ISA 540 (Revised)
Auditing Accounting Estimates and Related Disclosures
1Objective and scope
ISA 540 (Revised) deals with the auditor's responsibilities relating to accounting estimates and related disclosures in an audit of financial statements. It expands on how ISA 315, ISA 330, ISA 450, ISA 500 and other ISAs apply to estimates, including the requirements and guidance on misstatements and indicators of possible management bias. Estimates pervade modern financial statements: expected credit losses under IFRS 9, fair values of investment property and financial instruments, impairment of goodwill, provisions for warranties and litigation, useful lives and residual values, deferred tax recoverability, defined benefit obligations, revenue from variable consideration and long-term contracts. The 2018 revision (effective for periods beginning on or after 15 December 2019) made the standard scalable to the complexity of the estimate, introduced the three inherent risk factors specific to estimates, and required an explicit stand-back evaluation.
The objective is to obtain sufficient appropriate audit evidence about whether accounting estimates and related disclosures in the financial statements are reasonable in the context of the applicable financial reporting framework.
2Key definitions
3Requirements
Risk assessment procedures
- Obtain an understanding of the entity and its environment relevant to estimates: the transactions and events that give rise to them, the requirements of the framework, regulatory factors, and the nature of the estimates and related disclosures the entity is expected to include.
- Understand the entity's system of internal control as it relates to estimates: how management identifies the need for estimates, the risk assessment process, the information system (the methods, models, assumptions and data used, the degree of estimation uncertainty, any changes from prior periods, and whether management's experts are used), the controls over the estimation process, and how management reviews outcomes of prior estimates.
- Review the outcome of previous accounting estimates, or their subsequent re-estimation, to assist in identifying and assessing the risks of material misstatement in the current period (a retrospective review; it is not intended to call into question judgements that were reasonable on the information available at the time, but it reveals a pattern of bias and the effectiveness of the process).
- Identify and assess the risks of material misstatement at the assertion level by taking into account the degree to which the estimate is subject to estimation uncertainty and the degree to which complexity, subjectivity and other inherent risk factors affect the selection and application of methods, assumptions and data, and the selection of management's point estimate and related disclosures. Determine whether any is a significant risk.
Responses: the three approaches
The auditor's further procedures must be responsive to the assessed risks and include one or more of the following approaches, with the choice driven by the reasons for the assessment. Where a risk is significant, the auditor's procedures include those in (b) or (c), and where substantive procedures alone are relied on for a significant risk they include tests of details.
| Approach | What the auditor does |
|---|---|
| (a) Obtain evidence from events occurring up to the date of the auditor's report | Where subsequent events resolve or narrow the uncertainty: the settlement of a claim, the sale of inventory, the collection of a receivable, the outcome of a court case. Evaluate whether the evidence is relevant to the estimate as it stood at the reporting date, not merely to what happened afterwards. |
| (b) Test how management made the estimate | Evaluate the method: whether it is appropriate under the framework and consistently applied, whether any change is appropriate, whether the model is well designed and the calculations are accurate, and whether judgements give rise to bias. Evaluate the significant assumptions: whether they are appropriate in context, consistent with each other, with those in other estimates and with the entity's business plans, and whether management has the intent and ability to carry out any actions assumed. Evaluate the data: relevance, reliability, appropriate use, and consistency with the entity's own information. Where management has considered alternative assumptions or outcomes, understand how it selected its point estimate and evaluate whether that selection is appropriate. |
| (c) Develop an auditor's point estimate or range | Use the auditor's own methods, assumptions and data (or a different combination) to derive an estimate or a range; where a range is used, determine that it includes only amounts supported by evidence and evaluated as reasonable, and that it is not so wide that it is uninformative. An auditor's expert may be used under ISA 620. |
Estimation uncertainty and disclosures
- Evaluate whether management has taken appropriate steps to understand and address estimation uncertainty, including considering alternative assumptions, outcomes and methods. If management has not, and cannot be persuaded to, the auditor develops an auditor's point estimate or range and, where that is not possible either, considers the implications for the opinion (a limitation on scope or a disagreement).
- Obtain sufficient appropriate evidence about whether the disclosures related to estimates are reasonable in the context of the framework, including disclosures of the nature and extent of estimation uncertainty (the IAS 1 key sources of estimation uncertainty, IFRS 13 fair value hierarchy and sensitivity, IFRS 7 credit risk disclosures) and, for fair presentation frameworks, whether additional disclosure is needed for the statements to achieve fair presentation.
- Evaluate whether there are indicators of possible management bias in the estimates and disclosures, individually and in aggregate; bias alone may not be a misstatement in any single estimate but the pattern is evaluated for its effect on the audit, including on the risk assessment and the reliability of representations.
Overall evaluation and misstatements
Before concluding, the auditor evaluates, based on the procedures performed and evidence obtained, whether the assessments of risk remain appropriate, whether management's decisions about recognition, measurement, presentation and disclosure are in accordance with the framework, and whether sufficient appropriate evidence has been obtained. The auditor determines whether the estimate and its disclosures are reasonable or are misstated. A management point estimate outside the auditor's range is a misstatement of at least the difference between the point estimate and the nearest point of the range; a difference within the range is not a misstatement, though the auditor considers the cumulative effect of several estimates all sitting at the favourable end. Misstatements are accumulated under ISA 450 as factual, judgemental or projected.
4Documentation and reporting
- Document the key elements of the understanding of the entity and its system of internal control relating to estimates; the linkage of the further procedures with the assessed risks at the assertion level; the auditor's responses when management has not taken appropriate steps to address estimation uncertainty; the indicators of possible management bias and the evaluation of their implications; and the significant judgements relating to the determination of whether the estimates and disclosures are reasonable or misstated.
- Request written representations that management believes the significant assumptions and the methods used are appropriate and consistently applied, that disclosures are complete and reasonable, and that no subsequent event requires adjustment (ISA 580).
- Communicate significant qualitative aspects of the entity's estimation practices to those charged with governance under ISA 260, including where an estimate was reasonable but at the aggressive end, and the auditor's views on estimation uncertainty. Estimates with high estimation uncertainty are frequent key audit matters under ISA 701 for listed entities.
- A misstated estimate that management will not correct leads to a qualified or adverse opinion; an inability to obtain evidence about an estimate leads to a qualified opinion or disclaimer; a material uncertainty appropriately disclosed may warrant an Emphasis of Matter paragraph where it is fundamental to users' understanding.
5Examinable focus
What KASNEB tests
Scenario questions on provisions, impairment, expected credit losses, fair values of property, or useful lives are set at both levels; the marker wants the risk explained in terms of complexity, subjectivity and estimation uncertainty, then procedures that follow the three approaches (subsequent events, test management's method, assumptions and data, or develop the auditor's own estimate or range), then the treatment of a difference (inside the range: not a misstatement; outside: misstatement of at least the difference to the nearest end). Know the indicators of management bias and the retrospective review. A theory part may ask why estimates carry higher inherent risk or how ISA 540 links to ISA 620 (using an expert) and IAS 37, IAS 36 and IFRS 13.