Posted: 11 / 04 / 2024
As we all know, the production of a set of financial statements is not an exact science.
It’s made up of some hard numbers and some with a greater or lesser degree of estimation, including things like:
- Provisions against stock and receivables
- Long-term contract profit and loss recognition
- Pension liabilities
- Asset lives and depreciation rates
- Asset fair values
So, as preparers of accounts, what skills should you apply when assessing estimates? Estimates share one characteristic above all others – they are an attempt to look into the future and are consequently subject to a high degree of uncertainty, so have an inherent risk of misstatement.
Audit approach to accounting estimates
In assessing the reliability of an estimate, your auditor should apply a number of judgments:
- Estimation uncertainty – If an item is estimated to have a low value but is subject to high estimation uncertainty, that figure may be significantly understated when compared with the eventual outcome of the estimate.
- Adequacy of controls – Does the entity have a risk management system that draws upon the combined expertise of a team when addressing accounting estimates?
- Compliance with GAAP – Does the estimate comply with local GAAP fundamentals?
- Past experience – The degree of past experience and accuracy of applying estimates may well inform business methodology and its development.
- Specialist advice – Can the entity rely on suitably qualified specialist advice that the auditor can rely on (e.g., an external actuary or internal estimator)?
- Management bias – Is management disposed to skewing the results to meet a certain objective?
- Professional scepticism – The auditor should adopt a worst-case view in assessing risk.
- Range or point estimate – The auditor should establish their own point estimate or range.
- Disclosures – How willing are management to set out and inform the user of the degree of uncertainty and its likely impact on how the user interprets the financial position?
- Management representations – Of itself not sufficient, but necessary if the auditor relies on estimates.
Audit of estimates is subject to a high degree of uncertainty. The degree of audit risk is somewhat reduced by GAAP systems accepting that more than one estimate of the same uncertainty may give a true and fair view. So when thinking of estimates and uncertainties, be sure you have considered the internal control processes, you have support for the underlying assumptions being used and be conscious of bias. Critically when it comes to the disclosures in the financial statements, less is not more and sufficient disclosure of the circumstances and potential sensitivity of the uncertainty is needed to ensure that readers can make up their own mind.
