Auditing accounting estimates under AU-C 540 as amended by SAS 143

• Assess inherent risk for an estimate using estimation uncertainty, complexity and subjectivity
• Choose among the three AU-C 540 response approaches
• Test methods, significant assumptions and data, and develop an auditor’s range
• Evaluate indicators of management bias under AU-C 540

The framework

AU-C 540, as revised by SAS 143, applies to audits of periods ending on or after December 15, 2023. It covers every accounting estimate: allowances, inventory reserves, warranty liabilities, fair values, impairment, useful lives, revenue variable consideration, and more.

Start with a review of the outcome of prior-period estimates, or their re-estimation, to help identify and assess risks in the current period. The point is to learn how good management's process is, not to second-guess judgments that were reasonable when made.

When you assess inherent risk for an estimate, the standard requires you to take into account:

• the degree of estimation uncertainty, and
• the degree to which the selection and application of the method, assumptions and data, and the selection of the point estimate and disclosures, are affected by complexity, subjectivity or other inherent risk factors.

Inherent risk is assessed separately from control risk. You also decide whether any risk is a significant risk, and if so to identify controls that address it and evaluate their design and implementation.

Three ways to respond

Further procedures include one or more of:

1. Obtaining evidence from events occurring up to the report date. Example: collections after year-end on past-due receivables.
2. Testing how management made the estimate: the methods, significant assumptions and data, and how management selected the point estimate and developed disclosures about estimation uncertainty.
3. Developing an auditor's point estimate or range.

The higher the assessed risk, the more persuasive the evidence needs to be, and the procedures must not be biased toward corroborative evidence or toward excluding contradictory evidence. For a significant risk handled substantively only, the procedures include tests of details.

Testing management's process

• Method: appropriate under the framework, and any change from last year justified.
• Significant assumptions: consistent with each other, with market and entity information, and with management's plans and ability to carry them out. Test sensitivity: which assumption moves the estimate most?
• Data: relevant and reliable, accurately extracted from the accounting system. An allowance model built on an aging report that has not been tested is built on untested data.

If management has not taken appropriate steps to understand or address estimation uncertainty, the auditor requests more work from management, develops an auditor's point estimate or range if management's response is insufficient, and evaluates whether a control deficiency exists.

An auditor's range includes only amounts supported by evidence and evaluated as reasonable. A range wider than materiality rarely helps you conclude.

Bias and the overall evaluation

The auditor evaluates whether management's judgments, even if individually reasonable, indicate possible management bias. A pattern matters more than any one estimate: every reserve at the low end of its range in a year the company needs to hit a covenant is an indicator. Intentional bias is fraud. AU-C 240 separately requires a retrospective review of prior-year significant estimates for bias.

Finally, the auditor determines whether each estimate and its disclosures are reasonable or misstated. A difference between management's point estimate and an auditor's point estimate, or the nearest point of an auditor's range when management's estimate falls outside it, is a misstatement accumulated under AU-C 450.

Further reading: AU-C 540 summary, point estimates, ranges and bias.

Common file findings

• Estimate agreed to management's schedule with no test of the data.
• No retrospective review of last year's estimate.
• "Reasonable" conclusion with no range or sensitivity.
• Bias not evaluated across estimates.

Warranty reserve at Copperline Water Heaters, Inc.