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7073.5 Step 5: Test Significant Assumptions
Sep-2020

In This Section

Consider Appropriateness of Significant Assumptions in Accordance with Financial Reporting Framework

Auditing Assumptions Used in Discounted Cash Flow Models

Assess Consistency of Significant Assumptions

Assess Management’s Intent and Ability to Carry Out Specific Courses of Action

CAS Requirement

In applying the requirements of paragraph 22, with respect to significant assumptions, the auditor’s further audit procedures shall address (CAS 540.24):

(a) Whether the significant assumptions are appropriate in the context of the applicable financial reporting framework, and, if applicable, changes from prior periods are appropriate;

(b) Whether judgments made in selecting the significant assumptions give rise to indicators of possible management bias;

(c) Whether the significant assumptions are consistent with each other and with those used in other accounting estimates, or with related assumptions used in other areas of the entity’s business activities, based on the auditor’s knowledge obtained in the audit; and

(d) When applicable, whether management has the intent to carry out specific courses of action and has the ability to do so.

Consider Appropriateness of Significant Assumptions in Accordance with Financial Reporting Framework

CAS Guidance

When a change from prior periods in a method, significant assumption, or the data is not based on new circumstances or new information, or when significant assumptions are inconsistent with each other and with those used in other accounting estimates, or with related assumptions used in other areas of the entity’s business activities, the auditor may need to have further discussions with management about the circumstances and, in doing so, challenge management regarding the appropriateness of the assumptions used (CAS 540.A95).

When the auditor identifies indicators of possible management bias, the auditor may need a further discussion with management and may need to reconsider whether sufficient appropriate audit evidence has been obtained that the method, assumptions and data used were appropriate and supportable in the circumstances. An example of an indicator of management bias for a particular accounting estimate may be when management has developed an appropriate range for several different assumptions, and in each case the assumption used was from the end of the range that resulted in the most favorable measurement outcome (CAS 540.A96).

Relevant considerations for the auditor regarding the appropriateness of the significant assumptions in the context of the applicable financial reporting framework, and, if applicable, the appropriateness of changes from the prior period may include (CAS 540.A102):

  • Management’s rationale for the selection of the assumption;

  • Whether the assumption is appropriate in the circumstances given the nature of the accounting estimate, the requirements of the applicable financial reporting framework, and the business, industry and environment in which the entity operates; and

  • Whether a change from prior periods in selecting an assumption is based on new circumstances or new information. When it is not, the change may not be reasonable nor in compliance with the applicable financial reporting framework. Arbitrary changes in an accounting estimate may give rise to material misstatements of the financial statements or may be an indicator of possible management bias (see paragraphs A133–A136).

Management may evaluate alternative assumptions or outcomes of accounting estimates, which may be accomplished through a number of approaches depending on the circumstances. One possible approach is a sensitivity analysis. This might involve determining how the monetary amount of an accounting estimate varies with different assumptions. Even for accounting estimates measured at fair value, there may be variation because different market participants will use different assumptions. A sensitivity analysis may lead to the development of a number of outcome scenarios, sometimes characterized as a range of outcomes by management, and including ‘pessimistic’ and ‘optimistic’ scenarios (CAS 540.A103).

OAG Guidance

Significant assumptions

We need to evaluate all significant assumptions used to develop in scope accounting estimates. Refer to the section Assumptions in OAG Audit 7073.1 for guidance on understanding management’s assumptions and identifying significant assumptions.

Assumptions are integral components of measurement methods, e.g., valuation methods that employ a combination of estimates of expected future cash flows together with estimates of the values of assets or liabilities in the future, discounted to the present.

The more sensitive the estimate is to changes in an assumption, the more persuasive the evidence needed from testing that assumption. When performing a sensitivity analysis, one or more assumptions are changed by a reasonable variation to calculate the change in the estimate. The rationale for determining which assumptions are considered significant and will be subject to audit procedures needs to be documented. An assumption is generally considered significant if a reasonable variation in the assumption would materially affect the measurement of estimate.

In auditing recurring estimates, consider whether facts and circumstances have changed such that assumptions that were not significant in the previous period have now become significant assumptions.

Evaluating appropriateness of significant assumptions

CAS 540.24 requires us to evaluate the appropriateness of significant assumptions in the context of the applicable financial reporting framework. We need to consider the specific requirements of the applicable financial reporting framework when considering the appropriateness of significant assumptions, using our understanding obtained as part of planning and risk assessment. For example, a financial reporting standard covering retirement benefits may specify the nature of actuarial assumptions to be used in measuring defined benefit obligations (such as demographic and financial assumptions) and require that the assumptions be ‘unbiased and mutually compatible’ and that ‘financial assumptions be based on market expectations, at the end of the reporting period, for the period over which the obligations are to be settled’. Inquiry of the entity’s personnel alone does not provide sufficient appropriate audit evidence and would not be sufficient alone to support our evaluation of the appropriateness of significant assumptions. Refer to the section Requirements of the Applicable Financial Reporting Framework in OAG Audit 7072 for further guidance addressing the evaluation of significant assumptions.

We need to document what we evaluated and the conclusions reached when testing significant assumptions in sufficient detail, such that an experienced auditor having no previous connection with the audit can understand the matters considered, conclusions reached and the related impact on any decisions to perform further procedures.

Audit procedures relating to significant assumptions may require the application of considerable professional judgment because the assumptions are highly subjective or because they are particularly sensitive to changes in the underlying circumstances. Consider using specialists/experts where significant assumptions are complex and may require specialized expertise. Refer to OAG Audit 7073.2 for guidance on determining the need for specialized skills and knowledge.

Our evaluation of significant assumptions may encompass procedures such as:

  • Evaluating whether the data on which the assumption is based is accurate, complete and relevant (refer to OAG Audit 7073.6 for guidance on evaluating reliability of data supporting management’s assumptions)

  • Identifying the sources of data and factors that management used in forming the assumptions, and considering whether such data and factors are relevant, reliable, and sufficient for the purpose based on information gathered in other audit tests

  • Considering whether there are additional relevant factors or alternative assumptions about the factors

  • Considering whether changes in the business or industry may cause other factors to become significant to the assumptions

  • Reviewing available documentation of the assumptions used in developing the accounting estimates.

Inquire about any other plans, goals, and objectives of the entity, and consider their relationship to the assumptions

  • Benchmarking to available alternative assumptions used in the industry or market

  • Evaluating whether the entity has an appropriate base for the significant assumptions used in the accounting estimate. In some cases, the assumptions will be based on industry or government statistics, or other external data; in other cases they will be specific to the entity and will be based on internally generated data.

  • In evaluating the assumptions we would consider, among other things, whether they are:

    • Appropriate in the context of the applicable financial reporting framework requirements

    • Reasonable in light of actual results in prior periods

    • Consistent with those used for other accounting estimates

    • Consistent with management’s plans which themselves appear appropriate

    • Based on appropriate formulae

Consider significant assumptions at a disaggregated level to clearly understand changes from the base or previous period and prevent overlooking a significant change in factors due to a netting effect. For example, if revenue in a discounted cash flow model is best analyzed by product line, considering both price and volume, then we may need to obtain evidence to support the price assumption separately from the evidence to support the volume assumption for the same product line. Similarly, we may need to disaggregate operating expenses when evaluating the forecasted profit margin.

It is important to exercise professional skepticism in evaluating whether the assumptions are reasonable and challenge management about the appropriateness of the assumptions if we identify evidence that indicates the assumptions may not be reasonable or may be subject to management bias.

When auditing recurring estimates, consider if some significant assumptions have changed as compared to the previous period and evaluate if such changes are appropriate. Consider factors noted in CAS 540.A102 when performing this evaluation.

Test evidence with historical results

Consider if the assumption is in line with actual results achieved in recent years and whether consistency is appropriate. For example, if the entity has consistently achieved revenue growth of 3%–5% annually for the past 5 years, we need to be professionally skeptical and critically assess the reasonableness of a significantly higher growth rate assumption used in a discounted cash flow model. Additionally, when growth assumptions differ significantly from historical trends, consider whether this difference is supported by audit evidence, such as contracts or other relevant information, and test management’s plans to achieve these growth rates. As part of this evaluation, consider both price and volume assumptions that may affect the growth rate. For example, the entity may have new sales contracts that are expected to increase the sales volume, but related contract sales prices may be lower, as compared to previous contracts. Even modest growth assumptions may be contrary to recent entity trends which could include flat or negative volume/price trends.

While consistency with historical results is sometimes evidence of reasonable assumptions, we need to also consider if there is a reason that the estimates would in fact differ from historical experience. For instance, we need to consider factors such as the gain or loss of customer contracts, changes in technology, changes in economic conditions, or the presence of any other contradictory evidence when assessing if consistency is reasonable.

When historical results are limited or do not exist, we may consider results from similar events in prior periods or other available industry information. For example, if management is forecasting an increase in revenue due to a new product offering, we may compare the estimates of revenues from the new product to actual revenues achieved in past situations where management introduced a new, similar product, or compare the estimates to the available data for similar entities in the related industry.

Evidence inconsistent with the assumptions used by management

In evaluating evidence about significant assumptions, we need to consider evidence that corroborates management’s assumptions. But it is just as important that we also evaluate evidence that may be inconsistent with management’s assumptions.

During the engagement, additional information may come to light that could contradict the assumptions used by management. For example, if management is communicating information to investors and analysts about expected revenue growth rates that are lower than the assumptions made in the cash flow forecast used to perform an impairment test, this would be contradictory evidence that may call into question the reasonableness of the cash flow forecast.

It is important to exercise professional skepticism in evaluating whether the assumptions are reasonable. If we identify evidence that appears to contradict the assumptions used by management, discuss with the entity and perform further procedures to understand the reasons and challenge management regarding the appropriateness of the assumptions.

We also consider if contradictory evidence may indicate potential management bias (refer to OAG Audit 7073.9 for guidance) and take contradictory as well as corroborative evidence into account when performing an overall evaluation of accounting estimates (refer to guidance in the section Evaluating Appropriateness of Risk Assessment and Audit Evidence Obtained in OAG Audit 7073.10). Also refer to the section Assess Consistency of Significant Assumptions in OAG Audit 7073.5 for guidance on evaluating consistency of assumptions applied by management in other areas.

If we conclude that significant assumptions used by management are unreasonable, refer to the section Determine Whether the Accounting Estimates are Reasonable or Misstated in OAG Audit 7073.10 for guidance on performing overall evaluation and determining if the estimate is misstated.

Related Guidance

Auditing Assumptions Used in Discounted Cash Flow Models

OAG Guidance

Estimates of future cash flows arise in many different areas of the audit, including goodwill, intangibles, asset impairment analyses, valuation of assets acquired or liabilities assumed in a business combination, going concern analyses, recoverability assessments for deferred tax assets among other areas.

While cash flow forecasts are often only one of many factors used by management in calculating an estimate, the cash flow forecasts are usually a significant input to the estimate and are therefore an area of focus of our audit procedures. While the responsibility for auditing the cash flow forecasts inherent in management’s estimates rests with us, there are certain auditing procedures where an internal valuation specialist/expert can provide assistance. Accordingly, we consider whether to engage an internal valuation specialist/expert to obtain audit evidence in support of certain significant assumptions within the cash flow forecast or the fair value estimate, considering guidance in OAG Audit 7071.

Below are some examples of assumptions often found in cash flow forecasts and examples of potential methods to test those assumptions. These are provided for illustrative purposes only. We need to consider specific engagement circumstances when determining the relevant factors and developing our audit responses to the assessed risks.

Note that additional considerations not addressed in the examples below may be relevant when auditing asset impairment calculations using ‘Fair value less costs to sell’ (FVLCTS) or ‘Value in use’ (VIU).

Assumption Examples of relevant considerations

Revenue growth

  • Consider the actual historical revenue growth (growth rate) and whether this remains a good indicator of the likely future growth rate or whether significant entity‑specific or market-related changes may have occurred that will likely change the growth rate in the future.

  • Consider current, expiring and pending contracts—are they fixed price or do they allow for price increases? Has the entity been able to execute new contracts that include a price increase?

  • Consider the entity’s history of being able to obtain price increases.

  • Consider what the entity’s competitors are doing relative to pricing and how those actions may provide positive or negative evidence about the entity’s plans.

  • Consider if the sales volume growth is in line with the growth experienced in the most recent prior years. Also consider the potential impacts on volume from pricing assumptions (i.e., is it likely both volume and prices can increase simultaneously?).

  • Consider customer backlog (e.g., sales orders to be filled)—are the anticipated changes in volumes consistent with the trends in customer backlog?

  • Consider customer/contract win and loss rates and how management’s assumptions compare to historical rates.

  • Consider specific customer assumptions and whether any major customers are experiencing financial difficulty; where possible, compare customer-issued forecasts to the entity’s assumptions.

  • Consider if the entity’s forecasts are in‑line with our understanding of general economic and trading conditions, and are consistent with industry or market data and trade publications. Remember to consider the reliability of this evidence by performing the following: consider the reliability and reputation of the source publication, consider whether the entity’s results have historically been in line with the market data, and consider the objectivity of the market data (i.e., does the publisher get their information directly from the entity or develop independent estimates?).

  • Consider if the growth is consistent with comparable companies in the same industry by reviewing competitor regulatory filings and considering analyst expectations/reports.

  • For a recently acquired business, consider if the growth is consistent with recently prepared due diligence reports.

  • Consider if there is sufficient current or planned investment in the business (i.e., selling expenses, capital expenditures, advertising, R&D) to achieve the forecast growth (taking into account current plant capacity, employee productivity, and planned utilization levels). See also the “Capital Expenditures” section below.

  • Consider audit evidence provided by all events occurring up to the report date.

Margin (gross margin, EBIT/operating margin and EBITDA margin)

  • Consider if the projected margins are in line with those of competitors, historical results, prior forecasts and industry/market data and whether the actual historical margin remains a good indicator of the likely future margin rate or whether significant entity specific or market‑related changes may have occurred that will likely change the margin rate in the future.

  • Consider whether cost forecasts include contractual rate increases from leases, vendor or employment agreements, or other contracts.

  • Consider if changes in raw material prices are consistent with management’s intentions to reduce costs and other information we obtained in the audit (i.e., recent price testing of inventory). For commodity intensive businesses, consider management’s raw material assumptions versus publicly available data.

  • Consider whether forecasted incentive compensation costs take into account forecasted increases in sales and profitability and the level of required payments under bonus plans.

  • Consider management’s history of carrying out its stated intentions. Consider any impediments that precluded management from carrying out its previous plan (e.g. for cost reduction) and whether these impediments still exist.

  • Consider whether the forecast considers one‑time expenses associated with implementing any cost reduction initiatives (e.g., severance, pension charges, onerous lease costs).

  • Review management’s written plans and other documentation, including formally approved budgets, authorizations or meeting minutes and determine if this information is consistent with the cash flow projections. Note: While it may be a useful procedure, agreeing a cash flow forecast to a formally approved budget does not provide sufficient evidence without other corroborating procedures.

  • If a cash flow forecast includes a planned expansion in production capacity, determine whether it also includes the necessary capital expenditures.

  • Evaluate the entity’s ability to carry out the particular course of action given the entity’s economic circumstances, including the implications of its existing commitments (e.g., labor contracts), and the existence of any contractual restrictions (e.g. debt covenants) or regulations that may preclude the entity from executing against its plan.

  • If the cash flow forecast reflects a multi-period plan for changes, consider whether prior period projected results for the initiative were achieved in the current year compared to forecast results.

  • Consider audit evidence provided by all events occurring up to the report date.

Capital expenditures and depreciation/amortization

  • Capital expenditures represent the investment required to sustain the business growth implicit in the cash flow model. Therefore, an assumption of sustained growth over a long period needs to reflect the necessary capital investment to support the forecasted growth. For example, if the revenue growth assumption is predicated on the introduction of a new product or volume growth of existing products that would exceed existing available capacity, capital expenditures need to reflect the level of investment necessary to meet these forecasts.

  • Compare capital expenditures to historical levels and understand consistent or inconsistent trends and check if capital expenditures are in line with the entity’s investment plans (e.g., review minutes of the meetings, entity’s press announcements, approved capital budgets).

  • Depreciation expense is a common add back in the development of cash flow forecasts as it represents a non‑cash charge included in the margin rate. Similar to capital expenditures, compare depreciation to historical levels and forecasted capital expenditures for consistency.

  • Intangible asset amortization expense is another common non‑cash add back in cash flow forecasts. For this expense, compare expense to amortization schedules.

  • To the extent capital expenditures are increasing (or decreasing), consider if the depreciation expense reflects comparable changes (e.g., if capital expenditures are increasing, generally depreciation expense would be expected to increase correspondingly).

Working capital requirements

A change in the net working capital assumption is included in the analysis as it represents a change in cash flows. For example, if net working capital is projected to increase, the estimated cash flows for that period are reduced accordingly. Consider the change in net working capital in light of changes in estimates of future revenues and margins. For example, if revenues are expected to increase and the cash conversion cycle remains constant, the associated components of working capital also change and often result in an increase in net working capital. This is because accounts receivable would increase due to increased sales.

Discount rate

Typically, an entity would use the weighted average cost of capital (WACC) as its discount rate. Given the complexity and judgmental nature of determining the reasonableness of the WACC, management may have engaged its own expert to calculate it, and we may consider using an auditor’s internal expert to assist in our evaluation.

The weighted average cost of capital (“WACC”) represents the required rate of return used to discount expected future cash flows and is calculated as the weighted average rate of return on equity and debt based on market participant assumptions for the proportion of debt and equity in the entity’s capital structure.

The following are the key inputs used in calculating the WACC

  • Cost of equity: The cost of equity is the rate of return required by market participants for investing in the shares of an entity commensurate with the level of risk of holding the subject entity’s shares. The key inputs used in the calculation of the cost of equity include the following:
Item Explanation Examples of Relevant Considerations

Risk-free rate

The risk‑free rate is obtained from investing in securities considered free from credit risk, e.g., government bonds.

Typically the risk‑free rate is obtained by reference to the interest rate of the country treasury bills or the long‑term bond rate, which represent a proxy for the risk‑free rate. Consider if your territory has any specific guidance in this area.

Equity risk
premium

The equity risk premium represents the return investors expect, over and above the risk-free rate to compensate them for taking on additional risk by investing in stocks.

Often this rate can be developed by reference to subscription services such as Bloomberg, which attempt to quantify the expected equity risk premium for country common stocks.

The equity risk premium may, in some cases, also need to be adjusted for the low risk free rate environment to reflect the fact that the risk of making equity investments has not decreased to the extent implied by falling sovereign yields (sometimes referred to as a “conditional equity market risk adjustment”). This would be based on an assessment of a number of current benchmarks for equity risk, including dividend discount models, credit spread models, relative market volatility and an assessment of overall required equity market returns using long term economic measures.
Consider consulting the financial instruments internal specialist when in doubt.

Small stock
premium

A small stock premium represents the higher returns expected by investors to account for the higher risk associated with small capitalization stocks, which typically have higher risks than large capitalization stocks and provide for greater returns.

The small stock premium can often be obtained from subscription services such as Bloomberg and represents the difference between returns required by market participants for investing in small and large stocks.

Beta

The beta measures how much a company’s share price moves against the market as a whole. For example, a beta of 1.0 indicates a company’s share price moves in line with the market; a beta in excess of 1.0 means the company’s share price reacts greater (i.e., is more volatile) than the market and a beta of less than 1.0 implies the company’s shares are less volatile than the market.

The entity‑specific Beta is based on an entity’s specific volatility compared to the relevant market volatility. Determining the relevant market is a matter of judgment and often using a valuation specialist or expert will be necessary. The Beta is typically unlevered and then relevered at the optimal or target level of gearing for the entity’s market.

  • Cost of debt: The cost of debt represents what a market participant would expect to receive from an entity’s issuance of debt. As companies generally benefit from the tax deductions available on interest paid, the net cost of the debt is the market interest paid less the market tax savings from the tax‑deductible interest payment.

  • Entity specific risk premium: It may be appropriate to include an entity specific risk premium in the calculation of the discount rate, such as when specific risk factors exist relative to the entity’s peers. Such factors might include the size of the entity, pending lawsuits, concentration of customer base. In some cases, the entity’s valuation expert may include an entity specific risk premium because the cash flow forecasts carry a higher risk than typical expected cash flows of a market participant. In such cases, the calculation of the discount rate is adjusted by applying an entity specific risk premium to result in a rate that is comparable to the internal rate of return (“IRR”). When a risk premium is added to adjust for cash flow forecasts that the valuation expert believes to be optimistic, we may need to consider if additional audit procedures are necessary in testing the cash flow forecasts and consider any contrary evidence this presents.

    Evaluate if the discount rate used is supported by the available market data. These need to be supported by appropriate sources (e.g., agreed to the information available in Bloomberg).

    Consider if the discount rate is in line with the industry discount rate or discount rate common in a country. Generally, the discount rate for an emerging market is likely to be higher when compared to a developed market. The cost of equity would be adjusted for “country risk premium” if an entity has operations in developing or higher risk countries.

The following additional considerations may also be relevant to asset impairment calculations:

  • The discount rate used in the ‘Fair value less costs to sell’ (FVLCTS) calculation needs to be post tax and reflect a market participant’s required return on the investment.

  • The discount rate used in the Value in Use (VIU) calculation needs to be pre-tax and reflect current market assessments of the time value of money and any risks specific to the asset not already adjusted for in the forecasted cash flows. In practice, it can be difficult to obtain a pre-tax discount rate because often the only observable market rate of return is a post‑tax rate, so use of a post‑tax rate may be appropriate depending on the engagement circumstances. Consider consulting financial instruments internal specialist when in doubt.

  • The discount rate used in a VIU calculation needs to reflect the specific risks of the asset or cash generating unit (CGU). It is unusual that CGUs would be discounted at a rate below the base WACC. However, it may be appropriate to apply different levels of premia to discount rates for different CGUs to reflect different risk characteristics between CGUs.
Assess Consistency of Significant Assumptions

CAS Guidance

Through the knowledge obtained in performing the audit, the auditor may become aware of or may have obtained an understanding of assumptions used in other areas of the entity’s business. Such matters may include, for example, business prospects, assumptions in strategy documents and future cash flows. Also, if the engagement partner has performed other engagements for the entity, CAS 315 requires the engagement partner to consider whether information obtained from those other engagements is relevant to identifying risks of material misstatement. This information may also be useful to consider in addressing whether significant assumptions are consistent with each other and with those used in other accounting estimates (CAS 540.A104).

OAG Guidance

We need to consider the assumptions used to develop in scope estimates individually and as a whole in order to determine that they are consistent with each other, with assumptions used in other accounting estimates, and with actual events in the business. A common audit technique is comparing, as appropriate, the assumptions to similar assumptions used in the forecasts of other internally generated prospective financial information, such as Board of Directors’ presentations and internal operating budgets in order to identify any inconsistent information.

Some examples of places where we may identify inconsistent evidence:

  • Review of minutes (e.g., board meetings)

  • Analyst/industry reports

  • Procedures in other audit areas

  • Information obtained through other engagement team members, including Tax and Risk Assurance specialists

  • Historical results

  • Press releases and earnings calls

  • Client website, press publications and marketing materials

It is important to exercise professional skepticism when evaluating any inconsistent information. If we identify inconsistencies, discuss with the entity and perform further procedures to understand the reasons, as appropriate in the engagement circumstances. In evaluating the sufficiency and appropriateness of audit evidence we include in this evaluation inconsistent or contradictory evidence (in accordance with CAS 330.26 and CAS 540.34), and our documentation includes sufficient explanation of our point of view about its impact on the reasonableness of the assumption.

As noted in CAS 540.A104, if we performed other engagements for the entity, we also consider if information obtained from those other engagements may indicate potential inconsistencies in assumptions, which would need to be considered.

Assess Management’s Intent and Ability to Carry Out Specific Courses of Action

CAS Guidance

The appropriateness of the significant assumptions in the context of the requirements of the applicable financial reporting framework may depend on management’s intent and ability to carry out certain courses of action. Management often documents plans and intentions relevant to specific assets or liabilities and the applicable financial reporting framework may require management to do so. The nature and extent of audit evidence to be obtained about management’s intent and ability is a matter of professional judgment. When applicable, the auditor’s procedures may include the following (CAS 540.A105):

  • Review of management’s history of carrying out its stated intentions.

  • Inspection of written plans and other documentation, including, when applicable, formally approved budgets, authorizations or minutes.

  • Inquiry of management about its reasons for a particular course of action.

  • Review of events occurring subsequent to the date of the financial statements and up to the date of the auditor’s report.

  • Evaluation of the entity’s ability to carry out a particular course of action given the entity’s economic circumstances, including the implications of its existing commitments and legal, regulatory, or contractual restrictions that could affect the feasibility of management’s actions.

  • Consideration of whether management has met the applicable documentation requirements, if any, of the applicable financial reporting framework.

Certain financial reporting frameworks, however, may not permit management’s intentions or plans to be taken into account when making an accounting estimate. This is often the case for fair value accounting estimates because their measurement objective requires that significant assumptions reflect those used by marketplace participants.

OAG Guidance

As noted in CAS 540.A105, the appropriateness of significant assumptions may depend on management’s ability and intent to carry out certain courses of action. For example, one of the significant assumptions used in a discounted cash flow model may relate to the estimated revenue growth rate resulting from a business expansion, and we need to evaluate the entity’s ability to carry out the expansion given the entity’s economic circumstances.

In considering whether management genuinely intends to carry out courses of action, we consider whether evidence obtained in other areas of the audit is consistent with management’s stated intentions and, if necessary, obtain additional evidence to verify these intentions. For example, if management’s forecasts show a reduced level of operating costs and management states its intention to achieve this reduction by reducing expenditures in certain business units, we might consider examining trends in expenditures in those units after the period end and evaluating whether this corroborates or contradicts management’s stated intentions.

It is often an effective audit technique to consider management’s history of achieving its planned results. For example, if management is forecasting that revenue will increase by 5% annually due to anticipated price increases, we need to consider whether or not previous price increases were successfully implemented. We may also consider whether current agreements include fixed prices, whether recently executed contracts incorporate expected price increases, or other customer, market or related factors that might corroborate or be contrary to management’s forecasted increase in revenue. It would also be appropriate to consider whether price increases may have a negative impact on volumes sold.

For examples of other procedures we may perform, refer to CAS 540.A105. It is important to exercise professional skepticism and critically evaluate management’s intent and ability to carry out specific courses of action. If we identify evidence that does not support management’s assumptions, we need to communicate to management, challenge the related assumptions and perform further procedures, as appropriate in the engagement circumstances.