SA - 540 Auditing Accounting Estimates, Including Fair Value - - PowerPoint PPT Presentation

SA - 540

Auditing Accounting Estimates, Including Fair Value Accounting Estimates, And Related Disclosures.

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• By Silky Parmanandka

Introductjon

Scope of This Section

This Standard on Auditing (SA) deals with the auditor’s responsibilities regarding accounting estimates, including fair value accounting estimates, and related disclosures in an audit of financial statements. Specifically, it expands on how SA 315 and SA 330 and other relevant SAs are to be applied in relation to accounting

• estimates. It also includes requirements and guidance on misstatements of

individual accounting estimates, and indicators of possible management bias.

Effective Date

This SA is effective for audits of financial statements for periods beginning on or after April 1, 2009.

Scope of This Section

This Standard on Auditing (SA) deals with the auditor’s responsibilities regarding accounting estimates, including fair value accounting estimates, and related disclosures in an audit of financial statements. Specifically, it expands on how SA 315 and SA 330 and other relevant SAs are to be applied in relation to accounting

• estimates. It also includes requirements and guidance on misstatements of

individual accounting estimates, and indicators of possible management bias.

Effective Date

This SA is effective for audits of financial statements for periods beginning on or after April 1, 2009.

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What is Accountjng Estjmate?

“Accountjng estjmate" means an approximatjon of the amount of an item in the absence of a precise means of measurement. Management is responsible for making accountjng estjmates included in fjnancial statements. These estjmates are ofuen made in conditjons of uncertainty regarding the outcome of events that have occurred or are likely to occur and involve the use

• f judgement. As a result, the risk of material misstatement is greater when accountjng

estjmates are involved. Examples are: Allowances to reduce inventory and accounts receivable to their estjmated realisable ♦ value. Provisions to allocate the cost of fjxed assets over their estjmated useful lives. ♦ Accrued revenue. ♦ Provision for taxatjon. ♦ Provision for a loss from a lawsuit. ♦ Insurer's liability for outstanding claims. ♦ Losses on constructjon contracts in progress. ♦ Amortjsatjon of certain items like goodwill and deferred revenue expenditure. ♦ Provision to meet warranty claims. ♦ Provision for retjrement benefjts in the fjnancial statements of employers. ♦ “Accountjng estjmate" means an approximatjon of the amount of an item in the absence of a precise means of measurement. Management is responsible for making accountjng estjmates included in fjnancial statements. These estjmates are ofuen made in conditjons of uncertainty regarding the outcome of events that have occurred or are likely to occur and involve the use

• f judgement. As a result, the risk of material misstatement is greater when accountjng

estjmates are involved. Examples are: Allowances to reduce inventory and accounts receivable to their estjmated realisable ♦ value. Provisions to allocate the cost of fjxed assets over their estjmated useful lives. ♦ Accrued revenue. ♦ Provision for taxatjon. ♦ Provision for a loss from a lawsuit. ♦ Insurer's liability for outstanding claims. ♦ Losses on constructjon contracts in progress. ♦ Amortjsatjon of certain items like goodwill and deferred revenue expenditure. ♦ Provision to meet warranty claims. ♦ Provision for retjrement benefjts in the fjnancial statements of employers. ♦

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Nature of Accountjng Estjmate

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Types of Accountjng Estjmates

Fair Value Accounting Estimates Other Accounting Estimates

• The Measurement objective of Fair Value

Accounting Estimate is to estimate the value

• f Financial Statement items based on

conditions prevalent on the measurement date (say, 31st March or any interim period). Example: Net Realisable Value of any asset

• r liability.
• Example:

1.

Estimate of NRV of Inventory

2.

Estimate of Revaluation / Impairment of Asset.

3.

Estimate of futures and derivatives

4.

Estimate of Equity Share Based Payments.

• All accountjng estjmates other than Fair

value accountjng estjmate is the Other Accountjng Estjmates. The measurement

• bjectjve of these accountjng estjmates

can vary depending on the applicable fjnancial reportjng framework and the fjnancial item being reported.

• Example:

1.

Depreciatjon Method or Useful life of Asset.

2.

Provision of Bad and Doubtgul Debts

3.

Contjngencies arising out of Litjgatjons

4.

Outcome of a Long Term Contract.

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Estjmatjon Uncertainty

The Susceptibility of an accounting estimate to an inherent lack of precision in its measurement. The degree of estimation uncertainty affects the risk that financial statements are materially misstated and whether an estimate is particularly susceptible to management bias. The Susceptibility of an accounting estimate to an inherent lack of precision in its measurement. The degree of estimation uncertainty affects the risk that financial statements are materially misstated and whether an estimate is particularly susceptible to management bias.

Evaluating the degree of estimation uncertainty associated with an accounting estimate includes consideration of, for example: Evaluating the degree of estimation uncertainty associated with an accounting estimate includes consideration of, for example:

Level of Judgement involved Level of Judgement involved Sensitivity to changes in assumptions Sensitivity to changes in assumptions

Extent to which the estimate is based on

• bservable or

unobservable inputs Extent to which the estimate is based on

• bservable or

unobservable inputs

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Auditor’s Objective Auditor’s Objective

The objective of an auditor is to obtain sufficient appropriate audit evidence regarding accounting estimates in the context of the applicable Financial Reporting Framework: The objective of an auditor is to obtain sufficient appropriate audit evidence regarding accounting estimates in the context of the applicable Financial Reporting Framework: (a) accounting estimates, including fair value accounting estimates, in the financial statements, whether recognised or disclosed, are reasonable; and (a) accounting estimates, including fair value accounting estimates, in the financial statements, whether recognised or disclosed, are reasonable; and (b) related disclosures in the financial statements are adequate. (b) related disclosures in the financial statements are adequate.

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Risk Assessment Procedures and Related Actjvitjes

When performing risk assessment procedures and related activities to obtain an understanding of the entity and its environment, including the entity’s internal control, as required by SA 315 the auditor shall obtain an understanding of the following in order to provide a basis for the identification and assessment of the risks of material misstatement for accounting estimates: When performing risk assessment procedures and related activities to obtain an understanding of the entity and its environment, including the entity’s internal control, as required by SA 315 the auditor shall obtain an understanding of the following in order to provide a basis for the identification and assessment of the risks of material misstatement for accounting estimates:

• (a)The requirements of the applicable financial reporting framework relevant to accounting estimates, including related

disclosures

• (b) How management identifies those transactions, events and conditions that may give rise to the need for accounting

estimates to be recognised or disclosed in the financial statements. In obtaining this understanding, the auditor shall make inquiries of management about changes in circumstances that may give rise to new, or the need to revise existing, accounting estimates.

• (c) How management makes the accounting estimates, and an understanding of the data on which they are based, including:
• (i) The method, including where applicable the model, used in making the accounting estimate;
• (ii) Relevant controls;
• (iii) Whether management has used an expert;
• (iv) The assumptions underlying the accounting estimates;
• (v) Whether there has been or ought to have been a change from the prior period in the methods for making the accounting

estimates, and if so, why; and

• (vi) Whether and, if so, how management has assessed the effect of estimation uncertainty.

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Identjfying and Assessing the Risks of Material Misstatement

• In identifying and assessing the risks of material misstatement, as required by SA

315, the auditor shall evaluate the degree of estimation uncertainty associated with an accounting estimate.

• The auditor shall determine whether, in the auditor’s judgement, any of those

accounting estimates that have been identified as having high estimation uncertainty give rise to significant risks.

• In identifying and assessing the risks of material misstatement, as required by SA

315, the auditor shall evaluate the degree of estimation uncertainty associated with an accounting estimate.

• The auditor shall determine whether, in the auditor’s judgement, any of those

accounting estimates that have been identified as having high estimation uncertainty give rise to significant risks.

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Responses to the Assessed Risks of Material Misstatement

(a)

Determine whether events occurring up to the date of the auditor’s report provide audit evidence regarding the accounting estimate.

(b)

Test how management made the accounting estimate and the data on which it is

• based. In doing so, the auditor shall evaluate whether:
• The method of measurement used is appropriate in the circumstances; and
• The assumptions used by management are reasonable in light of the

measurement objectives of the applicable financial reporting framework.

In responding to the assessed risks of material misstatement, as required by SA 330, the auditor shall undertake one or more of the following, taking account of the nature of the accounting estimate:

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(c)

Test the operating effectiveness of the controls over how management made the accounting estimate, together with appropriate substantive procedures.

(d)

• btain an understanding of management’s assumptions or methods sufficient to establish that the

(e)

In determining the matters identified or in responding to the assessed risks of material misstatement, the auditor shall consider whether specialised skills or knowledge in relation to one or more aspects of the accounting estimates are required in order to obtain sufficient appropriate audit evidence.

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Further Substantjve Procedures to Respond to Signifjcant Risks

• How

manageme nt has considered alternative assumptio ns

• r
• utcomes,

and why it has rejected them,

• r

how manageme nt has

• therwise

addressed estimation uncertaint y in making the accounting estimate.

• How

manageme nt has considered alternative assumptio ns

• r
• utcomes,

and why it has rejected them,

• r

how manageme nt has

• therwise

addressed estimation uncertaint y in making the accounting estimate.

• Whet

her the signi fican t assu mpti

• ns

used by mana geme nt are reaso nable .

• Whet

her the signi fican t assu mpti

• ns

used by mana geme nt are reaso nable .

• Where

• f

• Where

• f

For accounting estimates that give rise to significant risks, in addition to other substantive procedures performed to meet the requirements of SA 330, the auditor shall evaluate the following: If, in the auditor’s judgment, management has not adequately addressed the effects of estimation uncertainty on the accounting estimates that give rise to significant risks, the auditor shall, if considered necessary, develop a range with which to evaluate the reasonableness of the accounting estimate.

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Audit Procedures Audit Procedures

Review and test the process used by management to develop the estimate Review and test the process used by management to develop the estimate

use an independent estimate for comparison with that prepared by management use an independent estimate for comparison with that prepared by management

review subsequent events which confirm the estimate made review subsequent events which confirm the estimate made

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Evaluatjng the Reasonableness of the Accountjng Estjmates, and Determining Misstatements

The auditor should obtain sufficient appropriate audit evidence as to whether an accounting estimate is reasonable in the circumstances and, when required, is appropriately disclosed in the financial statements. The evidence available to support an accounting estimate will often be more difficult to obtain and less conclusive than evidence available to support other items in the financial statements because of the uncertainties inherent in accounting estimates. When there is a difference between the auditor's estimate of the amount best supported by the available audit evidence and the estimated amount included in the financial statements, it does not necessarily mean a misstatement of financial statements. the auditor would determine if: (a)the difference is reasonable, whether the difference requires adjustment, because the amount in the financial statements might fall within a range of acceptable results and it may not require adjustment. (b)the difference is unreasonable, management would be requested to revise the estimate. If management refuses to revise the estimate, the difference would be considered a misstatement and the auditor should issue either a qualified or adverse report. The auditor should obtain sufficient appropriate audit evidence as to whether an accounting estimate is reasonable in the circumstances and, when required, is appropriately disclosed in the financial statements. The evidence available to support an accounting estimate will often be more difficult to obtain and less conclusive than evidence available to support other items in the financial statements because of the uncertainties inherent in accounting estimates. When there is a difference between the auditor's estimate of the amount best supported by the available audit evidence and the estimated amount included in the financial statements, it does not necessarily mean a misstatement of financial statements. the auditor would determine if: (a)the difference is reasonable, whether the difference requires adjustment, because the amount in the financial statements might fall within a range of acceptable results and it may not require adjustment. (b)the difference is unreasonable, management would be requested to revise the estimate. If management refuses to revise the estimate, the difference would be considered a misstatement and the auditor should issue either a qualified or adverse report.

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Disclosures Related to Accounting Estimates Disclosures Related to Accounting Estimates

• The auditor shall obtain sufficient appropriate audit evidence about whether

the disclosures in the financial statements related to accounting estimates are in accordance with the requirements of the applicable financial reporting framework.

• For accounting estimates that give rise to significant risks, the auditor shall

also evaluate the adequacy of the disclosure of their estimation uncertainty in the financial statements in the context of the applicable financial reporting framework.

• The auditor shall obtain sufficient appropriate audit evidence about whether

the disclosures in the financial statements related to accounting estimates are in accordance with the requirements of the applicable financial reporting framework.

• For accounting estimates that give rise to significant risks, the auditor shall

also evaluate the adequacy of the disclosure of their estimation uncertainty in the financial statements in the context of the applicable financial reporting framework.

Indicators

• f Possible

Managemen t Bias Indicators

• f Possible

Managemen t Bias

• The auditor shall review the judgements and decisions made

by management in the making of accounting estimates to identify whether there are indicators of possible management

• bias. Indicators of possible management bias do not

themselves constitute misstatements for the purposes of drawing conclusions on the reasonableness of individual accounting estimates.

• The auditor shall review the judgements and decisions made

by management in the making of accounting estimates to identify whether there are indicators of possible management

• bias. Indicators of possible management bias do not

themselves constitute misstatements for the purposes of drawing conclusions on the reasonableness of individual accounting estimates.

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Written Representations Written Representations

• Obtain written representation from the Management and where appropriate, those charged with governance regarding

the reasonableness of significant assumptions used in making accounting estimates, although management’s representation does not constitute sufficient audit evidence hence the auditor may get additional representations considering the nature, materiality and extend of estimation uncertainty.

Documentation Documentation

• Auditor must document
• the basis for the auditor’s conclusion about reasonableness of accounting estimates and their disclosure that give rise

to significant risks

• Indicators of possible management bias, if any

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MCQ’s

• Q1. As per SA -540, the objective of the auditor is to obtain sufficient and

appropriate audit evidence whether in the context of ________. a) Accounting Estimate b) Applicable Financial Reporting Framework c) Accounting Standard d) Auditing Procedure Answer : (b) - Applicable Financial Reporting Framework

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MCQ’s

• Q2. Auditor shall verify whether ______ related to accounting estimates have

been made. a) Proper disclosures b) Reporting c) Correction d) Verification Answer : (a) - Proper disclosures

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MCQ’s

• Q3. If auditor concludes that management has unreasonably changed the

method of estimation this will again constitute a misstatement and auditor should ______. a) Give Qualify / adverse report b) Give a disclaimer of opinion c) Withdraw from the audit engagement d) Obtain legal counsel Answer : (a) - Give Qualify / adverse report

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MCQ’s

• Q4. Accounting estimates are highly dependent on ________.

a) Expert b) Management c) Judgment d) Past judgment Answer : (c) - Judgment

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MCQ’s

• Q5. A difference between the outcome of an accounting estimate and the amount
• riginally recognized or disclosed in the financial statements does not necessarily

represent a _____ of the financial statements. a) Error b) Fraud c) Misstatement d) Fault Answer : (c) - Misstatement

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Thank You!!

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