Thursday, July 8, 2010

Audit Procedures on Accounting Estimates

An accounting estimate is an approximation of a financial statement element, item, or account in the absence of exact measurement. Examples of accounting estimates include periodic depreciation, the provision for bad debts, net realizable value of inventory, revenues from contracts accounted for by the percentage-of-completion method, and pension and warranty expenses.

Management is responsible for establishing the process and controls for preparing accounting estimates. Judgment is requires in making an accounting estimate. Accounting estimates may have a significant affect on a company’s financial statements.

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. As estimates are based on subjective as well as objective factors, it may be difficult for management to establish controls over them. Even when management’s estimation process involves competent personnel using relevant and reliable data, there is potential for bias in the subjective factors. Accordingly, when planning and performing procedures to evaluate accounting estimates, the auditor should consider, with an attitude of professional skepticism, both the subjective and objective factors.

SAS No. 57, Auditing Accounting Estimates (AU 342.07), states that the auditor’s objective in evaluating accounting estimates is to obtain sufficient competent evidential matter to provide reasonable assurance that :

  1. All accounting estimates that could be material to the financial statements have been developed;
  2. The accounting estimates are reasonable in the circumstances;
  3. The accounting estimates are presented in conformity with applicable accounting principles and are properly disclosed.

In determining whether all necessary estimates have been made, the auditor should consider the industry in which the entity operates, its methods of conducting business, and new accounting pronouncements. To evaluate the reasonableness of an estimate, the auditor should normally concentrate on the key factors and assumptions used by management including those that are :

  1. significant to the accounting estimate;
  2. sensitive to variations;
  3. deviations from historical patterns, and
  4. subjective and susceptible to misstatement and bias.

Evidence of the reasonableness of an estimate may be obtained by the auditor from one or a combination of the following approaches :

  1. Perform procedures to review and test management’s process in making the estimate;
  2. Prepare an independent expectation of the estimate;
  3. Review subsequent transactions and events occurring prior to completing the audit that pertain to the estimate.

The procedures to be performed include :

  1. considering the relevance, reliability, and sufficiency of the data and factors used by management,
  2. evaluating the reasonableness and consistency of the assumptions, and
  3. re-performing the calculations made by management.

In some cases, it may be useful to obtain the opinion of a specialist regarding the assumptions.

Because no one accounting estimate can be considered accurate with certainty, the auditor may determine that a difference between an estimated amount best supported by the audit evidence and the estimated amount included in the financial statements may not be significant, and such difference would not be considered to be a likely misstatement. However, if the auditor believes the estimated amount included in the financial statements is unreasonable, he or she should treat the difference between that estimate and the closes reasonable estimate as a likely misstatement (SAS No. 57 AU 342.14).

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