Auditing Accounting Estimates

Basics

• Accounting Estimates (including fair values )

usually involve significant subjective

assumptions and measurement uncertainty

• Measurement uncertainty & subjective

assumptions can lead to:

– Higher IR

– Designation as a significant account

– Designation as a significant risk for the valuation

assertion (and completeness assertion for liabilities)

PCAOB Steps

• Identify circumstances that require estimates

• Understand management’s process and controls

• Test the:

– assumptions,

– model, and

– underlying data (inputs)

• Develop an independent estimate to corroborate

• Consider “subsequent events”

• Obtain management representations and determine

that the Audit Committee is informed

Substantive Testing of Estimates

• Prior to designing substantive audit procedures – auditor

will:

– Identify accounting estimate in significant accounts

– Understand how mgmt. develops accounting estimates

– Consider ICFR, assess CR, and possibly test controls

• AS 2501 – identifies 3 approaches to auditing estimates:

– Test audit client’s process

– Auditor develops independent expectation of estimate for

comparison to audit client’s estimate

– Consider evidence from events or circumstances subsequent to

measurement date related to the estimate

• Auditor may use any of 3 approaches, or a combination,

based on judgment and risk considerations

What is Approach 1

1. Evaluate audit client’s methods

– Any models that are used

– Any changes to models/methods – appropriate (this usually raises

questions)?

– Will it generate a GAAP–compliant result if data

2. Test data used by audit client

– Internal data inputs used by audit client relevant to the objective

– If relevant, auditor tests completeness and accuracy of data –

either by testing controls or substantively testing data inputs

– External data – is it reliable and relevant to the objective

– Internal consistency of data used in multiple estimates

– Any changes in data source used from prior year – if yes – then

why; if not – why not

3. Identification of significant assumptions

– Assumptions with the greatest impact on estimate

– Where is the source of the measurement uncertainty

– Minor change in assumption has significant impact on estimate (sensitivity

assessment)

– Is assumption based on mgmt’s intent and ability to take action

4. Evaluating reasonableness of significant assumptions

– Most assumptions will have a range of amounts – is the client’s reasonable

– Most historical-cost based estimates will begin with historical experience in

developing significant assumptions

– Has historical experience been adjusted for current conditions

– Address whether mgmt-intent based assumptions can be executed by audit client

– Perform hindsight analysis

– Must consider contrary evidence

What is Approach #2

• Auditor STILL obtains an understanding of audit client’s process,

including the significant assumptions used by the audit client

• Auditor uses some or all of its own methods, data and assumptions in

developing its independent expectation

• Auditor may use assumptions obtained from a third party – auditor

assesses relevance and reliability (i.e., just as auditor would do if

audit client uses third party data)

• If auditor uses some of the audit client’s data or significant

assumptions – test the information no different than if testing

mgmt’s process

• Compare independent expectation to client’s recorded estimate –

within a tolerable amount?

• This approach most often used for fair value estimates; used less

extensively for historical-cost based estimates

• Must consider contrary evidence

What is Approach 3

• Possible uses:

– Allowance for doubtful accounts – considering subsequent

cash receipts

– FV of investment – sale in month following measurement date

– Litigation accrual – settlement in month following

measurement date

• Key issue – does the subsequent transaction reflect

conditions that EXISTED at the measurement date?

– Have events and conditions changed since measurement date

that would render the subsequent transaction not relevant

• Good evidence if it exists, but not always available