24 April 2020
Relevant or not?
When it comes to auditing estimates and related disclosures it is understandable to think that a new standard may not as relevant to small and medium practices. However, there are so many types of accounting estimates, to name a few:
- Bad debts
- Inventory obsolescence
- Depreciation the fair value of financial assets or financial liabilities
- Contingent Liability
- Holiday & Sick pay obligations
- Warranty estimates & obligations
- Credit losses allowances
- Useful life of an asset
A small entity may have complex estimates and a large entity may have estimates that are small and simple to measure. Therefore, from time to time you will need the guidance from this standard. Fortunately the IAASB has specifically designed the amendments to be scalable.
In this article we highlight how the revised ISA 540 will affect how you audit accounting estimates and related disclosures and what we are doing to assist you in this regard.
What are the key changes to the amended standard?
The objective of the auditor in the old standard was to obtain sufficient audit evidence in the financial statements that accounting estimates were reasonable and related disclosures were adequate.
Under the new standard auditors will need to obtain reasonable assurance for both accounting estimates and disclosures.
What is the concept of reasonable?
An entity’s Accounting Estimates and related disclosures are reasonable when:
- They fit within the context of the applicable financial reporting framework
- They reflect judgements that are consistent with each other and with those used in other accounting estimates or areas of the entity’s business activities
- They not only comply with the requirements of the applicable financial reporting framework but, in doing so, reflect judgements that are consistent with the objective of the measurement basis in that framework.
Essentially, reasonable assurance means that when auditing we can no longer work under the assumption of trust but verify. We must be professionally sceptical and assess whether management assertions around estimates agree to our expectations, collated audit evidence and the audit outcome.
Key Concepts and requirements within the standard:
The revised standard now requires a separation of assessment of inherent and control risks. There are three main inherent risks:
- Subjectivity – They arise from inherent limitations in knowledge or data reasonably available to value estimates.
- Complexity – The complexity inherent in the process of making an accounting estimate, such as when multiple data sets or assumptions are required or when complex models are used.
- Estimation Uncertainty – The susceptibility to an inherent lack of precision in the measurement of an accounting estimate. Estimation uncertainty influences the other inherent risk factors.
Overall, how an entity measures its estimates is highly subjective and this factor is largely interrelated with other inherent risk factors.
There is an increased emphasis on understanding the environment the entity operates in and the level of expertise it has in order to understand how management measures accounting estimates, internal procedures and controls around accounting estimates and disclosures. This means understanding:
- The entity’s transactions and other events and conditions relating to accounting estimates to be recognised or disclosed.
- Regulatory factors relevant to the entity’s accounting estimates, including, when applicable, regulatory frameworks related to a financial reporting framework, prudential supervision.
- The nature of the accounting estimates and related disclosures that the auditor expects to be included in the entity’s financial statements, based on the auditor’s understanding of the matters to the above.
- How the entity’s risk assessment process identifies and addresses risks, what methods are used by management to create estimates.
- In relation to the methods used, the auditor should focus on how management selects or designs and applies them.
The more significant the inherent risk the greater professional scepticism is required.
When the auditor assesses the risk to have a higher estimation uncertainty, complexity, and subjectivity, the greater the scepticism needed especially if they are more susceptible to management bias or fraud.
We must stand back and ask whether what we have seen reflects the results and expectations of the entity’s accounting estimates and review them to the outcome of past estimates. A solid understanding of ISA 315 and ISA 330 helps auditors to conclude that controls are designed and implemented satisfactorily safeguard against inherent risks.
The standard also requires engaging with management and governance. When starting the audit, we must ensure that we receive the following:
- Documented procedures on how management makes their decisions on what accounting estimates they present in their financial statements.
- Assumptions made.
- Data used and the internal controls over them.
Throughout the audit we must be communicating with governance and management around significant qualitative aspects of the entity’s accounting practices and significant deficiencies in internal control.
The emphasis is on the inherent risk factors and encouraging the entity to use a more statistical, historical, or reasoned approach to creating an estimate and disclosure.
Appendix 2 to the revised standard gives great examples of what you should be communicating to the entity’s governance and management.
What are Audit Assistant’s changes?
The template has been designed in three parts:
Accounting Estimates – The main page. The aim is to identify and assess the risks of material misstatement for accounting estimates and evaluate whether accounting estimates and disclosures are free from material misstatement.
Accounting Estimates Client Questionnaire – A sub-page to be shared with the client to provide the required information from the entity assists with assessing how the client makes estimates and any controls around this.
Specific Estimate – A sub-page to assist with auditing a specific accounting estimate and will help with the overall evaluation of accounting estimates – a version is created for each estimate. The goal is to:
- Assess management’s assumptions and judgements in making the accounting estimate and ascertain whether there is management bias.
- Assess whether controls are operating effectively on the estimate.
- Assess whether substantive procedures alone can provide sufficient appropriate audit evidence.
- Design tests of controls and substantive tests for the specific estimate.
NOTE: ISA (NZ) 540 (Revised) applies for periods beginning on or after 15 Dec 2019.
The standard does not say, as many do that early adoption is permitted, so for now we have provided the alternative to use the old workpapers, or the new ones based on the revised standard. We have also moved accounting estimates from the E section into the D “Other Matters” section.