7071 Introduction

Sep-2022

CAS Guidance

Accounting estimates vary widely in nature and are required to be made by management when the monetary amounts cannot be directly observed. The measurement of these monetary amounts is subject to estimation uncertainty, which reflects inherent limitations in knowledge or data. These limitations give rise to inherent subjectivity and variation in the measurement outcomes. The process of making accounting estimates involves selecting and applying a method using assumptions and data, which requires judgment by management and can give rise to complexity in measurement. The effects of complexity, subjectivity or other inherent risk factors on the measurement of these monetary amounts affects their susceptibility to misstatement (CAS 540.2).

A method is a measurement technique used by management to make an accounting estimate in accordance with the required measurement basis. For example, one recognized method used to make accounting estimates relating to share-based payment transactions is to determine a theoretical option call price using the Black Scholes option pricing formula. A method is applied using a computational tool or process, sometimes referred to as a model, and involves applying assumptions and data and taking into account a set of relationships between them (CAS 540.A2).

Assumptions involve judgments based on available information about matters such as the choice of an interest rate, a discount rate, or judgments about future conditions or events. An assumption may be selected by management from a range of appropriate alternatives. Assumptions that may be made or identified by a management’s expert become management’s assumptions when used by management in making an accounting estimate (CAS 540.A3).

For purposes of this CAS, data is information that can be obtained through direct observation or from a party external to the entity. Information obtained by applying analytical or interpretive techniques to data is referred to as derived data when such techniques have a well-established theoretical basis and therefore less need for management judgment. Otherwise, such information is an assumption. (CAS 540.A4)

Examples of data include (CAS 540.A5):

• Prices agreed in market transactions;
• Operating times or quantities of output from a production machine;
• Historical prices or other terms included in contracts, such as a contracted interest rate, a payment schedule, and term included in a loan agreement;
• Forward-looking information such as economic or earnings forecasts obtained from an external information source, or
• A future interest rate determined using interpolation techniques from forward interest rates (derived data).

Data can come from a wide range of sources. For example, data can be (CAS 540.A6):

• Generated within the organization or externally;
• Obtained from a system that is either within or outside the general or subsidiary ledgers;
• Observable in contracts; or
• Observable in legislative or regulatory pronouncements.

CAS Guidance

CAS 315 requires a separate assessment of inherent risk for identified risks of material misstatement at the assertion level. In the context of CAS 540, and depending on the nature of a particular accounting estimate, the susceptibility of an assertion to a misstatement that could be material may be subject to or affected by estimation uncertainty, complexity, subjectivity or other inherent risk factors, and the interrelationship among them. Accordingly, the assessment of inherent risk depends on the degree to which the inherent risk factors affect the likelihood or magnitude of misstatement, and varies on a scale that is referred to as the spectrum of inherent risk (CAS 540.4).

Inherent risk factors are characteristics of events or conditions that affect susceptibility to misstatement, whether due to fraud or error, of an assertion about a class of transactions, account balance or disclosures, before consideration of controls. Appendix 1 further explains the nature of these inherent risk factors, and their interrelationships, in the context of making accounting estimates and their presentation in the financial statements (CAS 540.A8).

When assessing the risks of material misstatement at the assertion level, in addition to estimation uncertainty, complexity, and subjectivity, the auditor also takes into account the degree to which inherent risk factors included in CAS 315 (other than estimation uncertainty, complexity, and subjectivity) affect susceptibility of assertions to misstatement about the accounting estimate. Such additional inherent risk factors include (CAS 540.A9):

• Change in the nature or circumstances of the relevant financial statement items, or requirements of the applicable financial reporting framework which may give rise to the need for changes in the method, assumptions or data used to make the accounting estimate.
• Susceptibility to misstatement due to management bias or other fraud risk factors insofar as they affect inherent risk, in making the accounting estimate.
• Uncertainty, other than estimation uncertainty.

Not all accounting estimates are subject to a high degree of estimation uncertainty. For example, some financial statement items may have an active and open market that provides readily available and reliable information on the prices at which actual exchanges occur. However, estimation uncertainty may exist even when the valuation method and data are well defined. For example, valuation of securities quoted on an active and open market at the listed market price may require adjustment if the holding is significant or is subject to restrictions in marketability. In addition, general economic circumstances prevailing at the time, for example, illiquidity in a particular market, may impact estimation uncertainty (CAS 540.A16).

This CAS refers to relevant requirements in CAS 315 and CAS 330, and provides related guidance, to emphasize the importance of the auditor’s decisions about controls relating to accounting estimates, including decisions about whether (CAS 540.5):

• There are controls required to be identified by CAS 315, for which the auditor is required to evaluate their design and determine whether they have been implemented.
• To test the operating effectiveness of controls.

CAS 315 also requires a separate assessment of control risk when assessing the risks of material misstatement at the assertion level. In assessing control risk, the auditor takes into account whether the auditor’s further audit procedures contemplate planned reliance on the operating effectiveness of controls. If the auditor does not plan to test the operating effectiveness of controls, or does not intend to rely on the operating effectiveness of controls, the auditor’s assessment of control risk is such that the assessment of the risk of material misstatement is the same as the assessment of inherent risk (CAS 540.6).

In assessing control risk at the assertion level in accordance with CAS 315, the auditor takes into account whether the auditor plans to test the operating effectiveness of controls. When the auditor is considering whether to test the operating effectiveness of controls, the auditor’s evaluation that controls are effectively designed and have been implemented supports an expectation, by the auditor, about the operating effectiveness of the controls in establishing the plan to test them (CAS 540.A10).

This CAS emphasizes that the auditor’s further audit procedures (including, where appropriate, tests of controls) need to be responsive to the reasons for the assessed risks of material misstatement at the assertion level, taking into account the effect of one or more inherent risk factors and the auditor’s assessment of control risk. (CAS 540.7)

The exercise of professional skepticism in relation to accounting estimates is affected by the auditor’s consideration of inherent risk factors, and its importance increases when accounting estimates are subject to a greater degree of estimation uncertainty or are affected to a greater degree by complexity, subjectivity or other inherent risk factors. Similarly, the exercise of professional skepticism is important when there is greater susceptibility to misstatement due to management bias or other fraud risk factors insofar as they affect inherent risk (CAS 540.8).

Paragraphs A60, A95, A96, A137 and A139 are examples of paragraphs that describe ways in which the auditor can exercise professional skepticism. Paragraph A152 provides guidance on ways in which the auditor’s exercise of professional skepticism may be documented, and includes examples of specific paragraphs in this CAS for which documentation may provide evidence of the exercise of professional skepticism. (CAS 540.A11)

This CAS requires the auditor to evaluate, based on the audit procedures performed and the audit evidence obtained, whether the accounting estimates and related disclosures are reasonable in the context of the applicable financial reporting framework, or are misstated. For purposes of this CAS, reasonable in the context of the applicable financial reporting framework means that the relevant requirements of the applicable financial reporting framework have been applied appropriately, including those that address (CAS 540.9):

• The making of the accounting estimate, including the selection of the method, assumptions and data in view of the nature of the accounting estimate and the facts and circumstances of the entity;
• The selection of management’s point estimate; and
• The disclosures about the accounting estimate, including disclosures about how the accounting estimate was developed and that explain the nature, extent, and sources of estimation uncertainty.

Other considerations that may be relevant to the auditor’s consideration of whether the accounting estimates and related disclosures are reasonable in the context of the applicable financial reporting framework include whether (CAS 540.A12):

• The data and assumptions used in making the accounting estimate are consistent with each other and with those used in other accounting estimates or areas of the entity’s business activities; and
• The accounting estimate takes into account appropriate information as required by the applicable financial reporting framework.

The term “applied appropriately” as used in paragraph 9 means in a manner that not only complies with the requirements of the applicable financial reporting framework but, in doing so, reflects judgments that are consistent with the objective of the measurement basis in that framework. (CAS 540.A13)

CAS Guidance

Examples of accounting estimates related to classes of transactions, account balances and disclosures include (CAS 540.A1):

• Inventory obsolescence.
• Depreciation of property and equipment.
• Valuation of infrastructure assets.
• Valuation of financial instruments.
• Outcome of pending litigation.
• Provision for expected credit losses.
• Valuation of insurance contract liabilities.
• Warranty obligations.
• Employee retirement benefits liabilities.
• Share-based payments.
• Fair value of assets or liabilities acquired in a business combination, including the determination of goodwill and intangible assets.
• Impairment of long-lived assets or property or equipment held for disposal.
• Non-monetary exchanges of assets or liabilities between independent parties.
• Revenue recognized for long-term contracts.

CAS Guidance

Financial reporting frameworks often call for neutrality, that is, freedom from bias. Estimation uncertainty gives rise to subjectivity in making an accounting estimate. The presence of subjectivity gives rise to the need for judgment by management and the susceptibility to unintentional or intentional management bias (for example, as a result of motivation to achieve a desired profit target or capital ratio). The susceptibility of an accounting estimate to management bias increases with the extent to which there is subjectivity in making the accounting estimate. (CAS 540.A17)

Management bias may be difficult to detect at an account level and may only be identified by the auditor when considering groups of accounting estimates, all accounting estimates in aggregate, or when observed over a number of accounting periods. For example, if accounting estimates included in the financial statements are considered to be individually reasonable but management’s point estimates consistently trend toward one end of the auditor’s range of reasonable outcomes that provide a more favorable financial reporting outcome for management, such circumstances may indicate possible bias by management. (CAS 540.A133)

CAS Guidance

Although this CAS applies to all accounting estimates, the degree to which an accounting estimate is subject to estimation uncertainty will vary substantially. The nature, timing and extent of the risk assessment and further audit procedures required by this CAS will vary in relation to the estimation uncertainty and the assessment of the related risks of material misstatement. For certain accounting estimates, estimation uncertainty may be very low, based on their nature, and the complexity and subjectivity involved in making them may also be very low. For such accounting estimates, the risk assessment procedures and further audit procedures required by this CAS would not be expected to be extensive. When estimation uncertainty, complexity or subjectivity are very high, such procedures would be expected to be much more extensive. This CAS contains guidance on how the requirements of this CAS can be scaled. (CAS 540.3).

Examples of paragraphs that include guidance on how the requirements of this CAS can be scaled include paragraphs A20–A22, A63, A67, and A84. (CAS 540.A7)

The nature, timing and extent of the auditor’s procedures to obtain the understanding of the entity and its environment, the applicable financial reporting framework, and the entity’s system of internal control, related to the entity’s accounting estimates, may depend, to a greater or lesser degree, on the extent to which the individual matter(s) apply in the circumstances. For example, the entity may have few transactions or other events or conditions that give rise to the need for accounting estimates, the applicable financial reporting requirements may be simple to apply, and there may be no relevant regulatory factors. Further, the accounting estimates may not require significant judgments, and the process for making the accounting estimates may be less complex. In these circumstances, the accounting estimates may be subject to, or affected by, estimation uncertainty, complexity, subjectivity, or other inherent risk factors to a lesser degree, and there may be fewer identified controls in the control activities component. If so, the auditor’s risk identification and assessment procedures are likely to be less extensive and may be obtained primarily through inquiries of management with appropriate responsibilities for the financial statements, such assimple walk-throughs of management’s process for making the accounting estimate (including when evaluating whether identified controls in that process are designed effectively and when determining whether the control has been implemented) (CAS 540.A20).

By contrast, the accounting estimates may require significant judgments by management, and the process for making the accounting estimates may be complex and involve the use of complex models. In addition, the entity may have a more sophisticated information system, and more extensive controls over accounting estimates. In these circumstances, the accounting estimates may be subject to or affected by estimation uncertainty, subjectivity, complexity or other inherent risk factors to a greater degree. If so, the nature or timing of the auditor’s risk assessment procedures are likely to be different, or be more extensive, than in the circumstances in paragraph A20. (CAS 540.A21)

The following considerations may be relevant for entities with only simple businesses, which may include many smaller entities: (CAS 540.A22)

• Processes relevant to accounting estimates may be uncomplicated because the business activities are simple or the required estimates may have a lesser degree of estimation uncertainty.
• Accounting estimates may be generated outside of the general and subsidiary ledgers, controls over their development may be limited, and an owner-manager may have significant influence over their determination. The owner-manager’s role in making the accounting estimates may need to be taken into account by the auditor both when identifying the risks of material misstatement and when considering the risk of management bias.

Specialized Skills or Knowledge

Many accounting estimates do not require the application of specialized skills or knowledge. For example, specialized skills or knowledge may not be needed for a simple inventory obsolescence calculation. However, for example, for expected credit losses of a banking institution or an insurance contract liability for an insurance entity, the auditor is likely to conclude that it is necessary to apply specialized skills or knowledge. (CAS 540.A63)

Inherent Risk Factors

The reasons for the auditor’s assessment of inherent risk at the assertion level may result from one or more of the inherent risk factors of estimation uncertainty, complexity, subjectivity or other inherent risk factors. For example (CAS 540.A67):

• Accounting estimates of expected credit losses are likely to be complex because the expected credit losses cannot be directly observed and may require the use of a complex model. The model may use a complex set of historical data and assumptions about future developments in a variety of entity specific scenarios that may be difficult to predict. Accounting estimates for expected credit losses are also likely to be subject to high estimation uncertainty and significant subjectivity in making judgments about future events or conditions. Similar considerations apply to insurance contract liabilities.
• An accounting estimate for an obsolescence provision for an entity with a wide range of different inventory types may require complex systems and processes, but may involve little subjectivity and the degree of estimation uncertainty may be low, depending on the nature of the inventory.
• Other accounting estimates may not be complex to make but may have high estimation uncertainty and require significant judgment, for example, an accounting estimate that requires a single critical judgment about a liability, the amount of which is contingent on the outcome of the litigation.

Further Audit Procedures

The nature, timing and extent of the auditor’s further audit procedures are affected by, for example (CAS 540.A84):

• The assessed risks of material misstatement, which affect the persuasiveness of the audit evidence needed and influence the approach the auditor selects to audit an accounting estimate. For example, the assessed risks of material misstatement relating to the existence or valuation assertions may be lower for a straightforward accrual for bonuses that are paid to employees shortly after period end. In this situation, it may be more practical for the auditor to obtain sufficient appropriate audit evidence by evaluating events occurring up to the date of the auditor’s report, rather than through other testing approaches.
• The reasons for the assessed risks of material misstatement.