Supporting Notes - Welcome to the International Federation of

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Supporting Notes - Welcome to the International Federation of

    ISA 540 Auditing Accounting Estimates,

    Including Fair Value Accounting Estimates, and Related Disclosures

    ISA Implementation Support Module

    Notes for Select Slides

The following supporting notes accompany the PowerPoint slides for this module and do

    not amend or override the ISAs, the texts of which alone are authoritative. Reading these

    notes is not a substitute for reading the ISAs. The notes are not meant to be exhaustive and

    reference to the ISAs themselves should always be made. In conducting an audit in

    accordance with ISAs, the auditor is required to comply with all the ISAs that are relevant

    to the engagement.

Slide 5 Notes

    - Several factors have persuaded the IAASB to conclude that ISA 540 (Revised), Auditing

    Accounting and Related Disclosures (Other Than Those Involving Fair Value Measurements

    and Disclosures) and ISA 545, Auditing Fair Value Measurements and Disclosures, should

    be combined. First, as financial reporting standards move further towards fair value

    measurement, references therein are increasing predominantly in connection with the

    measurement of fair value for financial statement items where there is a need to derive fair

    value through a process of estimation. As a result, the distinction between accounting

    estimates and fair value accounting estimates is often becoming more difficult to draw.

    Maintaining a separate ISA on fair values therefore appears to have little foundation from an

    auditing point of view, as similar issues often arise in auditing accounting estimates and fair

    value accounting estimates.

    - Second, the incorporation of ISA 545 in ISA 540 (Revised) focuses the requirements and

    guidance on auditing fair values on areas of estimation uncertainty and risk. The IAASB

    believes that this is appropriate. It also believes that the combination will enhance the

    auditor’s understanding of auditing issues associated with accounting estimates and fair value

    accounting estimates, specifically because it highlights the similarities between the two and

    contrasts their subtle differences.

    - Third, the combination effectively revises ISA 545. It aligns the requirements and guidance

    on auditing fair values fully with the audit risk model, and improves them for matters

    covered as part of the revision of ISA 540 (e.g., use of ranges, indicators of possible

    management bias, etc.).

    - Finally, in accordance with the principles of the Clarity project, it minimizes unnecessary


    - While the measurement objectives of accounting estimates and fair values differ, they can be

    Module ISA 540 Notes for Select Slides

    difficult to distinguish in practice and the same audit approach largely applies. - All the requirements in the ISA are equally applicable to accounting estimates and fair values

    and auditors are required to comply with them when auditing both. It is the application and

    other explanatory material that guides the auditor in how to comply with the requirements in

    both circumstances.

Slide 12 Notes

    - ISA 540 focuses the auditor’s work effort on those accounting estimates that have high

    estimation uncertainty especially those that the auditor determines are significant risks. - Not all estimates have high estimation uncertainty for example, allowances for doubtful

    accounts in a stable business with a large number of relatively small customers can be

    predicted with reasonable accuracy based on prior year experience. On the other hand, there

    may be high estimation uncertainty when an accounting estimate is relatively complex for

    example, the determination of fair value for some complex financial instruments.

Slide 14 Notes

    - The ISA specifies a choice of audit procedures to respond to risks of material misstatement

    based on the nature of the accounting estimate.

    - The auditor’s decision as to which of these responses, individually or in combination, to

    undertake to respond to the risks of material misstatement may be influenced by such matters


    o The nature of the accounting estimate, including whether it arises from routine or non

    routine transactions.

    o Whether the procedure(s) is expected to effectively provide the auditor with sufficient

    appropriate audit evidence.

    o The assessed risk of material misstatement, including whether the assessed risk is a

    significant risk.

    - For example, when evaluating the reasonableness of the allowance for doubtful accounts, an

    effective procedure for the auditor may be to review subsequent cash collections in

    combination with other procedures. Where the estimation uncertainty associated with an

    accounting estimate is high, for example, an accounting estimate based on a proprietary

    model for which there are unobservable inputs, it may be that a combination of the responses

    to assessed risks outlined in the ISA is necessary in order to obtain sufficient appropriate

    audit evidence.

    - The ISA provides further guidance as to when each of these responses may be most


    Module ISA 540 Notes for Select Slides

    appropriate, including which may be most appropriate in the context of auditing fair values.

    (para references?)

Slide 15 Notes

    Developing a Point Estimate or Range

    - Developing a point estimate or a range to evaluate management’s point estimate may be an

    appropriate response where, for example:

    o An accounting estimate is not derived from the routine processing of data by the

    accounting system.

    o The auditor’s review of similar accounting estimates made in the prior period financial

    statements suggests that management’s current period process is unlikely to be effective.

    o The entity’s controls within and over management’s processes for determining

    accounting estimates are not well designed or properly implemented.

    o Events or transactions between the period end and the date of the auditor’s report

    contradict management’s point estimate.

    o There are alternative sources of relevant data available to the auditor which can be used

    in making a point estimate or a range.

    - Even where the entity’s controls are well designed and properly implemented, developing a

    point estimate or a range may be an effective or efficient response to the assessed risks. In

    other situations, the auditor may consider this approach as part of determining whether

    further procedures are necessary and, if so, their nature and extent. - The approach taken by the auditor in developing either a point estimate or a range may vary

    based on what is considered most effective in the circumstances. For example, the auditor

    may initially develop a preliminary point estimate, and then assess its sensitivity to changes

    in assumptions to ascertain a range with which to evaluate management’s point estimate.

    Alternatively, the auditor may begin by developing a range for purposes of determining,

    where possible, a point estimate.

    - The ability of the auditor to make a point estimate, as opposed to a range, depends on several

    factors, including the model used, the nature and extent of data available and the estimation

    uncertainty involved with the accounting estimate. Further, the decision to develop a point

    estimate or range may be influenced by the applicable financial reporting framework, which

    may prescribe the point estimate that is to be used after consideration of the alternative

    outcomes and assumptions, or prescribe a specific measurement method (for example, the

    use of a discounted probability-weighted expected value). Narrowing a Range


    Module ISA 540 Notes for Select Slides

    - When the auditor concludes that it is appropriate to use a range to evaluate the reasonableness of management’s point estimate (the auditor’s range), the ISA requires that

    range to encompass all “reasonable outcomes” rather than all possible outcomes. The range

    cannot be one that comprises all possible outcomes if it is to be useful, as such a range would be too wide to be effective for purposes of the audit. The auditor’s range is useful and

    effective when it is sufficiently narrow to enable the auditor to conclude whether the

    accounting estimate is misstated.

    - Ordinarily, a range that has been narrowed to be equal to or less than performance materiality

    is adequate for the purposes of evaluating the reasonableness of management’s point

    estimate. However, particularly in certain industries, it may not be possible to narrow the

    range to below such an amount. This does not necessarily preclude recognition of the

    accounting estimate. It may indicate, however, that the estimation uncertainty associated with

    the accounting estimate is such that it gives rise to a significant risk. Additional responses to significant risks are described in paragraphs A102-A115 of the ISA.

    - Narrowing the range to a position where all outcomes within the range are considered

    reasonable may be achieved by:

    (a) Eliminating from the range those outcomes at the extremities of the range judged by the

    auditor to be unlikely to occur; and

    (b) Continuing to narrow the range, based on audit evidence available, until the auditor

    concludes that all outcomes within the range are considered reasonable. In some rare

    cases, the auditor may be able to narrow the range until the audit evidence indicates a

    point estimate.

    Slide 18 Notes

    - Financial reporting frameworks often call for neutrality, that is, freedom from bias.

    Accounting estimates are imprecise, however, and can be influenced by management

    judgment. Such judgment may involve unintentional or intentional management bias (for

    example, as a result of motivation to achieve a desired result). The susceptibility of an

    accounting estimate to management bias increases with the subjectivity involved in making

    it. Unintentional management bias and the potential for intentional management bias are

    inherent in subjective decisions that are often required in making an accounting estimate. For

    continuing audits, indicators of possible management bias identified during the audit of the

    preceding periods influence the planning and risk identification and assessment activities of

    the auditor in the current period.

    - Management bias can be difficult to detect at an account level. It may only be identified when considered in the aggregate of groups of accounting estimates or all accounting

    estimates, or when observed over a number of accounting periods. Although some form of


    Module ISA 540 Notes for Select Slides

    management bias is inherent in subjective decisions, in making such judgments there may be

    no intention by management to mislead the users of financial statements. Where, however,

    there is intention to mislead, management bias is fraudulent in nature. - During the audit, the auditor may become aware of judgments and decisions made by

    management which give rise to indicators of possible management bias. Such indicators may

    affect the auditor’s conclusion as to whether the auditor’s risk assessment and related

    responses remain appropriate, and the auditor may need to consider the implications for the

    rest of the audit. Further, these indicators may affect the auditor’s evaluation of whether the

    financial statements as a whole are free from material misstatement, as discussed in ISA 700.

Slide 20 Notes

    - The presentation of financial statements in accordance with the applicable financial reporting

    framework includes adequate disclosure of material matters. The applicable financial

    reporting framework may permit, or prescribe, disclosures related to accounting estimates,

    and some entities may disclose voluntarily additional information in the notes to the financial

    statements. Such disclosures are relevant to users in understanding the accounting estimates

    recognized or disclosed in the financial statements, and sufficient appropriate audit evidence

    needs to be obtained about whether the disclosures are in accordance with the requirements

    of the applicable financial reporting framework.

    - In some cases, the applicable financial reporting framework may require specific disclosures

    regarding uncertainties.

    - In relation to accounting estimates having significant risk, even where the disclosures are in

    accordance with the applicable financial reporting framework, the auditor may conclude that

    the disclosure of estimation uncertainty is inadequate in light of the circumstances and facts

    involved. The auditor’s evaluation of the adequacy of disclosure of estimation uncertainty

    increases in importance the greater the range of possible outcomes of the accounting estimate

    is in relation to materiality (see related discussion in paragraph A94 of the ISA). - In some cases, the auditor may consider it appropriate to encourage management to describe,

    in the notes to the financial statements, the circumstances relating to the estimation

    uncertainty. ISA 705 provides guidance on the implications for the auditor’s opinion when

    the auditor believes that management’s disclosure of estimation uncertainty in the financial

    statements is inadequate or misleading.

Slide 21 Notes

    - Extant ISA 545, which dealt strictly with fair values, required auditors to determine the need

    to use the work of an expert. Extant ISA 540, which dealt with accounting estimates, did not

    have a similar requirement. The IAASB was of the view that while this requirement was


    Module ISA 540 Notes for Select Slides

    particularly relevant in the case of fair value accounting estimates, it would also be

    applicable to other types of accounting estimates.

    - In planning the audit, the auditor is required to ascertain the nature, timing and extent of

    resources necessary to perform the audit. This includes making sure that the engagement

    team has the appropriate competence and capabilities, and may result in the identification of

    individuals with specialized skills and knowledge to be included on the engagement team. In

    many cases, it is likely that such skills and knowledge won’t be necessary whether because

    the estimates are less complex or the engagement team is more experienced in a particular

    industry or with that entity. However, as the accounting estimates become more complex, it

    may be necessary to bring in someone with expertise not held by the core engagement team. - For example, when an entity uses a model, or has relied on the work of a management’s

    expert, it may be more likely that an auditor’s expert will be needed. This could include, for

    example, quantitative experts who review the model used by management, including the

    assumptions it uses. These experts may also choose to develop their own models to compare

    with the results of that used by management.

    Copyright ? October 2009 by the International Federation of Accountants (IFAC). All rights reserved. Permission is granted to make copies of this work provided that such copies are for use in academic classrooms or for personal use and are not sold or disseminated and provided that each copy bears the following credit line: “Copyright ? October 2009 by the International Federation of Accountants (IFAC). All rights

    reserved. Used with permission of IFAC. Contact for permission to reproduce, store, or transmit this work.” Otherwise, written permission from IFAC is required to reproduce, store, or transmit, or to make other similar uses of, this work, except as permitted by law. Contact

    ISBN: ISBN: 978-1-60815-040-3


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