Nature of Accounting Estimates

Because of the uncertainties inherent in business activities, some financial

statement items can only be estimated. Further, the specific characteristics
of an asset, liability or component of equity, or the basis of or method of
measurement prescribed by the financial reporting framework, may give rise
to the need to estimate a financial statement item. Some financial reporting
frameworks prescribe specific methods of measurement and the disclosures
that are required to be made in the financial statements, while other
financial reporting frameworks are less specific. The Appendix to this ISA
discusses fair value measurements and disclosures under different financial
reporting frameworks.

Some accounting estimates involve relatively low estimation uncertainty and

may give rise to lower risks of material misstatements, for example:
Accounting estimates arising in entities that engage in business activities
that are not complex.
• Accounting estimates that are frequently made and updated because they
relate to routine transactions.
• Accounting estimates derived from data that is readily available, such as
published interest rate data or exchange-traded prices of securities.
Such data may be referred to as “observable” in the context of a fair value
accounting estimate.
• Fair value accounting estimates where the method of measurement
prescribed by the applicable financial reporting framework is simple and
applied easily to the asset or liability requiring measurement at fair value.
• Fair value accounting estimates where the model used to measure the
accounting estimate is well-known or generally accepted, provided that the
assumptions or inputs to the model are observable.
For some accounting estimates, however, there may be relatively high
estimation uncertainty, particularly where they are based on significant
assumptions, for example:
• Accounting estimates relating to the outcome of litigation.
• Fair value accounting estimates for derivative financial instruments not
publicly traded.
• Fair value accounting estimates for which a highly specialized entity
developed model is used or for which there are assumptions or inputs that
cannot be observed in the marketplace.
The degree of estimation uncertainty varies based on the nature of the
accounting estimate, the extent to which there is a generally accepted
method or model used to make the accounting estimate, and the subjectivity
of the assumptions used to make the accounting estimate. In some cases,
estimation uncertainty associated with an accounting estimate may be so
great that the recognition criteria in the applicable financial reporting
framework are not met and the accounting estimate cannot be made.

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Not all financial statement items requiring measurement at fair value,
involve estimation uncertainty. For example, this may be the case for some
financial statement items where there is an active and open market that
provides readily available and reliable information on the prices at which
actual exchanges occur, in which case the existence of published price
quotations ordinarily is the best audit evidence of fair value. However,
estimation uncertainty may exist even when the valuation method and data
are well defined. For example, valuation of securities quoted on an active
and open market at the listed market price may require adjustment if the
holding is significant in relation to the market or is subject to restrictions in
marketability. In addition, general economic circumstances prevailing at the
time, for example, illiquidity in a particular market, may impact estimation
uncertainty.
. Additional examples of situations where accounting estimates, other than
fair value accounting estimates, may be required include:
• Allowance for doubtful accounts.
• Inventory obsolescence.
• Warranty obligations.
• Depreciation method or asset useful life.
• Provision against the carrying amount of an investment where there is
uncertainty regarding its recoverability.
• Outcome of long term contracts.
• Costs arising from litigation settlements and judgments.
Additional examples of situations where fair value accounting estimates may
be required include:
• Complex financial instruments, which are not traded in an active and open
market.
• Share-based payments.
• Property or equipment held for disposal.
• Certain assets or liabilities acquired in a business combination, including
goodwill and intangible assets.
• Transactions involving the exchange of assets or liabilities between
independent parties without monetary consideration, for example, a non-
monetary exchange of plant facilities in different lines of business.

. Estimation involves judgments based on information available when the

financial statements are prepared. For many accounting estimates, these
include making assumptions about matters that are uncertain at the time of
estimation.
The auditor is not responsible for predicting future conditions, transactions or
events that, if known at the time of the audit, might have significantly
affected management’s actions or the assumptions used by management.

23.1 Definitions
For purposes of the ISAs, the following terms have the meanings attributed
below:

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(a) Accounting estimate – 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.
Auditor’s point estimate or auditor’s range – The amount, or range of
amounts, respectively, derived from audit evidence for use in evaluating
management’s point estimate.
(c) Estimation uncertainty – The susceptibility of an accounting estimate and
related disclosures to an inherent lack of precision in its measurement.
(d) Management bias – A lack of neutrality by management in the
preparation of information.
(e) Management’s point estimate – The amount selected by management for
recognition or disclosure in the financial statements as an accounting
estimate.

23.2 Risk Assessment Procedures and Related Activities

8. When performing risk assessment procedures and related activities to
obtain an understanding of the entity and its environment, including the
entity’s internal control, as required by ISA 315, the auditor shall obtain an
understanding of the following in order to provide a basis for the
identification and assessment of the risks of material misstatement for
accounting estimates:

(a) The requirements of the applicable financial reporting framework relevant

to accounting estimates, including related disclosures.

(b) How management identifies those transactions, events and conditions

that may give rise to the need for accounting estimates to be recognized or
disclosed in the financial statements. In obtaining this understanding, the
auditor shall make inquiries of management about changes in circumstances
that may give rise to new, or the need to revise existing ,accounting
estimates

The preparation of the financial statements requires management to

determine whether a transaction, event or condition gives rise to the need to
make an accounting estimate, and that all necessary accounting estimates
have been recognized, measured and disclosed in the financial statements
in accordance with the applicable financial reporting framework.

Management’s identification of transactions, events and conditions that give

rise to the need for accounting estimates is likely to be based on:
• Management’s knowledge of the entity’s business and the industry in
which it operates.

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• Management’s knowledge of the implementation of business strategies in
the current period.

• Where applicable, management’s cumulative experience of preparing the

entity’s financial statements in prior periods.

Inquiries of management about changes in circumstances may include, for

example, inquiries about whether:
• The entity has engaged in new types of transactions that may give rise to
accounting estimates.
• Terms of transactions that gave rise to accounting estimates have
changed.
• Accounting policies relating to accounting estimates have changed, as a
result of changes to the requirements of the applicable financial reporting
framework or otherwise.
• Regulatory or other changes outside the control of management have
occurred that may require management to revise, or make new, accounting
estimates.
• New conditions or events have occurred that may give rise to the need for
new or revised accounting estimates.

(c) How management makes the accounting estimates, and an

understanding of the data on which they are based
Obtaining an Understanding of How Management Makes the Accounting
Estimates

The preparation of the financial statements also requires management to

establish financial reporting processes for making accounting estimates,
including adequate internal control. Such processes include the following:
• Selecting appropriate accounting policies and prescribing estimation
processes, including appropriate estimation or valuation methods, including,
where applicable, models.
• Developing or identifying relevant data and assumptions that affect
accounting estimates.
• Periodically reviewing the circumstances that give rise to the accounting
estimates and re-estimating the accounting estimates as necessary.
. Matters that the auditor may consider in obtaining an understanding of how
management makes the accounting estimates include, for example:
• The types of accounts or transactions to which the accounting estimates
relate (for example, whether the accounting estimates arise from the
recording of routine and recurring transactions or whether they arise from
non-recurring or unusual transactions).
• Whether and, if so, how management has used recognized measurement
techniques for making particular accounting estimates.
• Whether the accounting estimates were made based on data available at
an interim date and, if so, whether and how management has taken into

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account the effect of events, transactions and changes in circumstances
occurring between that date and the period end.

(i) The method, including where applicable the model, used in making the
accounting estimate;

In some cases, the applicable financial reporting framework may prescribe

the method of measurement for an accounting estimate, for example, a
particular model that is to be used in measuring a fair value estimate. In
many cases, however, the applicable financial reporting framework does not
prescribe the method of measurement, or may specify alternative methods
for measurement.
When the applicable financial reporting framework does not prescribe a
particular method to be used in the circumstances, matters that the auditor
may consider in obtaining an understanding of the method or, where
applicable the model, used to make accounting estimates include, for
example:
• How management considered the nature of the asset or liability being
estimated when selecting a particular method.
• Whether the entity operates in a particular business, industry or
environment in which there are methods commonly used to make the
particular type of accounting estimate.
. There may be greater risks of material misstatement, for example, in cases
when management has internally developed a model to be used to make the
accounting estimate or is departing from a method commonly used in a
particular industry or environment.

(ii) Relevant controls

Matters that the auditor may consider in obtaining an understanding of

relevant controls include, for example, the experience and competence of
those who make the accounting estimates, and controls related to:
• How management determines the completeness, relevance and accuracy
of the data used to develop accounting estimates.
• The review and approval of accounting estimates, including the
assumptions or inputs used in their development, by appropriate levels of
management and, where appropriate, those charged with governance.
• The segregation of duties between those committing the entity to the
underlying transactions and those responsible for making the accounting
estimates, including whether the assignment of responsibilities appropriately
takes account of the nature of the entity and its products or services (for
example, in the case of a large financial institution, relevant segregation of
duties may include an independent function responsible for estimation and
validation of fair value pricing of the entity’s proprietary financial products
staffed by individuals whose remuneration is not tied to such products).

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Other controls may be relevant to making the accounting estimates
depending on the circumstances. For example, if the entity uses specific
models for making accounting estimates, management may put into place
specific policies and procedures around such models. Relevant controls may
include, for example, those established over:
• The design and development, or selection, of a particular model for a
particular purpose.

• The use of the model.

• The maintenance and periodic validation of the integrity of the model.

(iii) Whether management has used an expert;

Management may have, or the entity may employ individuals with, the
experience and competence necessary to make the required point
estimates. In some cases, however, management may need to engage an
expert to make, or assist in making, them. This need may arise because of,
for example:
• The specialized nature of the matter requiring estimation, for example, the
measurement of mineral or hydrocarbon reserves in extractive industries.
• The technical nature of the models required to meet the relevant
requirements of the applicable financial reporting framework, as may be the
case in certain measurements at fair value.
• The unusual or infrequent nature of the condition, transaction or event
requiring an accounting estimate.

(iv) The assumptions underlying the accounting estimates;

(v) Whether there has been or ought to have been a change from the prior
period in the methods for making the accounting estimates, and if so, why;
and
(vi) Whether and, if so, how management has assessed the effect of
estimation uncertainty.

Matters that the auditor may consider in obtaining an understanding of

whether and, if so, how management has assessed the effect of estimation
uncertainty include, for example:
• Whether and, if so, how management has considered alternative
assumptions or outcomes by, for example, performing a sensitivity analysis
to determine the effect of changes in the assumptions on an accounting
estimate.
• How management determines the accounting estimate when analysis
indicates a number of outcome scenarios.
• Whether management monitors the outcome of accounting estimates
made in the prior period, and whether management has appropriately
responded to the outcome of that monitoring procedure.

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Identifying and Assessing the Risks of Material Misstatement
. In identifying and assessing the risks of material misstatement, as required
by ISA 315 the auditor shall evaluate the degree of estimation uncertainty
associated with an accounting estimate11. The auditor shall determine
whether, in the auditor’s judgment, any of those accounting estimates that
have been identified as having high estimation uncertainty give rise to
significant risks

Responses to the Assessed Risks of Material Misstatement

12. Based on the assessed risks of material misstatement, the auditor shall
determine:
(a) Whether management has appropriately applied the requirements of the
applicable financial reporting framework relevant to the accounting estimate;
and
(b) Whether the methods for making the accounting estimates are
appropriate and have been applied consistently, and whether changes, if
any, in accounting estimates or in the method for making them from the
prior period are appropriate in the circumstances.

In responding to the assessed risks of material misstatement, as required by

ISA 330,the auditor shall undertake one or more of the following, taking
account of the nature of the accounting estimate
(a) Determine whether events occurring up to the date of the auditor’s
report provide audit evidence regarding the accounting estimate.
(b) Test how management made the accounting estimate and the data on
which it is based. In doing so, the auditor shall evaluate whether:
(i) The method of measurement used is appropriate in the circumstances;
and)
(ii) The assumptions used by management are reasonable in light of the
measurement objectives of the applicable financial reporting framework.
(c) Test the operating effectiveness of the controls over how management
made the accounting estimate, together with appropriate substantive
procedures
(d) Develop a point estimate or a range to evaluate management’s point
estimate.
(i) If the auditor uses assumptions or methods that differ from
management’s, the auditor shall obtain an understanding of management’s
assumptions or methods sufficient to establish that the auditor’s point
estimate or range takes into account relevant variables and to evaluate any
significant differences from management’s point estimate.
(ii) If the auditor concludes that it is appropriate to use a range, the auditor
shall narrow the range, based on audit evidence available, until all outcomes
within the range are considered reasonable.

In determining the matters identified or in responding to the assessed risks

of material misstatement , the auditor shall consider whether specialized

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skills or knowledge in relation to one or more aspects of the accounting
estimates are required in order to obtain sufficient appropriate audit
evidence.

Further Substantive Procedures to Respond to Significant Risks

Estimation Uncertainty
For accounting estimates that give rise to significant risks, in addition to
other substantive procedures performed to meet the requirements of ISA
330, the auditor shall evaluate the following:
(a) How management has considered alternative assumptions or outcomes,
and why it has rejected them, or how management has otherwise addressed
estimation uncertainty in making the accounting estimate.

(b) Whether the significant assumptions used by management are

reasonable
(c) Where relevant to the reasonableness of the significant assumptions
used by management or the appropriate application of the applicable
financial reporting framework, management’s intent to carry out specific
courses of action and its ability to do so.
If, in the auditor’s judgment, management has not adequately addressed the
effects of estimation uncertainty on the accounting estimates that give rise
to significant risks, the auditor shall, if considered necessary, develop a
range with which to evaluate the reasonableness of the accounting estimate

Recognition and Measurement Criteria

For accounting estimates that give rise to significant risks, the auditor shall
obtain sufficient appropriate audit evidence about whether:
(a) management’s decision to recognize, or to not recognize, the accounting
estimates in the financial statements; and
(b) the selected measurement basis for the accounting estimates are in
accordance with the requirements of the applicable financial reporting
framework.

Evaluating the Reasonableness of the Accounting Estimates, and

Determining Misstatements
. The auditor shall evaluate, based on the audit evidence, whether the
accounting estimates in the financial statements are either reasonable in the
context of the applicable financial reporting framework, or are misstated.
Disclosures Related to Accounting Estimates
The auditor shall obtain sufficient appropriate audit evidence about whether
the disclosures in the financial statements related to accounting estimates
are in accordance with the requirements of the applicable financial reporting
framework
For accounting estimates that give rise to significant risks, the auditor shall
also evaluate the adequacy of the disclosure of their estimation uncertainty

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in the financial statements in the context of the applicable financial reporting
framework.

Indicators of Possible Management Bias

. The auditor shall review the judgments and decisions made by
management in the making of accounting estimates to identify whether
there are indicators of possible management bias. Indicators of possible
management bias do not themselves constitute misstatements for the
purposes of drawing conclusions on the reasonableness of individual
accounting estimates.
Written Representations
The auditor shall obtain written representations from management and,
where appropriate, those charged with governance whether they believe
significant assumptions used in making accounting estimates are reasonable
Documentation
. The auditor shall include in the audit documentation
(a) The basis for the auditor’s conclusions about the reasonableness of
accounting estimates and their disclosure that give rise to significant risks;
and
(b) Indicators of possible management bias, if any