AU-C 540 Accounting Estimates and SAS 143 Explained

AU-C section 540, Auditing Accounting Estimates and Related Disclosures, sets out how an auditor of a nonissuer deals with estimates such as the allowance for credit losses, inventory reserves, warranty accruals, deferred tax valuation allowances, impairment, and fair values. SAS No. 143 revised the section and applies to audits of financial statements for periods ending on or after December 15, 2023. SAS No. 144, issued in 2021 and effective for the same periods, amended AU-C 501, AU-C 540 and AU-C 620 on the use of specialists and on the use of pricing information from external information sources.

This page paraphrases the standard. Read AU-C 540 in AICPA Professional Standards before relying on any point here.

What is the objective of AU-C 540?

The auditor's 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.

What changed with SAS 143?

The revision aligns the section with the risk-based approach in AU-C 315 as revised by SAS 145. In summary, the standard now:

puts more weight on estimation uncertainty, complexity and subjectivity as the characteristics that drive the risk in an estimate
requires separate assessments of inherent risk and control risk for each estimate at the assertion level, instead of a combined risk
requires the auditor to consider how susceptible an estimate is to management bias and fraud, as part of the inherent risk assessment
focuses on management's process: the methods, significant assumptions and data it used, and whether management selected them appropriately
requires a stand-back evaluation at the end, which looks at the reasonableness of the estimates and disclosures overall, and at indicators of management bias across them

How is risk assessed for an estimate?

The auditor obtains an understanding of the entity and its environment relevant to estimates, and of how management identifies the transactions and conditions that require estimates. The auditor then looks at management's method, the assumptions it applied, the data it used, and any specialists it engaged. The auditor also considers how management understands and addresses estimation uncertainty.

Inherent risk for each estimate is assessed on the spectrum used in AU-C 315. The factors that move an estimate toward the high end include:

Factor	Question to ask	Example
Estimation uncertainty	How much inherent imprecision is there in the outcome?	Loss on a lawsuit that has no trial date
Complexity	How complicated are the method, model or data?	A discounted cash flow model with several scenarios
Subjectivity	How much does the estimate rely on judgment, and how much does the framework limit it?	A reserve for slow-moving inventory with no formal aging policy
Other inherent risk factors	Change, uncertainty, or susceptibility to bias or fraud	A bonus accrual that affects management compensation

For an estimate that is a significant risk, the auditor understands the related controls under AU-C 315 and responds under AU-C 330, which requires tests of details if substantive procedures are the only response. A simple accrual with a stable basis and a low assessed risk may need only limited work.

How does the auditor respond?

AU-C 540 requires the auditor's further procedures to be responsive to the assessed risk. The auditor takes one or more of these approaches, taking into account the nature of the estimate:

Events up to the report date. Obtain evidence from events that occur up to the date of the auditor's report. A collection of a receivable in January is evidence about a December collectibility estimate. This approach works where the estimate is a prediction of an outcome that soon becomes known.
Test how management made the estimate. Test the method, significant assumptions and data. This covers whether the method is appropriate under the framework, applied consistently, whether assumptions are reasonable and consistent with each other and with other assumptions in the statements, and whether the data are accurate and complete.
Develop a point estimate or range. The auditor builds an independent estimate, or a range, to compare with management's. If management's point estimate lies outside the auditor's range, that points to a misstatement to be measured and evaluated under AU-C 450.

For estimates that are significant risks or have high inherent risk, the auditor also performs procedures on the related disclosures, and considers whether those disclosures adequately convey estimation uncertainty.

Using the work of others

When an estimate involves specialized skill, such as an actuarial reserve or an appraisal, the auditor may use an auditor's specialist under AU-C 620. SAS 144 amended AU-C 620, AU-C 501 and AU-C 540 on specialist work and the use of pricing information from external sources such as pricing services. The auditor stays responsible for the conclusion. Read the current text of those sections for the requirements.

What is management bias and how is it evaluated?

Management bias is a lack of neutrality in preparing information. It can be intentional or unintentional. The standard asks the auditor to evaluate whether judgments and decisions in making estimates, even if individually reasonable, indicate possible bias. If they do, the auditor evaluates the implications for the audit.

Signs of possible bias include:

assumptions that consistently move estimates in a direction that helps results, such as repeated under-reserving
changes in method or assumptions between years that do not follow a change in circumstances
an estimate that sits at the edge of a reasonable range each year
an estimate that moves in step with a bonus target or loan covenant

A retrospective review of last year's estimates against actual outcomes is a standard tool here. It does not on its own prove bias, but a pattern of misses in one direction is a signal.

The stand-back evaluation

Based on the audit evidence, the auditor evaluates whether the accounting estimates and related disclosures are reasonable in the context of the framework or are misstated. That includes considering the estimates together, not only one at a time. A set of individually acceptable estimates that all favor the same direction deserves a second look.

Written representations and communication

The auditor requests written representations on whether the methods, significant assumptions and data used in making estimates are appropriate and consistently applied, and on whether the disclosures about estimates are complete, and on whether subsequent events require adjustment of the estimates. See AU-C 580.

The auditor also communicates with those charged with governance about the qualitative aspects of significant estimates and any indicators of management bias. AU-C 260 covers this communication.

What must be documented?

Key elements of the understanding of the entity relating to estimates, and the assessment of inherent and control risk for each estimate
The auditor's response and the evidence obtained
Indicators of possible management bias and the auditor's evaluation of them
The basis for the conclusion on whether estimates and disclosures are reasonable or misstated

See AU-C 230 audit documentation.

Common weaknesses in estimates files

Practice checks, not requirements of the standard. Gaps to avoid:

Inherent risk and control risk not assessed separately for estimates
Management's method accepted without testing the data or assumptions
No retrospective review of prior-year estimates
Specialist work used without evaluating competence, scope and findings
No documented consideration of management bias
Disclosures about estimation uncertainty not tested

Sources

AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures, as revised by SAS No. 143 (periods ending on or after December 15, 2023)
AICPA, SAS No. 144, amendments to AU-C 501, 540 and 620 (periods ending on or after December 15, 2023)
AICPA, AU-C Sections 315, 330, 450, 580 and 260

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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error

AU-C 540 Accounting Estimates: SAS 143 Requirements, Risk Factors and Management Bias