Six sections make up specific templates. For this article, we will focus on two sections as they have underlying concepts that are crucial for auditors to be aware of to audit accounting estimates:
- Identifying and assessing the risks of material misstatement.
- Developing an auditor’s point estimate or range.
To identify and assess the risks of material misstatement. Three concepts will be beneficial to understand:
- The inherent risk factors (estimation uncertainty, complexity, subjectivity, and other inherent risks).
- What is a significant risk?
- Auditor's point estimate.
Estimation Uncertainty
To understand Estimation Uncertainty's level, the auditor must look at the method, assumptions, and business environment.
Examples that give rise to estimation uncertainty are:
- Unobservable inputs and data, assumptions that require long forecast periods and, therefore, hard to develop.
- Entities that are trading in an active market with significant currency fluctuations.
- External events like COVID-19.
- Information around the value of an asset is accessible from an open market.
Complexity
Internally generated models may have a greater susceptibility to material misstatement, especially when management has had little experience doing so or uses a model that applies a method that is not established or commonly used in a particular industry or environment. There is often the need for specialised skills or knowledge when applying a method of estimation and analysing contractual agreements terms like estimating potential revenue and expenses from a contract.
Financial reporting frameworks requirements around measurement bases may result in the need for a complex method/s that requires multiple sources of historical and forward-looking data or assumptions, with multiple interrelationships between them.
Processes around deriving, maintaining the integrity of data can be complex. Data from specific sources may be more reliable than from others, and this is important to look at concerning the relevance and reliability of the data.
Subjectivity
In considering the degree to which the selection and application of method, assumptions or data are affected by subjectivity, the auditor may consider:
- The degree to which the applicable financial reporting framework does not specify the valuation approaches, concepts, techniques, factors to use in the estimation method. The decision is left up to management and can be highly subjective.
- Suppose there is uncertainty regarding the amount or timing (including the length of the forecast period). The amount and timing are a source of inherent estimation uncertainty and give rise to the need for management judgment in selecting a point estimate, which creates an opportunity for management bias.
For example, an accounting estimate that incorporates forward-looking assumptions may have a high degree of subjectivity which may be susceptible to management bias.
What is the process for identifying significant risk?
The auditor’s assessment of inherent risk considers the degree to which an accounting estimate is subject or affected by estimation uncertainty, complexity, subjectivity or other inherent risk factors. The auditor uses this assessment in determining whether any of the risks of material misstatement identified and assessed are a significant risk.
Developing an auditor’s point estimate or range
What is management's point estimate?
This is the amount selected by management for recognition or disclosure in the financial statements as an accounting estimate.
When is it appropriate to develop an auditor’s point estimate or range?
Developing an auditor’s point estimate or range to evaluate management’s point estimate and related disclosures about estimation uncertainty may be an appropriate approach when, for example:
- The auditor’s review of similar accounting estimates made in the prior period financial statements suggests that management’s current period process is not expected to be effective.
- The entity’s controls within and over management’s process for making accounting estimates are not well designed or properly implemented.
- Events or transactions between the period end and the date of the auditor’s report have not been adequately considered when it is appropriate for management to do so, and such events or transactions appear to contradict management’s point estimate.
- Management has not taken appropriate steps to understand or address the estimation uncertainty.
Reporting Frameworks influence what point estimate or range to use for auditor’s and the entity
Applicable financial reporting framework can prescribe the point estimate that is to be used after consideration of the alternative outcomes and assumptions or prescribe a specific measurement method (for example, the use of a discounted probability-weighted expected value or the most likely outcome).
Examples of ways to develop an auditor’s point estimate or range
The auditor may develop a point estimate or a range in several ways, for example,
- Using a different model than the one used by management, for example, one that is commercially available for use in a particular sector or industry, or a proprietary or auditor-developed model.
- Developing alternative assumptions or data sources to those used by management.
- Using their method but developing alternative assumptions to those used by management.