Definition
AU-C 540 defines an accounting estimate as a monetary amount whose measurement under the applicable framework is subject to estimation uncertainty. Examples include the allowance for credit losses, inventory reserves, warranty and legal accruals, useful lives, fair values and impairment amounts. Management develops a point estimate, and the uncertainty around it is the estimation uncertainty. A change in an estimate is accounted for in the period of change and later periods under ASC 250-10-45.
Why it matters in an audit or review
Estimates are where management bias can hide, so AU-C 540 requires the auditor to assess inherent risk using the degree of estimation uncertainty, complexity and subjectivity. Responses include testing how management made the estimate, developing an independent point estimate or range, and reviewing the outcome of prior-period estimates against what actually happened. SAS 143, which revised AU-C 540, applies to audits of periods ending on or after December 15, 2023.
Example
Illustrative: a warranty accrual of $180,000 is based on a 2.0% claim rate. Prior-year claims ran at 2.6% of sales. The team asks why the rate fell, tests recent claim data and considers whether the accrual is a favorable bias.
Common mistakes
- Treating an estimate change as an error and restating prior periods.
- Accepting management's assumptions without testing source data.
Sources
- AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures (SAS No. 143)
- FASB ASC 250-10-45, Accounting Changes and Error Corrections, Other Presentation Matters
- PCAOB, AS 2501, Auditing Accounting Estimates, Including Fair Value Measurements (pcaobus.org)
Definitions paraphrase AICPA and FASB guidance; read the standard itself before relying on a requirement. Example figures are illustrative. This page is guidance, not professional advice. Report an error