Annual Audit Manual

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7073.9 Step 9: Consider Management Bias
Sep-2020

In This Section

Consider Management Bias

Consider Management Bias

CAS Requirement

In applying the requirements of paragraph 22, with respect to methods, the auditor’s further audit procedures shall address (CAS 540.23):

(a) Whether the method selected is appropriate in the context of the applicable financial reporting framework, and, if applicable, changes from the method used in prior periods are appropriate;

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

(c) Whether the calculations are applied in accordance with the method and are mathematically accurate;

(d) When management’s application of the method involves complex modelling, whether judgments have been applied consistently and whether, when applicable:

(i) The design of the model meets the measurement objective of the applicable financial reporting framework, is appropriate in the circumstances, and, if applicable, changes from the prior period’s model are appropriate in the circumstances; and

(ii) Adjustments to the output of the model are consistent with the measurement objective of the applicable financial reporting framework and are appropriate in the circumstances; and

(e) Whether the integrity of the significant assumptions and the data has been maintained in applying the method.

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.

In applying the requirements of paragraph 22, with respect to data, the auditor’s further audit procedures shall address (CAS 540.25):

(a) Whether the data is 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 data give rise to indicators of possible management bias;

(c) Whether the data is relevant and reliable in the circumstances; and

(d) Whether the data has been appropriately understood or interpreted by management, including with respect to contractual terms.

The auditor shall evaluate whether judgments and decisions made by management in making the accounting estimates included in the financial statements, even if they are individually reasonable, are indicators of possible management bias. When indicators of possible management bias are identified, the auditor shall evaluate the implications for the audit. Where there is intention to mislead, management bias is fraudulent in nature (CAS 540.32).

CAS Guidance

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).

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).

Examples of indicators of possible management bias with respect to accounting estimates include (CAS 540.A134):

  • Changes in an accounting estimate, or the method for making it, when management has made a subjective assessment that there has been a change in circumstances.

  • Selection or development of significant assumptions or the data that yield a point estimate favorable for management objectives.

  • Selection of a point estimate that may indicate a pattern of optimism or pessimism.

When such indicators are identified, there may be a risk of material misstatement either at the assertion or financial statement level. Indicators of possible management bias themselves do not constitute misstatements for purposes of drawing conclusions on the reasonableness of individual accounting estimates. However, in some cases the audit evidence may point to a misstatement rather than simply an indicator of management bias.

Indicators of possible management bias may affect the auditor’s conclusion as to whether the auditor’s risk assessment and related responses remain appropriate. The auditor may also need to consider the implications for other aspects of the audit, including the need to further question the appropriateness of management’s judgments in making accounting estimates. Further, indicators of possible management bias may affect the auditor’s conclusion as to whether the financial statements as a whole are free from material misstatement, as discussed in CAS 700 (CAS 540.A135).

In addition, in applying CAS 240, the auditor is required to evaluate whether management’s judgments and decisions in making the accounting estimates included in the financial statements indicate a possible bias that may represent a material misstatement due to fraud. Fraudulent financial reporting is often accomplished through intentional misstatement of accounting estimates, which may include intentionally understating or overstating accounting estimates. Indicators of possible management bias that may also be a fraud risk factor, may cause the auditor to reassess whether the auditor’s risk assessments, in particular the assessment of fraud risks, and related responses remain appropriate (CAS 540.A136).

OAG Guidance

Paragraphs 23-25 of CAS 540 require that when testing how management made the estimate, we perform procedures to address whether judgments made by management in selecting methods, assumptions and data give rise to indicators of possible management bias. This enables us to identify whether indicators of management bias exist within the context of individual judgments, or a combination of judgments made in making an individual estimate. However, while such judgments may appear reasonable individually or at the individual estimate level, it may only be when they are considered collectively across all accounting estimates that indicators of management bias emerge.

While consistent behavioral patterns (such as selecting an amount towards one end of an acceptable range for several estimates) may indicate management bias, changes in these patterns from one period to the next may also indicate management bias if there is no commercial or other rationale, such as where new circumstances or new information support a change.

For example, where management has a history of making selections from the mid-point of a range of possible point estimates, we may have concluded based on evidence available that this does not indicate intentional management bias. However, if management suddenly starts to adopt a more pessimistic or prudent approach and selects point estimates from the high end of the range without valid commercial or other rationale, this may indicate that they are manipulating the estimate to achieve desired objectives (such as deferring earnings to future periods in which they anticipate more difficult trading conditions).

CAS 240.33 requires that we evaluate whether circumstances producing bias represent a risk of material misstatement due to fraud. Under CAS 540.32, where there is an intention to mislead, management bias is fraudulent in nature. Accordingly, when evaluating whether the presence of management bias may indicate the existence of risks of material misstatement due to fraud, we need to consider whether management bias is intentional in nature and may represent an intention to mislead.

In practice, it may be difficult to identify whether management bias is intentional, particularly in areas that are subject to a greater degree of judgment. It is therefore especially important that we demonstrate skepticism and challenge management in these areas. Examples of how we demonstrate skepticism and challenge might include:

  • Robust inquiries of management as to the rationale for their judgments, how they have considered alternatives and why they did not consider those alternatives to be more appropriate;

  • Considering historic trends (including the results of retrospective review) and whether they support management’s judgments or indicate that current period estimates might not be reasonable, even where we have not identified misstatements based on our testing of methods, significant assumptions and data; or

  • Seeking alternative sources of evidence and considering whether they provide information that contradicts management’s explanations or evidence already received by us in the course of our audit.

The section Interrelationships Between Inherent Risk Factors in OAG Audit 7073.3 provides guidance on the impact of management bias on our assessment of inherent risk, including its relationship with other inherent risk factors.