International Auditing and Assurance Standards Board

Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures
ISA Implementation Support Module
Prepared by IAASB Staff

October 2009

Overview
Introduction Risk-Based Approach Estimation Uncertainty Responses to Assessed Risks Indicators of Possible Management Bias Disclosures Related to Accounting Estimates Additional Aspects of ISA 540 SME Considerations
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Introduction

IAASBs Objectives in Revising ISA 540

To increase the rigor and skepticism to be applied in auditing accounting estimates

To provide enhanced guidance on estimation uncertainty and management bias

To conform with the risk-based approach reflected in ISA 315 and ISA 330

Introduction

Auditors Objective
To obtain sufficient appropriate audit evidence about whether

accounting estimates, including fair value accounting estimates, in the financial statements, whether recognized or disclosed, are reasonable; and
related disclosures are adequate,

in the context of the applicable financial reporting framework

Introduction

Application to Both Accounting Estimates and Fair Value Accounting Estimates

Principles in auditing fair values and more traditional accounting estimates are the same Application material in ISA 540 explains how particular requirements are applied in the context of both accounting estimates and fair values More guidance has been added related to fair value auditing considerations, including the use of models Extant ISA 545 to be withdrawn
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Risk-Based Approach

Risk Assessment Procedures

Understanding of how management makes the accounting estimates, and of the underlying data
The method, including the applicable model, used and changes in the method from the prior period Relevant controls Whether an expert has been used The underlying assumptions Whether and, if so, how management has assessed the effects of estimation uncertainty 6

Risk-Based Approach

Risk-Based Approach
ISA 540 expands on how ISAs 315, 330, and others are to be applied to accounting estimates
Obtaining an understanding of the entity and its environment, through risk assessment procedures Based on that understanding, identifying and assessing the risks of material misstatement Obtaining sufficient appropriate audit evidence regarding the assessed risks, through designing and implementing appropriate responses to those risks
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Risk-Based Approach

Risk Assessment Procedures

Understanding of the requirements of the applicable financial reporting framework relevant to accounting estimates, including related disclosures Understanding of how management identifies the need for accounting estimates to be recognized or disclosed
Includes making inquiries about changes in circumstances that may give rise to new accounting estimates or the need to revise existing ones

Risk-Based Approach

Risk Assessment Procedures

Review the outcome of accounting estimates included in the prior period financial statements or, as applicable, their subsequent re-estimation in the current period
Nature and extent of review takes account of the nature of the estimate and whether information to be obtained is likely relevant to identifying and assessing risks

Not intended to revisit prior judgments

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Risk-Based Approach

Identifying and Assessing Risks of Material Misstatement

In identifying and assessing risks
Evaluate the degree of estimation uncertainty associated with an accounting estimate Determine whether, in the auditors judgment, any of those accounting estimates that have been identified as having high estimation uncertainty gives rise to significant risks

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Estimation Uncertainty

Nature of Estimation 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 the financial statements are materially misstated and whether an estimate is particularly susceptible to management bias
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Estimation Uncertainty

Evaluation of Estimation Uncertainty

Evaluating the degree of estimation uncertainty associated with an accounting estimate includes consideration of, for example,
Level of judgment involved Sensitivity to changes in assumptions Extent to which the estimate is based on observable or unobservable inputs
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Responses to Assessed Risks

Responding to the Assessed Risks

Based on the assessed risks, determine
Whether management has appropriately applied the requirements of the applicable financial reporting framework Whether the methods for making accounting estimates are appropriate and applied consistently
If there have been changes in the method, are they appropriate?
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Responses to Assessed Risks

Responding to the Assessed Risks

One or more of the following, taking account of nature of the accounting estimate
Use of evidence from events occurring up to the date of the auditors report Testing of how management made the accounting estimate and underlying data
Includes evaluation of measurement method and reasonableness of assumptions
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Responses to Assessed Risks

Responding to the Assessed Risks

Testing the operating effectiveness of controls, together with appropriate substantive procedures Developing a point estimate or range to evaluate managements point estimate
Remains necessary to understand managements assumptions and methods

Range needs to be narrowed based on audit evidence until all outcomes within the range are considered reasonable 15

Responses to Assessed Risks

Further Substantive Procedures to Respond to Significant Risks

Evaluate how management has considered alternative assumptions or outcomes and why they have been rejected, or how management has otherwise addressed estimation uncertainty

Evaluate whether the significant assumptions used are reasonable

Where relevant, evaluate managements intent and ability
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Responses to Assessed Risks

Further Substantive Procedures to Respond to Significant Risks

Where necessary, develop a range to evaluate reasonableness of the accounting estimate
Done when, in the auditors judgment, management has not adequately addressed the effects of estimation uncertainty

Obtain sufficient appropriate audit evidence regarding recognition and measurement decisions
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Indicators of Possible Management Bias

Identifying Indicators
Review the judgments and decisions made by management in making accounting estimates to identify whether there are indicators of possible management bias
Susceptibility of an estimate to management bias increases with subjectivity involved Indicators may affect auditors conclusion of whether risk assessment or responses remain appropriate, but do not themselves constitute misstatements for purposes of concluding on reasonableness of individual estimates

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Indicators of Possible Management Bias

Examples
Changes in an accounting estimate or method where management has made a subjective assessment that there has been a change in circumstances Use of an entitys own assumptions for fair value when they are inconsistent with observable marketplace assumptions Selection or construction of significant assumptions that yield a point estimate favorable to managements objectives Selection of a point estimate that may indicate a pattern 19 of optimism or pessimism

Disclosures Related to Accounting Estimates

Disclosures
Obtain sufficient appropriate audit evidence about whether disclosures related to accounting estimates are in accordance with the applicable financial reporting framework For estimates giving rise to significant risks, also evaluate the adequacy of the disclosure of estimation uncertainty in the context of the applicable financial reporting framework
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Additional Aspects of ISA 540

Using Specialized Skills or Knowledge

In response to assessed risks, consider whether specialized skills or knowledge in relation to aspects of the accounting estimate are needed to obtain sufficient appropriate audit evidence
Individuals become part of the engagement team if the matters are accounting- and auditing-related Those with experience in a field other than accounting or auditing are considered auditors experts and ISA 620 applies
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Additional Aspects of ISA 540

Written Representations
Obtain written representations regarding the reasonableness of significant assumptions used in making accounting estimates
Representations alone do not constitute sufficient appropriate audit evidence

Guidance provided regarding additional representations the auditor may consider depending on nature, materiality, and extent of estimation uncertainty
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Additional Aspects of ISA 540

Documentation
Document
The basis for the auditors conclusions about the reasonableness of accounting estimates and their disclosure that give rise to significant risks Indicators of possible management bias, if any

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SME Considerations

Applicability of the ISA to SME Audits

Obtaining an understanding of how management (or owner-manager) identifies the need for accounting estimates is often relatively straightforward The ISA allows for different approaches for responding to assessed risks depending on the nature of the accounting estimate In many cases (other than for fair value estimates), review of events occurring up to the date of the auditors report may be an effective and efficient approach
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Note
This set of support slides does not amend or override the ISAs, the texts of which alone are authoritative. Reading the slides is not a substitute for reading the ISAs. The slides are not meant to be exhaustive and reference to the ISAs themselves should always be made. In conducting an audit in accordance with ISAs, the auditor is required to comply with all the ISAs that are relevant to the engagement.

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International Federation of Accountants

Copyright October 2009 by the International Federation of Accountants (IFAC). All rights reserved. Permission is granted to make copies of this work provided that such copies are for use in academic classrooms or for personal use and are not sold or disseminated and provided that each copy bears the following credit line: Copyright October 2009 by the International Federation of Accountants (IFAC). All rights reserved. Used with permission of IFAC. Contact permissions@ifac.org for permission to reproduce, store, or transmit this work. Otherwise, written permission from IFAC is required to reproduce, store, or transmit, or to make other similar uses of, this work, except as permitted by law. Contact permissions@ifac.org. ISBN: 978-1-60815-040-3 www.ifac.org