ASA 540 - Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures - October 2009
Nature of Accounting Estimates (Ref: ParNature of Accounting Estimates (Ref: Para. 2)
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Because of the uncertainties inherent in business activities, some financial report items can only be estimated. Further, the specific characteristics of an asset, liability or component of equity, or the basis of or method of measurement prescribed by the financial reporting framework, may give rise to the need to estimate a financial report item. Some financial reporting frameworks prescribe specific methods of measurement and the disclosures that are required to be made in the financial report, while other financial reporting frameworks are less specific. Appendix 1 discusses fair value measurements and disclosures under different financial reporting frameworks.
Some accounting estimates involve relatively low estimation uncertainty and may give rise to lower risks of material misstatements, for example:
Accounting estimates arising in entities that engage in business activities that are not complex.
Accounting estimates that are frequently made and updated because they relate to routine transactions.
Accounting estimates derived from data that is readily available, such as published interest rate data or exchange‑traded prices of securities. Such data may be referred to as “observable” in the context of a fair value accounting estimate.
Fair value accounting estimates where the method of measurement prescribed by the applicable financial reporting framework is simple and applied easily to the asset or liability requiring measurement at fair value.
Fair value accounting estimates where the model used to measure the accounting estimate is well‑known or generally accepted, provided that the assumptions or inputs to the model are observable.
For some accounting estimates, however, there may be relatively high estimation uncertainty, particularly where they are based on significant assumptions, for example:
Accounting estimates relating to the outcome of litigation.
Fair value accounting estimates for derivative financial instruments not publicly traded.
Fair value accounting estimates for which a highly specialised entity‑developed model is used or for which there are assumptions or inputs that cannot be observed in the marketplace.
The degree of estimation uncertainty varies based on the nature of the accounting estimate, the extent to which there is a generally accepted method or model used to make the accounting estimate, and the subjectivity of the assumptions used to make the accounting estimate. In some cases, estimation uncertainty associated with an accounting estimate may be so great that the recognition criteria in the applicable financial reporting framework are not met and the accounting estimate cannot be made.
Section Nature of Accounting Estimates (Ref: Par - ASA 540 - Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures - October 2009 - Nature of Accounting Estimates (Ref: Para. 2) | Zoe
Not all financial report items requiring measurement at fair value, involve estimation uncertainty. For example, this may be the case for some financial report items where there is an active and open market that provides readily available and reliable information on the prices at which actual exchanges occur, in which case the existence of published price quotations ordinarily are the best audit evidence of fair value. However, estimation uncertainty may exist even when the valuation method and data are well defined. For example, valuation of securities quoted on an active and open market at the listed market price may require adjustment if the holding is significant in relation to the market or is subject to restrictions in marketability. In addition, general economic circumstances prevailing at the time, for example, illiquidity in a particular market, may impact estimation uncertainty.
Additional examples of situations where accounting estimates, other than fair value accounting estimates, may be required include:
Allowance for doubtful accounts.
Inventory obsolescence.
Warranty obligations.
Depreciation method or asset useful life.
Provision against the carrying amount of an investment where there is uncertainty regarding its recoverability.
Outcome of long term contracts.
Costs arising from litigation settlements and judgements.
Additional examples of situations where fair value accounting estimates may be required include:
Complex financial instruments, which are not traded in an active and open market.
Share‑based payments.
Property or equipment held for disposal.
Certain assets or liabilities acquired in a business combination, including goodwill and intangible assets.
Transactions involving the exchange of assets or liabilities between independent parties without monetary consideration, for example, a non‑monetary exchange of plant facilities in different lines of business.
Estimation involves judgements based on information available when the financial report is prepared. For many accounting estimates, these include making assumptions about matters that are uncertain at the time of estimation. The auditor is not responsible for predicting future conditions, transactions or events that, if known at the time of the audit, might have significantly affected management’s actions or the assumptions used by management.
Management Bias
Financial reporting frameworks often call for neutrality, that is, freedom from bias. Accounting estimates are imprecise, however, and can be influenced by management judgement. Such judgement may involve unintentional or intentional management bias (for example, as a result of motivation to achieve a desired result). The susceptibility of an accounting estimate to management bias increases with the subjectivity involved in making it. Unintentional management bias and the potential for intentional management bias are inherent in subjective decisions that are often required in making an accounting estimate. For continuing audits, indicators of possible management bias identified during the audit of the preceding periods influence the planning and risk identification and assessment activities of the auditor in the current period.
Management bias can be difficult to detect at an account level. It may only be identified when considered in the aggregate of groups of accounting estimates or all accounting estimates, or when observed over a number of accounting periods. Although some form of management bias is inherent in subjective decisions, in making such judgements there may be no intention by management to mislead the users of the financial report. Where, however, there is intention to mislead, management bias is fraudulent in nature.
Considerations Specific to Public Sector Entities
Public sector entities may have significant holdings of specialised assets for which there are no readily available and reliable sources of information for purposes of measurement at fair value or other current value bases, or a combination of both. Often specialised assets held do not generate cash flows and do not have an active market. Measurement at fair value therefore ordinarily requires estimation and may be complex, and in some rare cases may not be possible at all.