market.
The complexity of the requirements of the applicable financial reporting framework relevant to accounting estimates, including whether there are areas known to be subject to differing interpretation or practice is inconsistent or developing.
The procedures the auditor intends to undertake in responding to assessed risks.
For the majority of accounting estimates, even when there is estimation uncertainty, it is unlikely that specialised skills or knowledge will be required. For example, it is unlikely that specialised skills or knowledge would be necessary for an auditor to evaluate an allowance for doubtful accounts.
However, the auditor may not possess the specialised skills or knowledge required when the matter involved is in a field other than accounting or auditing and may need to obtain it from an auditor’s expert. ASA 620[22] establishes requirements and provides guidance in determining the need to employ or engage an auditor’s expert and the auditor’s responsibilities when using the work of an auditor’s expert.
Further, in some cases, the auditor may conclude that it is necessary to obtain specialised skills or knowledge related to specific areas of accounting or auditing. Individuals with such skills or knowledge may be employed by the auditor’s firm or engaged from an external organisation outside of the auditor’s firm. Where such individuals perform audit procedures on the engagement, they are part of the engagement team and accordingly, they are subject to the requirements in ASA 220.
Depending on the auditor’s understanding and experience of working with the auditor’s expert or those other individuals with specialised skills or knowledge, the auditor may consider it appropriate to discuss matters such as the requirements of the applicable financial reporting framework with the individuals involved to establish that their work is relevant for audit purposes.