The revised ASA 540 Auditing Accounting Estimates and Related Disclosures is operative for financial reporting periods beginning on or after 15 December 2019 with early adoption permitted. For our Australian stakeholders with June year ends, 1 July 2020 will be the beginning of the first year of auditing clients accounting estimates and related disclosures under the revised standard.
Yes, accounting estimates vary widely in nature. They are required to be made by management, applying an appropriate method and using appropriate data and assumptions, when the monetary amounts cannot be directly observable. However, the degree to which an accounting estimate is subject to estimation uncertainty will vary depending on the circumstances. As such the nature, timing and extent of audit procedures required by the revised ASA 540 will vary in relation to the estimation uncertainty and the assessed risk of material misstatement. As an example, depreciation expense or a bonus provision is an accounting estimate that needs to be assessed under the standard.
The recently revised ASA 540 Auditing Accounting Estimates and Related Disclosures enables auditors to deal with increasingly complex accounting estimates and related disclosures. Under the revised standard, auditors are prompted to devote greater attention to addressing potential management bias in accounting estimates and applying professional scepticism. Some of the key changes include:
ASA 540 Revised introduces a number of provisions designed to enhance professional scepticism. One of these is that further audit procedures designed and performed by the auditors should not be biased towards obtaining corroborative evidence or towards excluding contradictory evidence (ASA 540, paragraph 34). That is, auditors don’t just look for supporting evidence but equally don’t disregard contradictory evidence. Obtaining audit evidence in an unbiased manner may involve obtaining evidence from multiple sources within and outside the entity. However, auditors are not required to perform an exhaustive search to identify all sources of audit evidence (ASA 540, paragraph A82).
Enhanced application of professional scepticism is also introduced through a stand-back requirement (ASA 540, paragraph 33). Auditors are required to ask themselves and evaluate, based on the audit procedures performed and audit evidence obtained, whether:
The stand-back requirement allows auditors to reflect on work performed, the appropriateness of the risk assessments and whether they have obtained unbiased sufficient appropriate audit evidence.
ASA 540 Revised requires auditors to perform separate inherent risk and control risk assessments at the assertion level to form the basis for designing and performing further audit procedures to respond to the risks of material misstatement (ASA 540, paragraphs 4,6 and 16).
In recognition that all risks are not equal, the revised standard also introduces the concept of the spectrum of inherent risk. This is one of the key drivers of scalability in the revised standard because where the assessed risk falls on the spectrum will determine what further audit procedures the auditor will need to perform. Ultimately, the higher on the spectrum the risk falls, the more persuasive the audit evidence needs to be. These risk assessments are based on auditors’ understanding of the entity, its environment and internal control, and ASA 540 Revised has enhanced risk assessment procedures (ASA 540, paragraphs 13-15), to ensure that auditors have gained a good knowledge of the business.
The revised ASA 540 introduces and formalises the idea of ‘inherent risk factors.’ The three key ones that the standard addresses are:
There may, however, be other inherent risk factors such as change, susceptibility to misstatement due to management bias or fraud to also consider.
So, the auditors’ assessment of inherent risk will depend on the degree to which these risk factors affect the likelihood or magnitude of misstatement. The higher the risk falls on the spectrum, and accordingly the higher the auditor’s risk assessment, the more work auditors will need to do to obtain sufficient appropriate audit evidence. This is where exercising and demonstrating professional scepticism is particularly relevant.
As part of the risk assessment process, the auditor reviews the outcome of previous accounting estimates (ASA 540 Revised, paragraph 14). This is important as it helps auditors to make judgments about management’s track record in making estimates and assists in identifying and assessing the risks of material misstatement in the current period.
This may include obtaining information regarding the effectiveness of management’s previous estimation process. A difference between the outcome of an accounting estimate and the amount recognised in the prior period’s financial report does not necessarily mean that management is not effective in their assessments.
The auditor may consider the reasons for the difference and whether the difference arises from information that was available to management when the previous period’s financial report was finalised, or that could reasonably be expected to have been obtained and taken into account. Conversely, while management may have been effective in their estimation process in the past where conditions were more benign, this may not be reflective of management’s effectiveness in the current period. Therefore, an appropriate level of professional scepticism over accounting estimates should be exercised.
The auditor is required to design and perform tests to obtain sufficient appropriate audit evidence as to the operating effectiveness of relevant controls, if (ASA 540, paragraph 19):
(a) the assessment of risks of material misstatement at the assertion level (taking into account the effect of one or more inherent risk factors and your assessment of control risk) includes an expectation that the controls are operating effectively; or
(b) Substantive procedures alone cannot provide sufficient appropriate audit evidence at the assertion level.
ASA 540 Revised paragraph 18 require that an auditor’s further audit procedures should be responsive to the assessed risks of material misstatement, considering the reasons for the assessment given to those risks and may include any of the three testing approaches (individually or in combination) as outlined below:
In undertaking further audit procedures, auditors are reminded of the revisions to ASA 540 that seek to emphasise the importance of the appropriate application of professional scepticism. ASA 540 Revised, paragraph 18, requires that the auditor designs and performs further audit procedures in a manner that is not biased towards obtaining audit evidence that may be corroborative or towards excluding audit evidence that may be contradictory. Additionally, the auditor’s further audit procedures need to take into account that the higher the assessed risk of material misstatement, the more persuasive the audit evidence needs to be (ASA 540, paragraph 18, ASA 330, paragraph 6(b)). Persuasiveness relates to the auditor obtaining appropriate audit evidence that is sufficient for the auditor to draw reasonable conclusions. Quantity is not a sole determinant of persuasiveness, for example, obtaining more of the same type of audit evidence may not compensate for its lack of appropriateness.
ASA 540 Revised paragraph A125 clarifies that this situation is more likely to arise in circumstances when the estimation uncertainty associated with the accounting estimate is itself a multiple of materiality. This is more common for certain types of accounting estimates or in certain industries, such as insurance or banking, where a high degree of estimation uncertainty is more typical and there may be specific requirements in the applicable financial reporting framework in that regard.
When a range that is multiples of materiality is, in the auditor’s judgment, appropriate in the circumstances, the auditor’s evaluation of the reasonableness of the disclosures about estimation uncertainty becomes increasingly important, particularly:
For estimates where the application of specialised skill or knowledge is required, management may engage a management’s expert. ASA 540 Revised paragraph A130 states that assumptions made or identified by a management’s expert become management’s assumptions when used by management in making an accounting estimate. Accordingly, the auditor will need to apply audit procedures when evaluating the work of the management’s expert.
Both extant ASA 540 paragraph 8 and ASA 540 Revised paragraph 13 require the auditor to understand how management makes the accounting estimates, and to gain an understanding of the data on which they are based, including whether management has used an expert. Where a management’s expert is used, the auditor may find the guidance contained in the recently revised GS 005 Evaluating the Appropriateness of a Management’s Expert’s Work beneficial.
In particular, paragraph 49 of GS 005 identifies factors that may be relevant to the auditor in evaluating the reasonableness of a management’s expert’s assumptions, including consideration of the degree of estimation uncertainty associated with the management’s expert’s underlying assumptions and the degree of stress testing undertaken.
Extant ASA 540 requires the auditor to determine whether disclosures in the financial report relating to accounting estimates are adequate while ASA 540 Revised requires the auditor to determine whether such disclosures are reasonable.
Some accounting estimates may involve significant management judgement and often disclosures relating to accounting estimates are critical to users understanding of accounting policies applied, the nature and extent of estimation uncertainty and key judgements.
The greater the degree to which an accounting estimate is subject to estimation uncertainty and management judgement, the more likely the risks of material misstatement will be assessed as higher and therefore the more persuasive the audit evidence needs to be to determine whether management’s point estimate and related disclosures about estimation uncertainty are reasonable in the context of the applicable financial reporting framework (ASA 540 Revised, paragraph A113). Accordingly, auditors may expect to spend more time and focus additional audit effort in auditing disclosures around estimation uncertainty.
ASA 540 Revised, provides more granular requirements and more expansive application material than extant ASA 540, to assist auditors in the area of documentation.
It is particularly important that the documentation demonstrates how auditors have exercised professional scepticism throughout the audit. Auditors need to document the journey to their conclusions, including the challenges and judgments they made along the way. For example, when the audit evidence obtained includes evidence that both corroborates and contradicts management’s assertions, the documentation may include how the auditor evaluated that evidence, including the professional judgments made in forming a conclusion as to the sufficiency and appropriateness of the audit evidence obtained.
Examples of areas where the auditor exercises professional scepticism that can be evidenced through documentation include how the auditor:
The documentation requirements of ASA 540 Revised have been expanded to include the auditor’s understanding of the entity and its environment, the assessment and the corresponding response to the risks of material misstatements, indicators of possible management bias, and other judgements 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.
ASA 540 Revised, provides more granular requirements and more expansive application material to assist auditors in this area.
ASA 540 Revised requires the auditor to request written representations from management and, when appropriate, those charged with governance about whether the methods, significant assumptions and the data used in making the accounting estimates and the related disclosures are appropriate to achieve recognition, measurement or disclosure that is in accordance with the applicable financial reporting framework. Additionally, the auditor is required to consider the need to obtain representations about specific accounting estimates, including in relation to the methods, assumptions, or data used.
Auditors are reminded that although written representations provide necessary audit evidence, they do not provide sufficient appropriate audit evidence on their own about any of the matters with which they deal. Furthermore, the fact that management has provided reliable written representations does not affect the nature or extent of other audit evidence that the auditor obtains about the fulfilment of management’s responsibilities, or about specific assertions.
The AUASB has issued a series of COVID related FAQs in relation to ASA 540, a link to these FAQs can be found here.