Accounting estimates sit behind many of the largest and most contested numbers in a private company's financial statements: allowance for credit losses, inventory reserves, warranty accruals, goodwill and intangible impairment, fair value of investments, useful lives, revenue constraints, loss contingencies and share-based compensation. AU-C 540, Auditing Accounting Estimates and Related Disclosures, as revised by SAS No. 143, sets out how the auditor identifies, assesses and responds to the risks they carry.
SAS 143 is effective for audits of financial statements for periods ending on or after December 15, 2023, and works together with the risk assessment framework in AU-C 315 as revised by SAS 145. This guide covers the risk factors, the three approaches and how to use a range.
What the standard treats as an accounting estimate
An accounting estimate is a monetary amount for which the measurement, in accordance with the requirements of the applicable financial reporting framework, is subject to estimation uncertainty. It includes amounts that are fair values and other amounts that need judgment, and the related disclosures. Not every number is an estimate: cash on hand and amounts fixed by contract are not, while a reserve or an impairment charge is.
Risk assessment: three inherent risk factors
AU-C 540 asks the auditor to understand the entity's process for making estimates and to assess the risk of material misstatement considering how estimates are affected by:
- Estimation uncertainty: the susceptibility of an estimate to an inherent lack of precision in measurement. A warranty accrual based on a few years of history has more estimation uncertainty than depreciation on a straight-line asset.
- Complexity: the complexity of the process, the method, the model, the data and the assumptions. A discounted cash flow model with scenario weighting is more complex than an aging-based reserve.
- Subjectivity: the degree to which management must apply judgment, for instance in choosing assumptions where the framework allows different reasonable alternatives.
These factors combine with other inherent risk factors from AU-C 315, including susceptibility to misstatement due to management bias or fraud. The more a number is uncertain, complex and subjective, the higher it sits on the spectrum of inherent risk, and the more persuasive the evidence must be.
What to understand about management's process
The auditor obtains an understanding of:
- the requirements of the framework relating to the estimate and its disclosure
- how management identifies the transactions and conditions that need estimates
- the method, including models, used, and the controls over it
- the data used, where it comes from, and how it is processed
- the assumptions, including how they are chosen
- whether management used a specialist (see using the work of a specialist)
- how management assesses and addresses estimation uncertainty
- the results of prior-period estimates
Review how prior-period estimates turned out. If the prior-year allowance or warranty reserve proved off by a lot, that informs the risk assessment, and the direction of the difference may show bias.
Assess inherent risk and control risk separately
Under the revised standards, the auditor assesses inherent risk and control risk separately for each relevant assertion. For an estimate that is a significant risk, controls over it must be understood, including their design and implementation. If you plan to rely on controls over the estimate, you need to test their operating effectiveness. See substantive testing vs test of controls.
The audit responses: three approaches
AU-C 540 requires the auditor to design and perform further procedures responsive to the assessed risks. These procedures can use one or more of three approaches. The standard presents them as options, not a ladder or hierarchy, and most audits combine them.
1. Obtain evidence from events up to the date of the auditor's report
Events after the balance sheet date can show how an estimate turned out. Collections on receivables after year end, subsequent sales of inventory, settlement of a lawsuit or the actual cost of a warranty claim all give evidence about the estimate. This works best when the estimate depends on a condition that existed at the balance sheet date and the subsequent event resolves it. It is limited where the later event reflects conditions arising after the balance sheet date, and the auditor considers whether the event provides evidence about conditions at the date or about later conditions. See subsequent events.
2. Test how management made the estimate
The auditor evaluates:
- method: whether the method is appropriate under the framework, applied consistently, and whether any change is appropriate
- assumptions: whether they are reasonable, consistent with each other and with other information in the financial statements, and reflect management's intent and ability
- data: the relevance, completeness and accuracy of data used, tested where significant
- calculation: mathematical accuracy of the model
For a CECL allowance, for example, this means agreeing loss rates to historical data, testing the aging, testing the qualitative adjustments and recalculating the reserve. The accounts receivable aging and allowance guide and the allowance calculator show the mechanics. For the framework itself, see CECL for private companies.
3. Develop an auditor's point estimate or range
The auditor builds an independent expectation using the same or a different method, or different assumptions, and compares it with the recorded amount. This is particularly useful for high-risk, high-subjectivity estimates, and when management's process is weak. A common case is an actuary engaged by the auditor to estimate insurance reserves, or a valuation specialist who builds an independent discounted cash flow model.
Using a range
When the auditor develops a range, the standard requires the auditor to determine that the range includes only amounts that are supported by sufficient appropriate audit evidence and that the auditor has evaluated as reasonable under the framework's measurement objectives. That does not mean testing every outcome in the range; the auditor can instead obtain evidence that both ends of the range are reasonable. A range can be wide when estimation uncertainty is high, but a very wide range is a prompt to ask whether enough evidence has been obtained, and the disclosures about estimation uncertainty then matter more.
How the range is used:
- If management's point estimate is inside the auditor's range, there is no misstatement for the estimate itself, although the auditor still evaluates disclosures and bias.
- If management's estimate is outside the range, the misstatement is the difference between management's estimate and the nearest point of the auditor's range. If instead the evidence supports an auditor's point estimate that differs from management's, the difference between the two is the misstatement. The framework in the summary of uncorrected misstatements handles this as a judgmental misstatement under AU-C 450.
If the audit evidence cannot support the amounts within the range as reasonable, consider whether you need more evidence or a specialist.
Stand-back and management bias
After performing the procedures, the auditor stands back and evaluates:
- whether the assessments of risk for relevant assertions remain appropriate
- whether management's decisions on recognition, measurement, presentation and disclosure are consistent with the framework
- whether the evidence obtained is sufficient and appropriate
The auditor also evaluates indicators of possible management bias. Consistent movement of estimates in the same direction, such as reserves released to hit a target, is one indicator. Indicators of bias do not by themselves mean a misstatement, but they bear on the audit. The consideration of bias in the aggregate of estimates also feeds the fraud considerations in AU-C 240 and the journal entry testing.
Disclosures
Estimation uncertainty is often a disclosure matter. The auditor assesses whether disclosures are reasonable in the framework, including the significant assumptions, the sensitivity of amounts and the nature of the uncertainty. The related US GAAP disclosure on risks and uncertainties (use of estimates and near-term changes in significant estimates) is part of this.
Written representations
AU-C 540 requires the auditor to request representations from management about whether the methods, significant assumptions and data used in making the estimates and the related disclosures are appropriate to achieve recognition, measurement or disclosure under the framework, and considers whether representations about specific estimates are needed. A representation does not replace evidence. Use the management representation letter template as a starting point.
Documentation
AU-C 230 applies. For significant estimates, the file should show:
- the understanding of management's process and the key elements
- the assessed risks and the reasons, including inherent risk factors
- the approach chosen and why
- procedures on method, assumptions and data, and the results
- any range developed and the evidence supporting both ends of it
- indicators of bias and the evaluation
- the conclusion on reasonableness and any misstatement
Common problems
- Stopping at "agreed to the schedule." The calculation is tested but the assumptions are not challenged.
- Reliance on a specialist report without testing data.
- Ranges that include unsupported amounts.
- Using subsequent events without checking the cause.
- No review of prior-year outcomes.
- One-direction bias ignored because each individual estimate looks acceptable.
- No consideration of disclosures.
FAQ
When did SAS 143 become effective?
SAS 143 is effective for audits of financial statements for periods ending on or after December 15, 2023.
What are the three approaches to auditing an estimate?
The auditor can obtain evidence from events occurring up to the date of the report, test how management made the estimate, or develop an auditor's point estimate or range. Many audits use more than one approach for the same estimate.
How wide can an auditor's range be?
There is no fixed width. The range may include only amounts supported by sufficient appropriate evidence that the auditor has evaluated as reasonable, and it can be wide when estimation uncertainty is high. A very wide range is a signal to check whether you have enough evidence, and to look hard at the disclosures.
What are the inherent risk factors for estimates?
Estimation uncertainty, complexity and subjectivity, along with other factors such as susceptibility to management bias. Together they determine where the estimate falls on the spectrum of inherent risk.
Do I need a specialist for every estimate?
No. A specialist is needed when the team lacks the knowledge to evaluate the method, model or assumptions, or to develop an independent estimate. See the AU-C 620 guide for evaluating one.
Sources
- AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures (as revised by SAS No. 143; effective for audits of financial statements for periods ending on or after December 15, 2023)
- AICPA, AU-C Section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (as revised by SAS No. 145)
- AICPA, AU-C Section 450, Evaluation of Misstatements Identified During the Audit
- AICPA, AU-C Section 580, Written Representations
- AICPA, AU-C Section 230, Audit Documentation
- FASB ASC 275, Risks and Uncertainties
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