Justifying Your Accounting Estimates

Accountants involved in preparing financial statements can expect increased scrutiny and challenge
of their accounting estimates from their auditors.

Terry O'Rourke
June 03, 2019 | CharteredAccountants.com| IRE

https://www.charteredaccountants.ie/AccountancyIreland/Articles2/Technical/Latest-
News/Article-item/justifying-your-accounting-estimates

I suspect that most accountants would agree that non-accountants believe the numbers in
financial statements are more precise than they really are. Accountants, on the other hand, are much
more conscious of the level of estimation that goes into many of those reported numbers. I must admit I
didn’t become aware of the level of estimation involved until I entered the real world of auditing and
accounting. I certainly don’t recall gleaning it from my accounting lectures or from the texts I read for
my exams.

I spent many long days patrolling the aisles and shelves of warehouses and stockrooms
torturing myself about the best estimate of just how much could be realised from excess and out-of-
date lines of inventory, conscious that they had to be written down to their estimated selling price less
estimated costs to complete and sell. What followed was long hours quizzing credit controllers while
worrying about whether the 5% bad debt provision was the best estimate of the extent to which the
amounts due from customers would not be collected, and whether the credit controller was too
optimistic or too pessimistic.Estimating the useful life of buildings and plant is key to the depreciation
charge, an area of estimation where you might think an engineer would be more qualified than an
accountant, though a futurologist might be better when it comes to the question of technological
obsolescence. On the liabilities side of the balance sheet, significant judgement is applied in estimating
the amount of defined benefit pension obligations, including mortality and inflation assumptions, as well
as assessing the likely outcome of legal claims and court cases, where the assumption about success or
failure can be critical to the numbers included in the financial statements.

These are the some of the traditional areas of estimation uncertainty an accountant needs to
consider. And, all of this was before the challenge of estimating value in use and fair values poked its
head into so many areas of accounting. The implications of the new auditing rules for accountants in
business. So, why is it appropriate to focus on estimation at this point? Well, since the issue of IFRS 9
and its emphasis on expected credit losses on loans and receivables upped the ante on estimation still
further, auditing standard setters have seen fit to upgrade the rules on how to audit all types of
estimates. Inevitably, as auditors direct more attention to estimates, accountants in business involved in
financial reporting will feel the heat of incisive questions from their auditors as they apply the new rules
to the myriad of estimates underlying the financial statements. The Irish auditing standard setter, the
Irish Auditing and Accounting Supervisory Authority (IAASA), issued its new standard on auditing
accounting estimates (ISA 540) in late 2018 with mandatory effect for audits of financial statements for
periods commencing on or after 15 December 2019. That may seem some time away but, of course,
early adoption of the more demanding rules is permitted, and some auditors may consider it
appropriate to apply the new rules early. The implications of this for accountants in business are likely to
vary significantly depending on the auditor’s assessment of the risk that incorrect estimation may cause
a material misstatement.

Among the areas of particular focus in the updated ISA 540 is the requirement for the auditor to
show adequate professional skepticism and to be on alert for management bias. There is also a strong
emphasis on the auditor documenting – in detail – the management estimation process, including the
assessment of material misstatement risks. The level of subjectivity underlying these estimates, and the
degree of estimation uncertainty, will affect the design and completion of this process. Of course, some
auditors may have already been applying the new rules or, indeed, may have assessed that the new
rules will not add to their audit effort. Accountants in business will wish to avoid any late surprises as a
result of their auditor introducing additional audit procedures or placing increased demands on them. It
is worth remembering, too, that the auditor will seek written representations from management on
certain matters, including areas of accounting estimation, and will often report to the board or the audit
committee on areas of judgement and estimation, both of which can take up more senior audit effort.
Further, for many listed companies, the auditor’s report to the shareholders will explain how the auditor
has addressed significant estimates. When the updated ISA 540 was being developed, many
commentators, including some Irish auditors, had concerns that it might put an unnecessarily large
burden on the audits of smaller companies. The final version of ISA 540 has attempted to allay those
concerns by suggesting that the risk of material misstatement may be less significant in smaller
companies with a consequent lower level of audit effort required. It will be useful for company
accountants to be aware of where their auditor’s assessment of this risk lies along the spectrum and the
consequences for the degree of audit effort required.

The degree to which the auditor decides it is necessary to devote effort and focus to the
estimates can affect how accountants in business should prepare to justify their own estimates. That
preparation might include more detailed documentation of the appropriateness of the estimates, the
level of estimation uncertainty involved and the rigour of the internal control process surrounding the
estimation process. This should help the auditor conclude on their reasonableness, and reduce the
degree of effort spent drafting documentation they are required to complete. For some complex or
specialised areas of estimation, company accountants may wish to ensure that their auditors have the
necessary skills or expertise to assess the reasonableness of the estimates to reach their conclusions
promptly. This may arise in areas such as actuarial assumptions for pension obligations, valuation
techniques for derivatives and unquoted financial assets, the likely outcome of legal claims and
uncertain tax positions, and technical provisions in insurance companies, to name a few.

There is no getting away from the vital role that estimation plays in financial reporting.
Consequently, there can be no denying the importance of the auditor’s procedures in auditing those
estimates, notwithstanding the level of interrogation and challenge this may entail as the auditor seeks
to conclude on the reasonableness of the estimates. Clearly, it is desirable that maximum co-operation
between management and auditor is achieved by early communication, explanation and clarity on the
level and type of audit work planned, and the degree to which management and accountants in business
can enhance their documentation of the estimation process.

After all, making accounting estimates is the prerogative of management, and management should have
every opportunity to justify them to the auditors to ensure that the new, more onerous auditing rules
neither add significantly to the cost nor disrupt the harmony of the audit.
 I. TITLE
"An Article Review on Auditing and Accounting Estimates"

II. Article Under Review

O ’Rourke, T. (2019, June 3). Justifying your Accounting Estimate. Chartered

Accountant.https://www.charteredaccountants.ie/AccountancyIreland/Articles2/Technical/L
atest News/Article-item/justifying-your-accounting-estimates

III. Major Points/Issues

1. Accounting estimates are of particular concern to the auditor as, by their nature, there
may not be any physical evidence to support them and they are prone to
inaccuracy.They are also subjective and complex; therefore prone to management
bias
2. Significant issue is determining whether the assumptions underlying those significant
and critical estimates are reasonable and justified.
3. Insufficient appropriate evidence to support whether accounting estimates are
reasonable and adequate in the context of financial reporting framework, and
insufficient process of gathering the evidences and any controls over that process.
4. The components on the balance sheet are to a significant extent influenced by
accounting estimates and thus inaccurate and unreliable estimate could increase the
risk of material mistatement in the financial statement.
5. Failure to exercise sufficient professional skepticism of inherent risks in accounting
estimates
6. Lack of detailed documentation

IV. Definition of Terms

V. Discussion and Review of Related Literature

1. AICPA AU-C(540-A15), the preparation and fair presentation of the
financial statements requires management to determine whether a
transaction, an event, or a 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.
AICPA, AU-C (540), the risk of misstatement of an estimate is a
combination of the “complexity and subjectivity associated with the
process, the availability and reliability of relevant data, the number and
significance of assumptions that are made, and the degree of uncertainty
associated with the assumptions.”
AICPA, AU-C(540-A48), a seemingly immaterial accounting estimate may
have the potential to result in a material misstatement due to the
estimation uncertainty associated with the estimation (that is, the size of
the amount recognized or disclosed in the financial statements for an
accounting estimate may not be an indicator of its estimation
uncertainty).
IASB, (IASB, 2010), ''an estimate can provide relevant information, even if
the estimate is subject to a high level of measurement uncertainty.
Nevertheless, if measurement uncertainty is high, an estimate is less
relevant than it would be if it were subject to low measurement
uncertainty. Measurement uncertainty arises when a measure for an
asset or a liability cannot be observed directly and must instead be
estimated.''

PSA (540.2), 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 them susceptibility to unintentional or
intentional management bias.

PSA (540.21), 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.
ISA 540 A96. When the auditor identifies indicators of possible
management bias, the auditor may need a further discussion with
management and may need to reconsider whether sufficient appropriate
audit evidence has been obtained that the method, assumptions and data
used were appropriate and supportable in the circumstances.
Financial reporting frameworks often call for neutrality, that is, freedom
from bias. Estimation uncertainty gives rise to subjectivity in making an
accounting estimate. The presence of subjectivity gives rise to the need
for judgment by management and the susceptibility to unintentional or
intentional management bias (for example, as a result of motivation to
achieve a desired profit target or capital ratio). The susceptibility of an
accounting estimate to management bias increases with the extent to
which there is subjectivity in making the accounting estimate.
2. PCAOB AS (2501), the auditor should identify which of the assumptions
used by the company are significant assumptions to the accounting
estimate, that is, the assumptions that are important to the recognition or
measurement of the accounting estimate in the financial statements. In
identifying the significant assumptions, the auditor should take into
account the nature of the accounting estimate, including related risk
factors, the requirements of the applicable financial reporting framework,
and the auditor's understanding of the company's process for developing
the estimate.
PSA (540.15), For accounting estimates that give rise to significant risks, in
addition to other substantive procedures performed to meet the
requirements of PSA 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.
SEC Interpretive Guidance(FR-72), Many estimates and assumptions
involved in the application of GAAP have a material impact on reported
financial condition and operating performance and on the comparability
of such reported information over different reporting periods. When
preparing disclosure under the current requirements, companies should
consider whether they have made accounting estimates or assumptions
where:the nature of the estimates or assumptions is material due to the
levels of subjectivity and judgment necessary to account for highly
uncertain matters or the susceptibility of such matters to change; and the
impact of the estimates and assumptions on financial condition or
operating performance is material.
SEC Interpretive Guidance (FR-72), An accounting estimate is critical if (1)
the accounting estimate requires a material level of subjectivity or
judgment on behalf of the company to account for highly uncertain
matters, and (2) the company could have reasonably used different
accounting estimates in the current period and using these different
accounting estimates would materially impact the presentation of firm
performance.
PCAOB, For critical accounting estimates, the auditor should obtain an
understanding of how management analyzed the sensitivity of its
significant assumptions to change, based on other reasonably likely
outcomes that would have a material effect on its financial condition or
operating performance.19 The auditor should take that understanding
into account when evaluating the reasonableness of the significant
assumptions and potential management bias.
Auditors should be inclined to systematically evaluate management’s
assumptions and whether such estimate assumptions are reasonable in
the context of financial framework. Audtiors should address critical
accounting estimates or assumptions that bear the risk of material
misstatements. The reason may be that there is an uncertainty attached
to the estimate or assumption, or it just may be difficult to measure or
value. Equally important, that auditors should address to management
questions once critical accounting estimate or assumption has been
identified, by analyzing, to the extent material, such factors as how they
arrived at the estimate, how accurate the estimate or assumption has
been in the past, how much the assumption has changed in the past, and
whether the assumption is reasonably likely to change in the future. Since
critical accounting estimates and assumptions are based on matters that
are highly uncertain, an auditor should analyze their specific sensitivity to
change, based on other outcomes that are reasonably likely to occur and
would have a material effect. Companies should also provide quantitative
as well as qualitative disclosure when quantitative information is
reasonably available and will provide material information for investors.
3.PSA (540.6), The objective of the auditor is to obtain sufficient
appropriate audit evidence about whether:
(a) accounting estimates, including fair value accounting estimates, in the
financial statements, whether recognized or disclosed, are reasonable;
and
(b) related disclosures in the financial statements are adequate, in the
context of the applicable financial reporting framework.
PSA (540.18), 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.
ISA (540-A1) Audit evidence is necessary to support the auditor’s opinion
and report. It is cumulative in nature and is primarily obtained from audit
procedures performed during the course of the audit. It may, however,
also include information obtained from other sources such as previous
audits provided the auditor has determined whether changes have
occurred since the previous audit that may affect its relevance to the
current audit or a firm’s quality control procedures for client acceptance
and continuance. In addition to other sources inside and outside the
entity, the entity’s accounting records and other sources internal to the
entity are an important sources of audit evidence. Also, information that
may be used as audit evidence may have been prepared using the work of
a management’s expert. or be obtained from an external information
source. Audit evidence comprises both information that supports and
corroborates management’s assertions, and any information that
contradicts such assertions. In addition, in some cases the absence of
information (for example, management’s refusal to provide a requested
representation) is used by the auditor, and therefore, also constitutes
audit evidence

(ISA 540 A2) Most of the auditor’s work in forming the auditor’s opinion
consists of obtaining and evaluating audit evidence. Audit procedures to
obtain audit evidence can include inspection, observation, confirmation,
recalculation, reperformance, and analytical procedures, often in some
combination, in addition to inquiry. Although inquiry may provide
important audit evidence, and may even produce evidence of a
misstatement, inquiry alone ordinarily does not provide sufficient audit
evidence of the absence of a material misstatement at the assertion level,
nor of the operating effectiveness of controls.
ISA (330) requires the auditor to conclude whether sufficient appropriate
audit evidence has been obtained.Whether sufficient appropriate audit
evidence has been obtained to reduce audit risk to an acceptably low
level, and thereby enable the auditor to draw reasonable conclusions on
which to base the auditor’s opinion, is a matter of professional judgment.
PCAOB AS (1105.12), requires the auditor, when using information
produced by the company as audit evidence, to evaluate whether the
information is sufficient and appropriate for purposes of the audit by
performing procedures to
(1) test the accuracy and completeness of the information or test the
controls over the accuracy and completeness of that information, and
(2) evaluate whether the information is sufficiently precise and detailed
for purposes of the audit.
PCAOB AS (1105.13), If the company uses data from an external source,
the auditor should evaluate the relevance and reliability of the data in
accordance with AS 1105.
PCAOB AS (1105.14), The auditor should also evaluate whether the data
is appropriately used by the company in developing the accounting
estimate by evaluating whether:the data is relevant to the measurement
objective for the accounting estimate;he data is internally consistent with
its use by the company in other significant accounts and disclosures; and
The source of the company's data has changed from the prior year and, if
so, whether the change is appropriate.
PICPA (200.26), Accounting estimates are often based on data derived
from routine transactions processed by the entity's computer information
systems. Controls may be effective with respect to the completeness,
accuracy and validity (existence) of such underlying data.
Environmental factors and practical limitations often restrict the degree
of evidential support available to auditors, making it difficult, in some
circumstances, to determine what constitutes sufficient appropriate
evidence. The conventional presumption in auditing standards and most
audit research is that greater evidentiary support reduces uncertainty and
thus auditor reasonableness assessments should increase when greater
evidence is available to support the estimate. The determination of what
constitutes sufficient, appropriate evidence when auditing an uncertain
estimate is subjective, and likely influenced by various contextual
features. Gathering sufficient, appropriate evidence is a growing issue in
auditing, due in part to the increased use of estimates.
4.PCAOB (AS 2110), Identifying and Assessing Risks of Material
Misstatement, establishes requirements regarding the process of
identifying and assessing risks of material misstatement. This process
includes (1) identifying accounting estimates in significant accounts and
disclosures; (2) understanding the process by which accounting estimates
are developed;1 and (3) identifying and assessing the risks of material
misstatement related to accounting estimates, which includes
determining whether the components of estimates in significant accounts
and disclosures are subject to significantly differing risks, and which
accounting estimates are associated with significant risks.
PCAOB (AS 2301), The Auditor's Responses to the Risks of Material
Misstatement, requires the auditor to design and implement appropriate
responses that address risks of material misstatement. This includes
applying substantive procedures to accounting estimates in significant
accounts and disclosures. Responding to the risks of material
misstatement involves evaluating whether the accounting estimates are
in conformity with the applicable financial reporting frameworke and
reasonable in the circumstances, as well as evaluating potential
management bias in accounting estimates and its effect on the financial
statements.
PICPA (200.29), The auditor is responsible for evaluating the
reasonableness of accounting estimates made by management in the
context of the financial statements taken as a whole. If the auditor
believes there are material weaknesses, the auditor reports them to
management and, if appropriate, to those charged with governance.
PICPA (200.30), A difference between the outcome of an accounting
estimate and the amount originally recognized or disclosed in the
financial statements does not necessarily represent a misstatement of the
financial statements. This is particularly the case for fair value accounting
estimates, as any observed outcome is invariably affected by events or
conditions subsequent to the date at which the measurement is
estimated for purposes of the financial statements.
5. ISA (540.8) The exercise of professional skepticism in relation to
accounting estimates is affected by the auditor’s consideration of
inherent risk factors, and its importance increases when accounting
estimates are subject to a greater degree of estimation uncertainty or are
affected to a greater degree by complexity, subjectivity orother inherent
risk factors. Similarly, the exercise of professional skepticism is important
when there is greater susceptibility to misstatement due to management
bias or fraud. (Ref: Para. A11)
ISA ( 540), Auditing accounting estimates and related disclosures
introduces the concept of inherent risk factors and requires the auditor to
consider the degree to which accounting estimates are affected by these
factors in identifying and assessing the risks of material misstatement.
This Audit and Assurance guide explains what inherent risk factors are
and how they may influence your audit of accounting estimates.
Professional skepticism is especially important in dealing with matters of
judgement.The risk of inherent factors may be decreased if the
independent auditors approach the audit with an attitude of professional
skepticism. This attitude implies a questioning mind and a critical
assessment of audit evidence. All significant estimates should be
reviewed with professional skepticism and the reason for changes in
assumptions should be determined and justified by the internal auditor.
An attitude of professional skepticism should be maintained throughout
the audit, notwithstanding the auditor’s past experience with the entity.
6. ISA (540.39), The auditor shall include in the audit documentation

(a) Key elements of the auditor’s understanding of the entity and its
environment, including the entity’s internal control related to the entity’s
accounting estimates;
(b) The linkage of the auditor’s further audit procedures with the assessed
risks of material misstatement at the assertion level, taking into account
the reasons (whether related to inherent risk or control risk) given to the
assessment of those risks;
(c) The auditor’s response(s) when management has not taken
appropriate steps to understand and address estimation uncertainty;
(d) Indicators of possible management bias related to accounting
estimates, if any, and the auditor’s evaluation of the implications for the
audit.
(e) Significant judgments relating to the auditor's determination of
whether the accounting estimates and related disclosures are reasonable
in the context of the applicable financial reporting framework, or are
misstated.