Audit Method: Accounting Estimates

Accounting estimate as defined in ISA 540 – “An approximation of a monetary amount in the absence of a precise means of measurement. This term is used for an amount measured at fair value where there is estimation uncertainty, as well as for other amounts that require estimation. Where this ISA addresses only accounting estimates involving measurement at fair value, the term “fair value accounting estimates” is used.”

Some financial statement items cannot be measured precisely, but can only be estimated. For purposes of this discussion, such financial statement items are referred to as accounting estimates. The nature and reliability of information available to management to support the making of an accounting estimate varies widely, which thereby affects the degree of estimation uncertainty associated with accounting estimates. The degree of estimation uncertainty affects, in turn, the risks of material misstatement of accounting estimates, including their susceptibility to unintentional or intentional management bias.

Test of accounting estimates for bias

First perform a retrospective review of significant accounting estimates reflected in the financial statements of the prior year to determine whether management judgments and assumptions relating to the estimates indicate a possible bias on the part of management.

The significant accounting estimates selected for testing should include those that are based on highly sensitive assumptions or are otherwise significantly affected by judgments made by management. Consider the results of this retrospective review in evaluating the current-year estimates. If we identify a possible bias on the part of management in making prior-year accounting estimates, we should evaluate whether circumstances producing such a bias represent a risk of a material misstatement due to fraud.

Secondly, consider whether differences between estimates best supported by the audit evidence and the estimates included in the financial statements, even if they are individually reasonable, indicate a possible bias on the part of the entity's management. If so, reconsider estimates taken as a whole.

Practice

For accounting estimates (e.g., liabilities for certain employee benefits plans and legal contingencies), evaluate the reasonableness of the methods and assumptions management used to make the estimates. If management's methods and assumptions were reasonable, test the data and assumptions underlying the estimates, and re-compute the estimates. If management's methods and assumptions were not reasonable, develop an independent range of reasonable estimates and determine whether management's estimates fall within that range.