AU 342: Auditing Accounting Estimates1

AU-C 540: Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures

AU EFFECTIVE DATE AND APPLICABILITY

Original Pronouncement Statement on Auditing Standards (SAS) 57.
Effective Date This standard is now effective.
Applicability Audits of financial statements in accordance with generally accepted auditing standards (GAAS).

AU-C EFFECTIVE DATE AND SUMMARY OF CHANGES

SAS No. 122, Codification of Auditing Standards and Procedures, is effective for audits of financial statements with periods ending on or after December 15, 2012.

AU-C 540 does not change the extant requirements of AU 342 in any significant respect. AU-C 540 supersedes AU-C 328, Auditing Fair Value Measurements and Disclosures, and AU 342, Auditing Accounting Estimates.

AU DEFINITIONS OF TERMS

Accounting estimate. An accounting estimate is an approximation of a financial statement element, item, or account. Accounting estimates are included in historical financial statements because (1) the measurement of some amounts or the valuation of some accounts is uncertain, pending the outcome of future events, or (2) relevant data concerning events that have already occurred cannot be accumulated on a timely cost-effective basis.

Accounting estimates in historical financial statements measure the effects of past business transactions or events, or the present status of an asset or liability. Examples of accounting estimates include (1) net realizable values of inventory and accounts receivable, (2) property and casualty insurance loss reserves, (3) revenue from contracts accounted for by the percentage-of-completion method, and (4) pension and warranty expenses. (The “Illustration” section contain a list of typical accounting estimates. The examples are taken from Section 342.)

Key factors. The Statement does not define this term; however, it states that the auditor normally concentrates on key factors in evaluating the reasonableness of accounting estimates. The term is defined in Section AT 301, Financial Forecasts and Projections, as follows:

Key factors encompass matters that affect items such as sales, production, service, and financing activities. They are the foundation for prospective financial statements and are the bases for assumptions.

AU-C DEFINITIONS OF TERMS

Source: AU-C 540.07

Accounting estimate. An approximation of a monetary amount in the absence of a precise means of measurement. This term is used for an amount measured at fair value when there is estimation uncertainty, as well as for other amounts that require estimation. When this section addresses only accounting estimates involving measurement at fair value, the term fair value accounting estimates is used.

Auditor’s point estimate or auditor’s range. The amount or range of amounts, respectively, derived from audit evidence for use in evaluating the recorded or disclosed amount(s).

Estimation uncertainty. The susceptibility of an accounting estimate and related disclosures to an inherent lack of precision in its measurement.

Management bias. A lack of neutrality by management in the preparation and fair presentation of information.

Management’s point estimate. The amount selected by management for recognition or disclosure in the financial statements as an accounting estimate.

Outcome of an accounting estimate. The actual monetary amount that results from the resolution of the underlying transaction(s), event(s), or condition(s) addressed by the accounting estimate.

OBJECTIVES OF AU SECTION 342

Estimation is essential in the preparation of financial statements. Exact measurement of some amounts or the valuation of some accounts is uncertain until (1) the outcome of future events is known, or (2) all relevant data concerning events that have already occurred are accumulated.

Because they involve uncertainty and subjectivity, and because controls over them are more difficult to establish than controls over factual information, accounting estimates ordinarily are more susceptible to material misstatements than factual data. It is, therefore, necessary for the auditor to devote adequate audit resources to accounting estimates in light of the degree of uncertainty and subjectivity, quality of controls, and other relevant circumstances.

Section 342 provides guidance to auditors (1) on identifying circumstances that require accounting estimates, and (2) on obtaining and evaluating sufficient competent evidential matter to support accounting estimates in an audit of financial statements in accordance with GAAS.

OBJECTIVE OF AU-C SECTION 540

AU-C 540 states:

the objective of the auditor is to obtain sufficient appropriate audit evidence about whether, in the context of the applicable financial reporting framework

a. accounting estimates, including fair value accounting estimates, in the financial statements, whether recognized or disclosed, are reasonable and
b. related disclosures in the financial statements are adequate.

(AU-C 540.06)

FUNDAMENTAL REQUIREMENTS

Auditor’s Responsibility

The auditor is responsible for evaluating the reasonableness of accounting estimates made by management. The auditor should consider, with an attitude of professional skepticism, both the subjective and objective factors on which accounting estimates are based in planning and performing procedures to evaluate those estimates.

Auditor’s Objective

The auditor should evaluate accounting estimates to obtain reasonable assurance that:

1. All accounting estimates that could be material have been developed by management.
2. Those estimates are reasonable.
3. The estimates are presented and disclosed in conformity with generally accepted accounting principles (GAAP).

Identifying Circumstances That Require Material Accounting Estimates

When evaluating whether management has identified all material accounting estimates, the auditor should consider performing the following procedures:

1. Consider assertions embodied in the financial statements to determine what accounting estimates are needed (see “Illustration” for examples of accounting estimates included in financial statements).
2. Consider information obtained when performing other auditing procedures (see the “Techniques for Application” section).
3. Ask management about whether circumstances exist that may indicate the need to make an accounting estimate.

In addition to the guidance provided by Section 342:

  • Section 316, Consideration of Fraud in a Financial Statement Audit, states that the auditor should perform a retrospective review of estimates to respond to the risk of management override.
  • Section 318, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained, alerts the auditor that accounting estimates often are the source of significant risks.
NOTE: In evaluating whether all material estimates have been identified, the auditor considers the circumstances of the industry, the entity’s method of conducting business, new accounting pronouncements, and other relevant internal or external factors.

Evaluating Reasonableness

In evaluating reasonableness of accounting estimates, the auditor should do the following:

1. As a general rule, consider the historical experience of the entity in making past estimates and the auditor’s experience in the industry.
2. Understand how management developed the estimate.
3. Based on the understanding obtained in item 2, the auditor should do one or a combination of the following:
a. Review and test management’s process for developing the estimate.
b. Develop an independent expectation of the estimate to corroborate whether management’s estimate is reasonable.
c. Review subsequent events or transactions occurring before the completion of fieldwork.
NOTE: In evaluating reasonableness, the auditor should concentrate on key factors and assumptions that are
1. Significant
2. Sensitive to variations
3. Deviations from historical patterns
4. Subjective and susceptible to misstatement and bias

AU INTERPRETATION

Performance and Reporting Guidance Related to Fair Value Disclosures (February 1993; Revised October 2000; Revised March 2006; Revised June 2009)

The auditor should determine if the fair value disclosures presented represent only those required by Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 825, Financial Instruments, or whether additional voluntary disclosures are also presented.

For both required and voluntary disclosures, the auditor should reasonably assure that:

1. The valuation of principles are acceptable, consistently applied, and supported by underlying documentation.
2. The methods of estimation and significant assumptions used are properly disclosed.

Only Required Information Presented

If no other report modifications are needed, the auditor may issue a standard audit report. The auditor may elect to add an emphasis-of-matter paragraph calling attention to the nature and possible range of fair values. If required information is not presented, the auditor should consider whether a qualified or adverse opinion is required because of the departure from GAAP.

Both Required and Voluntary Information Presented

The auditor may audit the voluntary information only if:

1. The measurement and disclosure criteria used are reasonable.
2. Competent persons using the measurement and disclosure criteria would ordinarily obtain similar results.

Voluntary fair values may be presented as a complete balance sheet presentation or a less-than-complete balance sheet. When a complete balance sheet is presented, the following paragraph from AU 9342.06 should be added to the audit report:

We have also audited in accordance with auditing standards generally accepted in the United States of America the supplemental fair value balance sheet of ABC Company as of December 31, 20X1. As described in Note X, the supplemental fair value balance sheet has been prepared by management to present relevant financial information that is not provided by the historical-cost balance sheets and is not intended to be a presentation in conformity with generally accepted accounting principles. In addition, the supplemental fair value balance sheet does not purport to present the net realizable, liquidation, or market value of ABC Company as a whole. Furthermore, amounts ultimately realized by ABC Company from the disposal of assets may vary significantly from the fair values presented. In our opinion, the supplemental fair value balance sheet referred to above presents fairly, in all material respects, the information set forth therein as described in Note X.

When the required and voluntary fair values do not constitute a complete balance sheet and are located on the face of the financial statements or in footnotes, the standard audit report may be presented. However, if the partial disclosures are included in a separate schedule or exhibit in an auditor-submitted document, the auditor should add an additional paragraph to the audit report (see Section 551, Reporting on Information Accompanying the Basic Financial Statements in the Auditor-Submitted Documents) indicating that the fair value information is presented for additional analysis purposes and is not a required part of the basic financial statements. In situations when the auditor is not engaged to audit the voluntary fair value information or is unable to audit it, and the information is presented in an auditor-submitted document (on the face of the financial statements or in notes thereto or in a supplemental format), the voluntary information should be labeled “unaudited” and the auditor should disclaim an opinion on it (see Section 551). Finally, when the audited disclosures are presented on the face of the financial statements, in footnotes, or as supplements in a client-prepared document, the information should simply be labeled “unaudited.”

TECHNIQUES FOR APPLICATION

Client’s Responsibilities

In applying procedures to identify circumstances that require accounting estimates and evaluate the reasonableness of the estimates, the auditor should be aware of the entity’s responsibilities in the development of accounting estimates.

Developing Accounting Estimates

Management should establish the process for preparing accounting estimates. The process may not be documented or formally applied; however, it usually consists of:

1. Determining when accounting estimates are required
2. Determining the factors that influence the accounting estimate
3. Assembling data on which to base the estimate
4. Developing appropriate assumptions
5. Estimating the amount
6. Determining that the estimate is presented in the financial statements in conformity with appropriate accounting principles and that disclosure is adequate

If management’s process for developing accounting estimates is documented, generally the auditor should review the documentation. If the process is not documented, the auditor should make inquiries of management to determine how management developed its accounting estimates.

Internal Control

An entity’s internal control may reduce the likelihood that accounting estimates may be materially misstated. Aspects of control related to accounting estimates include the following:

1. Does management communicate the need for proper accounting estimates?
2. Are appropriate data on which to base the estimate accumulated?
3. Are estimates prepared by qualified personnel?
4. Are accounting estimates and supporting data adequately reviewed and approved?
5. Are past accounting estimates compared with actual results?
6. Has management considered whether the accounting estimate is consistent with its plans?

When the auditor documents his or her understanding of the entity’s internal control, he or she should document those aspects related to accounting estimates.

Identifying Circumstances That Require Accounting Estimates

1. Read the financial statements. The auditor should read the financial statements, including the notes, to determine if any elements, accounts, or items require an accounting estimate. The auditor’s knowledge of the client’s operations and industry help the auditor determine those components of the financial statements that require accounting estimates.
2. Obtain information by performing other procedures. By performing customary auditing procedures—reading minutes, inquiries, substantive tests of account balances—the auditor may obtain information that might indicate the need for an accounting estimate. The auditor should evaluate this information which includes the following:
a. Information about changes made or to be made in the entity’s business that may indicate that an account estimate is needed (see Section 311, Planning and Supervision). For example, estimates must be made if the entity has disposed of, or plans to dispose of, a segment of the business.
b. Changes in the process for accumulating financial information. Documenting the auditor’s understanding of the entity’s internal control would provide this information.
c. Information about identified litigation, claims, and assessments, and other contingencies. Inquiring of client’s lawyer and analysis of client’s legal expenses would provide this information (see Section 337, Inquiry of a Client’s Lawyer Concerning Litigation, Claims and Assessments).
d. Information from reading available minutes of meetings of stockholders, directors, and appropriate committees.
e. Information included in regulatory or examination reports, supervisory correspondence, and similar materials from regulatory agencies.
In addition, other auditing procedures, such as confirmation of receivables and observation of inventories might provide information about the need to reconsider the estimate for allowance for doubtful accounts or provide an estimate for inventory obsolescence.
3. Make inquiries of management. Throughout the audit the auditor makes inquiries of management. An inquiry should be made concerning the need for an accounting estimate.

Evaluating the Reasonableness of Accounting Estimates

Review and Test Management’s Process

In evaluating the reasonableness of accounting estimates, the auditor may consider performing the following procedures:

1. Consider the understanding that has been obtained of the process established by management to develop accounting estimates and whether the process is appropriate in the circumstances.
2. Identify controls over the process and the supporting data.
3. Identify the sources of information that management used in forming the assumptions, and consider whether the information is reliable and sufficient for the purpose based on information gathered in other audit tests.
4. Consider whether there are other key factors or alternative assumptions about the factors.
5. Evaluate whether the assumptions are consistent with one another, the supporting data, and relevant historical data.
6. Analyze historical data used in developing the assumptions to assess its comparability and consistency with data of the period under audit, and determine whether it is sufficiently reliable for the purpose.
7. Consider whether changes in the business or industry may cause other factors to significantly affect the assumptions.
8. Review available documentation of the assumptions used to develop the accounting estimates, and inquire about any of the entity’s other plans, goals, and objectives, as well as considering their relationship to the assumptions.
9. Test the calculations used to translate the assumptions and key factors into the accounting estimate.
10. Consider whether there are more appropriate ways to translate assumptions into estimates.
11. Consider obtaining the opinion of a specialist regarding certain assumptions (see Section 336, Using the Work of a Specialist).

Develop an Expectation

Based on his or her understanding of the facts and circumstances and knowledge of the client and its industry, the auditor may develop an independent expectation of the estimate by using factors and assumptions not used by the entity and compare that to the client’s estimate. Analytical procedures are a common method used in this approach (see Section 329, Analytical Procedures).

Review Subsequent Events

In evaluating the reasonableness of an accounting estimate, the auditor may review subsequent events to confirm the estimate or the appropriateness of the factors and assumptions used to develop the estimate or to obtain additional relevant information. For example, a loan that was 60 days past due at year-end might be 180 days past due near the completion of the audit.

AU ILLUSTRATION

The following list is taken from the Section 342 Appendix. It is not all-inclusive.

Illustration 1. Examples of Accounting Estimates
Receivables:
Uncollectible receivables
Allowance for loan losses
Uncollectible pledges
Inventories:
Obsolete inventory
Net realizable value of inventories where future selling prices and future costs are involved
Losses on purchase commitments
Financial instruments:
Valuation of securities
Trading vs. investment security classification
Probability of high correlation of a hedge
Sales of securities with puts and calls
Productive facilities, natural resources and intangibles:
Useful lives and residual values
Depreciation and amortization methods
Recoverability of costs
Recoverable reserves
Accruals:
Property and casualty insurance company loss reserves
Compensation in stock option plans and deferred plans
Warranty claims
Taxes on real and personal property
Renegotiation refunds
Actuarial assumptions in pension costs
Revenues:
Airline passenger revenue
Subscription income
Freight and cargo revenue
Dues income
Losses on sales contracts
Contracts:
Revenue to be earned
Costs to be incurred
Percent of completion
Leases:
Initial direct costs
Executory costs
Residual values
Litigation:
Probability of loss
Amount of loss
Rates:
Annual effective tax rate in interim reporting
Imputed interest rates on receivables and payables
Gross profit rates under program method of accounting
Other:
Losses and net realizable value on disposal of segment or restructuring of a business
Fair values in nonmonetary exchanges
Interim period costs in interim reporting
Current values in personal financial statements

1 This section is affected by the Public Company Accounting Oversight Board’s (PCAOB’s) Standard, Conforming Amendments to PCAOB Interim Standards Resulting from the Adoption of PCAOB Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements

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