Accounting Estimate 

& ISA 540 (Revised)

1) An accounting estimate is an approximation of the amount of a business
transaction for which there is no precise means of measurement. ... The amount of
an accounting estimate is based on historical evidence and the judgment of
the accountant.
The IAASB revised its standard on accounting estimates, ISA 540
(Revised), Auditing Accounting Estimates and Related Disclosures, to respond to
the rapidly evolving business environment. The revision ensures that the standard
continues to keep pace with the changing market and fosters a more independent
and challenging skeptical mindset in auditors.

2) Examples of accounting estimates include:

 Allowance for doubtful accounts,
 Work-in-progress inventory,
 Warranty obligations,
 Depreciation method or asset useful life,
 Recoverability provision against the carrying amount of investments,
 Fair value of goodwill and other intangibles,
 Long-term contracts,

3. ISA 540 (Revised) becomes effective for financial statement audits for periods
beginning on or after December 15, 2019.

ISA 540 (Revised) includes an enhanced work effort that addresses the challenges
that auditors face by providing more guidance and objective-based requirements
that are allow for scalability in the nature, timing and extent of procedures
performed in relation to the degree of estimation uncertainty and the assessed ...

4."Accounting estimate" means an approximation of the amount of an item in

the absence of a precise means of measurement. Examples are:

• Allowances to reduce inventory and accounts receivable to their estimated- realizable

value.

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 • Provisions to allocate the cost of fixed assets over their estimated useful
lives.
• Accrued revenue.
• Deferred tax.
• Provision for a loss from a lawsuit.
• Losses on construction contracts in progress.
• Provision to meet warranty claims.

Management is responsible for making accounting estimates included in financial

statements. These estimates are often made in conditions of uncertainty regarding
the outcome of events that have occurred or are likely to occur and involve the use
of judgment. As a result, the risk of material misstatement is greater when
accounting estimates are involved and in some cases the auditor may determine
that the risk of material misstatement related to an accounting estimate is a
significant risk that requires special audit consideration. See paragraphs 108-114 of
ISA 315, “Understanding the Entity and Its Environment and Assessing the Risks
of Material Misstatement.”…….

The Nature of Accounting Estimates

5. The determination of an accounting estimate may be simple or complex
depending upon the nature of the item. For example, accruing a charge for rent
may be a simple calculation, whereas estimating a provision for slow-moving or
surplus inventory may involve considerable analyses of current data and a forecast
of future sales. In complex estimates, there may be a high degree of special
knowledge and judgment required.

6. Accounting estimates may be determined as part of the routine information

system relevant to financial reporting operating on a continuing basis, or may be
non-routine, operating only at period end. In many cases, accounting estimates are
made by using a formula based on experience, such as the use of standard rates for
depreciating each category of fixed assets or a standard percentage of sales revenue
for computing a warranty provision. In such cases, the formula needs to be

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reviewed regularly by management, for example, by reassessing the remaining
useful lives of
assets or by comparing actual results with the estimate and adjusting the formula
when necessary.

7. The uncertainty associated with an item, or the lack of objective data may make
it incapable of reasonable estimation, in which case, the auditor needs to consider
whether the auditor's report needs modification to comply with ISA "The Auditor's
Report on Financial Statements." Audit Procedures Responsive to the Risk of
Material Misstatement of the Entity’s Accounting Estimates

8. The auditor should design and perform further audit procedures to obtain
sufficient appropriate audit evidence as to whether the entity’s accounting
estimates are reasonable in the circumstances and, when required, appropriately
disclosed. The audit evidence available to detect a material misstatement in an
accounting estimate will often be more difficult to obtain and less persuasive than
audit evidence available to detect a material misstatement in other items in the
financial statements. The auditor’s understanding of the entity and its environment,
including its internal control, assists the auditor in identifying and assessing the
risks of material misstatement of the entity’s accounting estimates.

9. An understanding of the procedures and methods, including internal relevant

control activities, used by management in making the accounting estimates is
important for the auditor to identify and assess risks of material misstatement in
order to design the nature, timing and extent of the further audit procedures.

10. The auditor should adopt one or a combination of the following approaches
in the audit of an accounting estimate:
(a) Review and test the process used by management to develop the estimate;
(b) Use an independent estimate for comparison with that prepared by
management; or
(c) Review of subsequent events which provide audit evidence of the
reasonableness of the estimate made.

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Reviewing and Testing the Process Used by Management
11. The steps ordinarily involved in reviewing and testing of the process used by
management are:
(a) Evaluation of the data and consideration of assumptions on which the estimate
is based;

(b) Testing of the calculations involved in the estimate;

(c) Comparison, when possible, of estimates made for prior periods with actual
results of those periods; and
(d) Consideration of management's approval procedures.

Evaluation of Data and Consideration of Assumptions

12. The auditor would evaluate whether the data on which the estimate is based is
accurate, complete and relevant. When information produced by the entity is used,
it will need to be consistent with the data processed through the information system
relevant to financial reporting. For example, in substantiating a warranty provision,
the auditor would obtain audit evidence that the data relating to products still
within the warranty period at period end agree with the sales information within
the information system relevant to financial reporting. ISA 500, “Audit Evidence”
paragraph 11 provides additional guidance on the requirement to obtain audit
evidence about the accuracy and completeness of information produced by the
entity when it is used in performing audit procedures.

13. The auditor may also seek evidence from sources outside the entity. For
example, when examining a provision for inventory obsolescence calculated by
reference to anticipated future sales, the auditor may, in addition to examining
internal data such as past levels of sales, orders on hand and marketing trends, seek
evidence from industry-produced sales projections and market analyses. Similarly,
when examining management's estimates of the financial implications of litigation
and claims, the auditor would seek direct communication with the entity's lawyers.

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14. The auditor would evaluate whether the data collected is appropriately
analyzed and projected to form a reasonable basis for determining the accounting
estimate. Examples are the analysis of the age of accounts receivable and the
projection of the number of months of supply on hand of an item of inventory
based on past and forecast usage.
15. The auditor would evaluate whether the entity has an appropriate base for the
principal assumptions used in the accounting estimate. In some cases, the
assumptions will be based on industry or government statistics, such as future
inflation rates, interest rates, employment rates and anticipated market growth. In
other cases, the assumptions will be specific to the entity and will be based on
internally generated data.

16. In evaluating the assumptions on which the estimate is based, the auditor would
consider, among other things, whether they are:

• Reasonable in light of actual results in prior periods.

• Consistent with those used for other accounting estimates.
• Consistent with management's plans which appear appropriate.

The auditor would need to pay particular attention to assumptions which

are sensitive to variation, subjective or susceptible to material misstatement.

17. In the case of complex estimating processes involving specialized techniques, it

may be necessary for the auditor to use the work of an expert,
for example, engineers for estimating quantities in stock piles of mineral ores.

18. The auditor would review the continuing appropriateness of formulae used
by management in the preparation of accounting estimates. Such a review would
reflect the auditor's knowledge of the financial results of the entity in prior periods,
practices used by other entities in the industry and the future plans of management
as disclosed to the auditor.

Testing of Calculations

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19. The auditor would perform audit procedures on the calculation procedures ISA
540 used by management. The nature, timing and extent of the auditor's procedures
will depend on the assessed risk of material misstatement, which is impacted by
such factors as the complexity involved in calculating the accounting estimate, the
auditor's understanding and evaluation of the procedures and methods, including
relevant control activities used by the entity in producing the estimate and the
materiality of the estimate in the context of the financial statements. Comparison of
Previous Estimates with Actual Results

20. When possible, the auditor would compare accounting estimates made for prior
periods with actual results of those periods to assist in:
(a) Obtaining audit evidence about the general reliability of the entity's estimating
procedures and methods, including relevant control activities;
(b) Considering whether adjustments to estimating formulae may be required; and
(c) Evaluating whether differences between actual results and previous estimates
have been quantified and that, where necessary, appropriate adjustments or
disclosures have been made.

Consideration of Management's Approval Procedures

21. Material accounting estimates are ordinarily reviewed and approved by
management. The auditor would consider whether such review and approval is
performed by the appropriate level of management and that it is evidenced in the
documentation supporting the determination of the accounting estimate.

Use of an Independent Estimate

22. The auditor may make or obtain an independent estimate and compare it with
the accounting estimate prepared by management. When using an independent
estimate the auditor would ordinarily evaluate the data, consider the assumptions
and perform audit procedures on the calculation procedures used in its
development. It may also be appropriate to compare accounting estimates made for
prior periods with actual results of those periods.
Review of Subsequent Events

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23. Transactions and events which occur after period end, but prior to completion
of the audit, may provide audit evidence regarding an accounting estimate made by
management. The auditor's review of such transactions and events may reduce, or
even remove, the need for the auditor to review and perform audit procedures on
the process used by management to develop the accounting estimate or to use an
independent estimate in assessing the reasonableness of the accounting estimate.

Evaluation of Results of Audit Procedures

24. The auditor should make a final assessment of the reasonableness of
the entity’s accounting estimates based on the auditor's understanding of the entity
and its environment and whether the estimates are consistent with other audit
evidence obtained during the audit.

25. The auditor would consider whether there are any significant subsequent
transactions or events which affect the data and the assumptions used in
determining the accounting estimates.

26. Because of the uncertainties inherent in accounting estimates, evaluating

differences can be more difficult than in other areas of the audit. 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, the auditor would determine whether such a difference requires
adjustment. If the difference is reasonable, for example, because the amount in the
financial statements falls within a range of acceptable results, it may not require
adjustment. However, if the auditor believes 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 would
be considered with all other misstatements in assessing whether the effect on the
financial statements is material.

27. The auditor would also consider whether individual differences which have
been accepted as reasonable are biased in one direction, so that, on a cumulative
basis, they may have a material effect on the financial statements. In such

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circumstances, the auditor would evaluate the accounting estimates taken as a
whole.