Audit Of Accounting Estimates

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What You Really Need to Know

Chapter 19: The Audit Of Accounting Estimates

LO1 Explain how audit professional judgment differs from accounting professional judgment.

  • Professional judgment is the application of relevant knowledge and experience to the facts and circumstances that are required for making informed audit decisions that are consistent with ethical requirements and CAS.

  • The goal in developing a framework for professional judgment is to assist auditors in properly exercising judgments, in carrying out professional standards, in forming judgments on specific assertions, and on financial statements as a whole and in rendering an opinion. The principles of professional judgment are to assess the level of assurance needed, assess materiality, identify the subject matter, assess the accountability relationships, identify the goals of the engagement and then justify the conclusion reached.

  • The five key concepts for professional judgment are the audit task environment, auditor characteristics, evidence, decision-making process, and qualitative attributes of professional judgment.

  • Auditors are susceptible to judgmental biases because of the use of short cuts or heuristics in the reasoning process. Heuristics such as the anchoring and adjustment heuristic, the representativeness heuristic, and the availability heuristic. Other biases include the hindsight bias and the confirmation bias.

  • Four main ways to counteract these biases is to (1) be aware of them, (2) consult with others, (3) document one’s reasoning, and (4) be knowledgeable about the subject matter.

LO2 Describe the main concepts of CAS 540 and its relevance for financial reporting.

  • Key definitions include:

    • Accounting estimate — an approximation of a monetary amount in the absence of a precise means of measurement.

    • Auditor’s point estimate or auditor’s range — the amount or range of amounts, derived from audit evidence for use in evaluating management’s point estimate.

    • Estimation uncertainty — susceptibility of an accounting estimate and related disclosures to an inherent lack of precision in its measurement.

    • Management bias — a lack of neutrality by management in the preparation and presentation of information.

    • Management’s point estimate — amount selected by management in the preparation and presentation of information.

    • Outcome of an accounting estimate — the actual monetary amount which results from resolution of the underlying transactions, events, or conditions addressed by the accounting estimate.

  • CAS 540 highlights

    • When a range should be used to evaluate the reasonableness of management’s point estimate, the range needs to encompass all reasonable outcomes rather than all possible outcomes.

    • The difference between the auditor’s point estimate and management’s estimate, or the nearest point of the auditor’s range and management’s point estimate is at least the minimum of the misstatement.

    • There are three types of misstatements: factual, judgmental and projected misstatements.

    • Factual statements are identical to identified misstatements and projected misstatements are identical to likely aggregate misstatements. Judgmental misstatements are defined as “differences arising from management’s judgments concerning accounting estimates that the auditor considers unreasonable, or the selection or application of accounting policies the auditor considers inappropriate”. Judgmental misstatements include inaccuracies in the forecasting of future events.

  • Accounting risk (AccR) is defined as a very specific and potentially very important type of judgment misstatement. Accounting risks can be huge and are the biggest source of risk in financial reporting. Accounting risks cannot be reduced by gathering more evidence, but is controlled through proper accounting disclosure.

  • To summarize, the estimation uncertainty of CAS 540 is complex and incorporates both audit and accounting risk.

LO3 Demonstrate an ability to apply CAS 540 in a qualitative way.

  • A reasonable estimate has been defined as anything within the reasonable range. Misstatements are defined as the difference between management’s point estimate and the nearest point of the reasonable range. This misstatement is then treated like any other misstatements and aggregated at the end of the audit.

  • Refer to the exhibit for an illustration of the logic of audit misstatements concept.

LO4 Explain the problems with the existing standards.

  • The Cockburn article relates to auditor’s reasonable ranges. The following are the key points:

    • The key issue is determining the width of the range.

    • The auditor must accept the reality that uncertainty may be associated with the range.

    • Specialists may need to be consulted.

    • The range estimate must be at the date the auditor has gathered all the evidence.

    • A key issue is the width of the range compared to materiality.

    • Estimates with ranges that are too wide should be treated as contingencies.

    • Ranges and their uncertainties should be disclosed.

    • There is pressure on the auditor from management regarding recording of estimates.

  • Risk-based reasoning (RBR) is a form of principle-based reasoning using logic consistent with that in statistical auditing. The general principle of statistical reasoning and the audit risk model is “if an actual estimation uncertainty associated with a recorded amount is greater than an acceptable level, then reject the recorded amount; otherwise, accept it.”

LO5 Calculate and evaluate accounting risk for reasonable range (RR).

  • Auditing Risk (AudR) is referred to as evidence risk of auditing, and the risk associated with material forecast errors as accounting risk (AccR). Audit procedures and the associated risks are not likely to affect client business risks and therefore AudR is relevant to the auditor, not the auditee. AccR is largely geared to reflect business risks of the auditee. Due to these differences, AccR and AudR can be assessed independently of each other.

  • A RR is determined through knowledge of the auditee’s business and research on the auditee’s industry and broader economic environment such as interest rates, inflation rates, and price of inputs.

  • The uniform distribution assumption is used for RR for two reasons: no tables or formulas are required and it is consistent with current standards.

  • The AccR probability can be calculated by dividing the (difference between the end of the range and the mid-point of the range) by (the width of the range).

LO6 Use a risk-based reasoning (RBR) matrix to decide if an accounting estimate should be accepted, rejected and disclosed in notes, or rejected and ignored for fairness of presentation of the estimate.

  • The RBR matrix tries to summarize all the possibilities of accounting uncertainties an auditor may encounter and classify them by reporting types. Under the RBR system, there are three possible ranges or regions of probabilities of payoffs to consider:

    1. The payoff is recorded when the probability of payoff is 1.00 to (one minus acceptable AccR).

    2. The payoff is disclosed when the probability of payoff is (one minus acceptable AccR) to (acceptable AccR).

    3. The payoff can be ignored when the probability of payoff is (acceptable AccR) to zero.

LO7 Calculate a benchmark range with insignificant judgmental misstatement risk.

  • Reasonable ranges (RR) should be based on facts and reasonable assumptions. Knowledge of the client’s business and business risk approaches to auditing help auditors evaluate the reasonableness of the assumptions.

  • RR must be limited to “reasonable outcomes, rather than all possible outcomes”. Well-calibrated, auditor reasonable ranges help identify inappropriate management assumptions and can be a key component of implementing auditor skepticism.

  • The RR with uniform represents “reality” about the future as far as the auditor is concerned. The concept of the benchmark (B) is a “risk adjusted” range of future values that controls AccR within levels acceptable to the auditor. RR is the reasonable range in reflecting future realizations whereas B is the set of values from within that range that is acceptable to the auditor for reporting.

LO8 Calculate the risk-based reasoning (RBR) summary of the different financial reporting possibilities.

  • A range cannot arbitrarily be reduced with the expectation this will solve the significant risk estimation uncertainties.

  • Each auditor must develop his or her own principle of acceptability for every item, for every engagement.

  • Generic rules of thumb:

    • Accounting estimate nirvana: the width of RR is less than or equal to material misstatement (MM), which means there is no significant risk for any estimates within RR.

    • Accounting estimate problem (ie. Cockburn’s problem): the width of RR is greater than MM, but not greater than two times MM, which means an estimate with no significant risk can be found within RR.

    • Accounting estimate nightmare: the width of RR is greater than two times MM, which means all values in RR may have significant risk of CAS 540. In other words, there is no estimate with an insignificant estimation risk possible in a nightmare situation.

  • To make feasible the calculation of the benchmark range, the auditor needs to define an acceptable accounting risk-level based on user needs and cost-benefit factors.

LO9 Calibrate a range so that it is reasonable.

  • Calibration is achieved through repetition and feedback which improves the quality of the estimate.

  • Calibration can be summarized in the following steps:

    • Repetition and feedback,

    • Equivalent bets,

    • Considering two pros and cons, and

    • Avoiding anchoring.

Smieliauskas/Bewley, 7e © McGraw-Hill Education, 2016

What You Really Need to Know 19-

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