Important definitions

Accounting estimates – The monetary amount exposed to estimate uncertainty.

Estimate uncertainty– It’s a lack of precision/accuracy in the measured/estimated amount.

Management bias– Audit management may be motivated to window-dress financial statements.

Scope of ISA 540

ISA 540 defines the auditor’s responsibilities regarding accounting estimates and related disclosures in the business financial statement.

The auditor is responsible for planning and executing audit procedures necessary for appropriate identification and assessment of the audit procedures at the assertions level.

Requirements of ISA 540

The auditor is required to understand the entity’s control environment, significant changes, and essential events, which result in estimates to be recorded in the business’s financial statements.

Accounting estimates are inherently risky and involve using varied data sets, judgment, and business understanding. However, different estimates contain different levels of risk and uncertainty. So, if an accounting estimate is complex and more subjective, extensive audit procedures must be planned and vice versa.

Further, the inherent risk of each estimate needs to be assessed separately. Thus, sufficient audit procedures can be planned in accordance with the assessed risk.

Likewise, audit evidence obtained via procedure execution must be tested regarding reasonableness. The test needs to consider the content used to make decisions. For instance, data complexity, assumptions used, and compliance with the applicable accounting framework.

Risk assessment

Based on the auditor’s understanding of management’s point estimates, if the auditor concludes that an accounting estimate comes with significant risk, the auditor is required to plan and execute extensive/additional audit procedures to obtain sufficient and appropriate audit evidence.

Designing response to assessed risk

The auditor must execute the following designed procedures against the assessed risk of material misstatement.

• Testing how management has developed estimates.
• Development of auditor’s point estimate.
• Analyzing the events occurring to the audit report date and studying their impact on the estimates.

Methods used for measuring the estimate

The audit procedures designed by the auditor are expected to address the following:

• Test the appropriateness of the methods used to measure the estimate.
• Analyze if the judgments used in estimating have been indicators of possible management bias.

Significant assumptions

The auditor must assess the assumptions’ appropriateness in the following aspects.

• The assumptions must comply with the applicable financial reporting framework. Additionally, any changes to the assumptions must be reasonable.
• Assumptions should not reflect management bias.

Management bias indication

Management bias indicates that management may not be neutral in estimating figures to be recorded in the financial statement.

Data used in accounting estimate

The data used in the accounting estimate need to be,

• Reliable and accurate in terms of compliance with financial reporting framework.
• Selected without management bias.
• Relevant and reliable in terms of circumstances.
• Understood and interpreted in respect of contractual terms.

Related disclosure about estimate uncertainty

The auditor must ensure the following concerning related disclosure about uncertainty.

• The management understands uncertainty.
• Selection of appropriate point estimate in terms of drafting related uncertainty disclosure.

Further, if the auditor believes the management hasn’t appropriately addressed uncertainty, the auditor shall do the following.

• Request management to understand estimates and related aspects further.
• Develop point estimate to evaluate management’s point estimate.

Written representations

The auditor is required to request written representation from management or those charged with governance concerning method, data, and significant assumptions used to develop estimates that have complied with the applicable accounting framework.

Documentation of the work

Regarding accounting estimates, the auditor must ensure the following are in the audit working papers:

• Entity’s internal controls related to accounting estimates.
• The relevant audit procedures were performed with the assessed RMM at the assertion level.
• Auditor’s response when management did not take appropriate steps to develop accounting estimates.
• Management bias and designed procedures to take care of accounting estimates.
• Assessment if related assumptions and disclosures are complied with the applicable financial reporting framework.

Wrap up

ISA 540 concerns accounting estimates and related disclosures in the financial statement. The auditor is responsible for understanding the relevant controls, data, method, and significant assumptions used to develop the accounting estimate.

If the auditor is not satisfied with management’s mechanism for developing estimates, the auditor will design further audit procedures and obtain written representation.