Statement on Auditing Standards – SA 540

Statement on Auditing Standards – SA 540

Scope and objectives

The auditing standards related to accounting estimates and fair value accounting estimates, and the responsibilities of auditors regarding them. SA 540 defines accounting estimates as financial statement items that cannot be measured precisely but can only be estimated. The nature and reliability of information available to management to support the making of an accounting estimate vary widely, which affects the degree of estimation uncertainty associated with accounting estimates. This estimation uncertainty affects the risks of material misstatement of accounting estimates, including their susceptibility to unintentional or intentional management bias.

The further describes different examples of accounting estimates, including fair value accounting estimates and non-fair value accounting estimates, and discusses the degree of estimation uncertainty associated with each of them. For example, accounting estimates arising in entities that engage in business activities that are not complex, or accounting estimates derived from data that is readily available, may involve lower estimation uncertainty and lower risks of material misstatements. On the other hand, accounting estimates based on significant assumptions, such as those related to the outcome of litigation, may involve higher estimation uncertainty and higher risks of material misstatements

SA 540 also highlights the responsibility of auditors to evaluate the management bias associated with accounting estimates. The financial reporting frameworks require neutrality, but the imprecise nature of accounting estimates can be influenced by management judgment, which may involve unintentional or intentional management bias. The auditor is responsible for assessing the risks of material misstatement associated with management bias and for designing audit procedures to address those risks

Overall, SA 540 provides guidance and requirements on how auditors should approach accounting estimates and fair value accounting estimates, evaluate the risks of material misstatements associated with them, and address the management bias that may influence accounting estimates.

Risk Assessment Procedures and Related Activities

The procedures and activities that an auditor needs to perform when conducting risk assessment procedures to obtain an understanding of the entity and its environment, including internal control, in order to identify and assess the risks of material misstatement for accounting estimates.

To provide a basis for identifying and assessing the risks of material misstatement for accounting estimates, the auditor must obtain an understanding of the requirements of the applicable financial reporting framework relevant to accounting estimates and how management identifies the need for accounting estimates.

The financial reporting framework provides guidance to management on determining point estimates where alternatives exist, and it may require the disclosure of information concerning the significant assumptions to which the accounting estimate is particularly sensitive.

Management has the responsibility to determine whether a transaction, event or condition gives rise to the need to make an accounting estimate, and that all necessary accounting estimates have been recognized, measured and disclosed in the financial statements in accordance with the applicable financial reporting framework.

The auditor’s understanding of the entity and its environment obtained during the performance of risk assessment procedures, together with other audit evidence obtained during the course of the audit, assists the auditor in identifying circumstances or changes in circumstances that may give rise to the need for an accounting estimate.

During the audit, the auditor may identify transactions, events and conditions that give rise to the need for accounting estimates that management failed to identify. In such cases, the auditor needs to assess whether there is a significant deficiency in internal control with regard to the entity’s risk assessment processes.

Considerations Specific to Smaller Entities

The specific considerations that auditors should take into account when obtaining an understanding of how management makes accounting estimates. Accounting estimates are an important aspect of financial reporting, as they are used to measure the financial impact of events, conditions, and transactions that do not have a clear and definitive outcome.

The process of obtaining an understanding of how management makes accounting estimates is often less complex for smaller entities, as their business activities are typically less complicated and their transactions are less complex. The auditor should seek to understand how management makes the accounting estimates, including the data on which they are based, and the processes for establishing financial reporting processes for making accounting estimates.

The auditor should consider in obtaining an understanding of how management makes accounting estimates, including the types of accounts or transactions to which the accounting estimates relate, the methods used to make the accounting estimates, and the relevant controls in place to ensure the accuracy and completeness of the accounting estimates. The auditor should also consider whether management has used an expert to make the accounting estimates and should seek to understand the assumptions underlying the accounting estimates.

The applicable financial reporting framework may prescribe the method of measurement for an accounting estimate, but in many cases, the applicable financial reporting framework does not prescribe the method of measurement. In these cases, the auditor should consider how management selects a particular method, and whether the entity operates in a particular business, industry, or environment in which there are methods commonly used to make the particular type of accounting estimate. There may be greater risks of material misstatement if management has internally developed a model to be used to make the accounting estimate or is departing from a method commonly used in a particular industry or environment.

 SA 540 notes that in smaller entities, the owner-manager is often capable of making the required point estimate. However, in some cases, an expert will be needed, and the auditor should discuss the nature of any accounting estimates with the owner-manager early in the audit process to assist them in determining the need to use an expert.

Reviewing Prior Period Accounting Estimates

The auditor’s responsibility to review the accounting estimates included in the prior period financial statements for the purpose of identifying and assessing the risks of material misstatement in the current period financial statements. The auditor should review the outcome of these estimates and whether they were subsequently re-estimated in the current period. The review should take into account the nature of the accounting estimates, and the information obtained from the review should be relevant to identifying and assessing risks of material misstatement of accounting estimates made in the current period financial statements.

The review is not intended to question the judgments made in the prior periods based on the information available at that time. The outcome of an accounting estimate may differ from the accounting estimate recognized in the prior period financial statements, and the auditor can obtain relevant information by performing risk assessment procedures to identify and understand the reasons for such differences. The review may also assist the auditor in identifying circumstances or conditions that increase the susceptibility of accounting estimates to, or indicate the presence of, possible management bias.

The auditor’s professional scepticism assists in identifying such circumstances or conditions and determining the nature, timing, and extent of further audit procedures. The auditor may judge that a more detailed review is required for accounting estimates that were identified as having high estimation uncertainty or have changed significantly from the prior period.

For fair value accounting estimates and other accounting estimates based on current conditions at the measurement date, there may be more variation between the fair value amount recognized in the prior period financial statements and the outcome or the amount re-estimated for the purpose of the current period. The auditor may focus the review on obtaining information relevant to identifying and assessing risks of material misstatement. A difference between the outcome of an accounting estimate and the amount recognized in the prior period financial statements does not necessarily represent a misstatement of the prior period financial statements. However, it may do so if the difference arises from information that was available to management when the prior period’s financial statements were finalized, or that could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements.

Identifying and Assessing the Risks of Material Misstatement

The process of identifying and assessing risks of material misstatement in financial statements as required by the auditing standard SA 315. In particular, it focuses on the evaluation of the degree of estimation uncertainty associated with accounting estimates. The degree of estimation uncertainty may be influenced by factors such as the extent of judgment involved, the sensitivity of the estimate to changes in assumptions, and the availability of reliable data.

The auditor is required to determine whether accounting estimates with high estimation uncertainty give rise to significant risks of material misstatement. Examples of such estimates include those highly dependent on judgment, those not calculated using recognized measurement techniques, and those where prior period accounting estimates had a substantial difference between the original estimate and the actual outcome. The size of an accounting estimate recognized in financial statements may not necessarily indicate its estimation uncertainty.

In cases where the estimation uncertainty is so high that a reasonable accounting estimate cannot be made, the financial reporting framework may preclude recognition of the item in the financial statements or its measurement at fair value. In such cases, the significant risks relate not only to recognition and measurement but also to the adequacy of disclosures.

When the auditor determines that an accounting estimate gives rise to significant risk, they are required to obtain an understanding of the entity’s controls, including control activities. In some cases, the estimation uncertainty of an accounting estimate may cast significant doubt about the entity’s ability to continue as a going concern, and SA 570 provides guidance in such circumstances.

Responses to the Assessed Risks of Material Misstatement

The auditors how respond to the assessed risks of material misstatement when auditing accounting estimates. The auditor must determine whether management has appropriately applied the requirements of the applicable financial reporting framework relevant to the accounting estimate, and whether the methods for making the accounting estimates are appropriate and have been applied consistently. The auditor’s response to these risks may include undertaking one or more of the following: determining whether events occurring up to the date of the auditor’s report provide audit evidence regarding the accounting estimate; recalculating the accounting estimate using the auditor’s own assumptions; reviewing subsequent events; obtaining an understanding of the methods and assumptions used to make the accounting estimate; and evaluating the reasonableness of the accounting estimate using relevant information from external sources.

The auditor’s decision as to which response, individually or in combination, to undertake may be influenced by the nature of the accounting estimate, whether the procedure(s) is expected to effectively provide the auditor with sufficient appropriate audit evidence, and the assessed risk of material misstatement. The text also notes that events that contradict the accounting estimate may indicate that management has ineffective processes for making accounting estimates, and the auditor should evaluate the effectiveness of management’s processes in making accounting estimates.

Evaluating the use of Models

The International Auditing and Assurance Standards Board (IAASB) guidance related to the evaluation of models and management assumptions used in financial reporting. The importance of using appropriate models and reasonable assumptions in making accounting estimates, particularly in the context of fair value accounting.

The guidance notes that the use of a model may depend on factors such as the nature of the entity and its environment, the industry in which it operates, and the specific asset or liability being measured. The auditor should consider whether the model has been validated, periodically reviewed, calibrated, and documented, and whether appropriate change control policies and procedures exist.

With respect to management assumptions, the auditor’s evaluation is based on the information available at the time of the audit and is performed in the context of the audit of the entity’s financial statements. The auditor may consider whether individual assumptions appear reasonable, whether the assumptions are interdependent and internally consistent, and whether they appear reasonable when considered collectively or in conjunction with other assumptions. In the case of fair value accounting estimates, the assumptions used should appropriately reflect observable marketplace assumptions.

The guidance notes that management assumptions may reflect the outcome of specific objectives and strategies, and the auditor may evaluate the reasonableness of such assumptions by considering factors such as the general economic environment and the entity’s economic circumstances, the entity’s plans, assumptions made in prior periods, and the experience of the entity. The auditor may also review written plans and other documentation, inquire of management about its reasons for a particular course of action, review events occurring subsequent to the date of the financial statements, and evaluate the entity’s ability to carry out a particular course of action.

The guidance further discusses matters that the auditor may consider in evaluating the reasonableness of assumptions used by management underlying fair value accounting estimates, including the incorporation of market-specific inputs, consistency with observable market conditions, reliability of sources of market-participant assumptions, and consideration of assumptions used in comparable transactions, assets or liabilities. Finally, the guidance notes that if fair value accounting estimates are based on unobservable inputs, the auditor should consider how management supports the identification of marketplace participant characteristics, modifications made to assumptions, incorporation of the best available information, and consideration of comparable transactions, assets, or liabilities.

Develop a point estimate

The process of developing a point estimate or a range to evaluate management’s point estimate in relation to accounting estimates. This approach may be appropriate when accounting estimates are not derived from routine data processing by the accounting system, when the auditor’s review of prior period financial statements suggests that management’s current period process is unlikely to be effective, or when the entity’s controls over management’s process for determining accounting estimates are not well designed or properly implemented.

The auditor may develop a point estimate or a range in various ways, including using a model, developing management’s consideration of alternative assumptions or outcomes, employing a person with specialized expertise, or referencing other comparable conditions, transactions, events, or markets for comparable assets or liabilities. The auditor may also need to obtain an understanding of management’s assumptions or methods if they differ from the auditors.

When the auditor concludes that it is appropriate to use a range, the range should be narrowed based on audit evidence available until all outcomes within the range are considered reasonable. The auditor’s range should encompass all reasonable outcomes rather than all possible outcomes. Ordinarily, a range that has been narrowed to be equal to or less than performance materiality is adequate for the purposes of evaluating the reasonableness of management’s point estimate. However, in certain industries, it may not be possible to narrow the range to below such an amount.

SA 540 notes that in planning the audit, the auditor must consider the nature, timing, and extent of resources necessary to perform the audit engagement, which may include specialized skills or knowledge in relation to one or more aspects of the accounting estimates.

Further Substantive Procedures to Respond to Significant Risks

In the audit accounting estimates that give rise to significant risks and how auditors can evaluate them.

The auditors should evaluate how management has assessed the effect of estimation uncertainty on the accounting estimate and the adequacy of related disclosures. For this purpose, management may consider alternative assumptions or outcomes and may undertake a sensitivity analysis. The auditor’s job is to ensure that management has assessed how estimation uncertainty may affect the accounting estimate and has addressed it accordingly.

For smaller entities, which may not have the expertise to consider alternative outcomes, the auditor may explain the process and the different methods available. However, this does not change the responsibilities of management for the preparation and presentation of the financial statements.

Auditors should also evaluate whether significant assumptions used by management are reasonable. An assumption used in making an accounting estimate may be deemed significant if a reasonable variation in the assumption would materially affect the measurement of the accounting estimate. The auditor may evaluate these assumptions through inquiries of and discussions with management, along with other audit procedures.

If in the auditor’s judgment, management has not adequately addressed the effects of estimation uncertainty on the accounting estimates that give rise to significant risks, the auditor may develop a range to evaluate the reasonableness of the accounting estimate. The auditor’s considerations in determining a range are described in the objectives.

Recognition and Measurement Criteria

The criteria are that auditors should follow when evaluating accounting estimates in the financial statements. Accounting estimates are used when the information needed to complete a financial statement is not available, and they involve significant judgment by management. Therefore, auditors need to obtain sufficient evidence to ensure that management’s decisions on whether to recognize or not recognize accounting estimates are in accordance with the applicable financial reporting framework.

The focus of the auditor’s evaluation depends on whether an accounting estimate has been recognized or not. If management has recognized an accounting estimate in the financial statements, the auditor’s evaluation is focused on whether the measurement of the accounting estimate is reliable enough to meet the recognition criteria of the applicable financial reporting framework. On the other hand, if an accounting estimate has not been recognized, the auditor’s evaluation is focused on whether the recognition criteria of the applicable financial reporting framework have been met. In some cases, even if an accounting estimate has not been recognized, there may be a need for disclosure of the circumstances in the notes to the financial statements.

Regarding the selected measurement basis for accounting estimates, it notes that for fair value accounting estimates, some financial reporting frameworks assume that fair value can be measured reliably. However, in some cases, this presumption may be challenged if there is no appropriate method or basis for measurement. In such cases, the auditor’s evaluation is focused on whether management’s basis for overcoming the presumption relating to the use of fair value set forth under the applicable financial reporting framework is appropriate.

Evaluating the Reasonableness of the Accounting Estimates, and Determining Misstatements

The auditor’s responsibility to evaluate the reasonableness of the accounting estimates in the financial statements and to determine if any misstatements exist. The auditor must evaluate the accounting estimates based on audit evidence to determine whether they are reasonable in the context of the applicable financial reporting framework or if they are misstated.

The audit evidence obtained; the auditor may conclude that the evidence points to an accounting estimate that differs from management’s point estimate. In this case, the difference between the auditor’s point estimate and management’s point estimate constitutes a misstatement. If the auditor has concluded that using the auditor’s range provides sufficient appropriate audit evidence, a management point estimate that lies outside the auditor’s range would not be supported by audit evidence. In such cases, the misstatement is no less than the difference between management’s point estimate and the nearest point of the auditor’s range.

SA 540 also states that if management has changed an accounting estimate or the method of making it, the auditor may regard it as an indicator of possible management bias, or may conclude that the accounting estimate is misstated as a result of an arbitrary change by management.

In addition, the guidance in SA 450 is provided to help auditors distinguish misstatements for purposes of evaluating the effect of uncorrected misstatements on the financial statements. A misstatement may arise as a result of factual misstatements, judgmental misstatements, or projected misstatements. Sometimes, a misstatement could arise as a result of a combination of these circumstances, making separate identification difficult or impossible.

Finally, SA 540 notes that evaluating the reasonableness of accounting estimates and related disclosures included in the notes to the financial statements involves essentially the same types of considerations applied when auditing an accounting estimate recognized in the financial statements.

Disclosures Related to Accounting Estimates

The auditor’s responsibility to obtain sufficient and appropriate evidence to ensure that disclosures related to accounting estimates in the financial statements are in accordance with the applicable financial reporting framework. The auditor must evaluate the adequacy of disclosures related to accounting estimates, including the assumptions used, method of estimation, basis for selection of the method, effect of changes in the method, and sources and implications of estimation uncertainty. The auditor must also ensure that specific disclosures required by the applicable financial reporting framework are made, such as disclosures of key sources of estimation uncertainty or critical accounting estimates, the range of possible outcomes, and the significance of fair value accounting estimates to the entity’s financial position and performance.

For accounting estimates that give rise to significant risks, the auditor must evaluate the adequacy of the disclosure of their estimation uncertainty in the financial statements in the context of the applicable financial reporting framework. The auditor’s evaluation of the adequacy of disclosure of estimation uncertainty increases in importance the greater the range of possible outcomes of the accounting estimate is in relation to materiality. In some cases, the auditor may consider it appropriate to encourage management to provide additional information about the circumstances relating to the estimation uncertainty. SA 705 provides guidance on the implications for the auditor’s report when the auditor believes that management’s disclosure of estimation uncertainty in the financial statements is inadequate or misleading.

Indicators of Possible Management Bias

The responsibility of the auditor to review the judgments and decisions made by management in making accounting estimates to identify whether there are any indicators of possible management bias. Indicators of possible bias may include a consistent overstatement or understatement of estimates, failure to revise estimates when new information becomes available, and selecting assumptions that are at the most extreme end of the range of possible outcomes. However, it’s important to note that these indicators do not themselves constitute misstatements for the purposes of drawing conclusions on the reasonableness of individual accounting estimates.

Additionally, the SA 54 emphasizes that for accounting estimates that give rise to significant risks, the auditor should evaluate the adequacy of the disclosure of estimation uncertainty in the financial statements in the context of the applicable financial reporting framework. In some cases, the auditor may conclude that the disclosure of estimation uncertainty is inadequate in light of the circumstances and facts involved, even if the disclosure is in accordance with the applicable financial reporting framework. The auditor may encourage management to provide more information on the circumstances relating to the estimation uncertainty in the notes to the financial statements. SA 705 provides guidance on the implications for the auditor’s report when the auditor believes that management’s disclosure of estimation uncertainty in the financial statements is inadequate or misleading.

Written Representations

The auditing standard outlines the requirement for auditors to obtain written representations from management and those charged with governance regarding the reasonableness of significant assumptions used in making accounting estimates. The purpose of this requirement is to obtain additional evidence to support the auditor’s assessment of the reasonableness of accounting estimates.

The written representations may include representations about the appropriateness of measurement processes, consistency in application, management’s intent and ability to carry out specific courses of action, completeness and appropriateness of disclosures, and the absence of subsequent events requiring adjustment to the accounting estimates.

For accounting estimates that are not recognised or disclosed in the financial statements, the written representations may also include representations about the appropriateness of the basis used by management for determining that the recognition or disclosure criteria of the applicable financial reporting framework have not been met and the appropriateness of the basis used to overcome the presumption relating to the use of fair value set forth under the entity’s applicable financial reporting framework.

Documentation

The audit documentation should include the basis for the auditor’s conclusion on the reasonableness of accounting estimates, and their disclosure that give rise to significant risks, as well as indicators of possible management bias, if any. The purpose of documenting indicators of possible management bias is to assist the auditor in concluding whether their risk assessment and responses remain appropriate, and to evaluate whether the financial statements are free from material misstatement.

The examples of possible indicators of management bias mentioned in paragraph A125 include:

  • Selection of assumptions or inputs that are not supported by objective evidence or are inconsistent with industry practice;
  • Selecting assumptions or inputs that are biased;
  • A history of selecting assumptions or inputs that are biased;
  • A lack of willingness to provide the auditor with information relevant to the assumptions or inputs used in accounting estimates;
  • Inadequate documentation of the methods, data and assumptions used in developing accounting estimates;
  • Management’s refusal to consider alternative accounting estimates or assumptions proposed by the auditor;
  • Management’s use of an inappropriate framework for developing accounting estimates;
  • A lack of consultation with external experts when developing accounting estimates;
  • Significant changes in assumptions or inputs used in accounting estimates without adequate explanation or justification.

Overall, documentation of these indicators of management bias helps the auditor to assess the reliability and objectivity of the accounting estimates in the financial statements.

Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures

The recent change made to ISA 540 (International Standard on Auditing) regarding the application of the standard to public sector entities. The Application Section of ISA 540 previously included specific guidance on the application of the standard to the audits of public sector entities regarding significant holdings of specialized assets for which there are no readily available and reliable sources of information for purposes of measurement at fair value or other current value bases, or a combination of both.

However, SA 540 states that the Standards issued by the Auditing and Assurance Standards Board apply equally to all entities, irrespective of their form, nature, and size. As a result, the specific reference to the applicability of the standard to public sector entities has been deleted.

SA 540 also notes that even non-public sector entities may have significant holdings of specialized assets for which there are no readily available and reliable sources of information for purposes of measurement at fair value. Therefore, the part of ISA 540 that highlights the requirement of estimation at fair value in the case of specialized assets has been retained.

Fair Value Measurements and Disclosures Under Different Financial Reporting Frameworks

The fair value measurements and disclosures under different financial reporting frameworks. It explains that various financial reporting frameworks require or permit different fair value measurements and disclosures in financial statements, and they also differ in the level of guidance they provide on the basis for measuring assets and liabilities or the related disclosures.

Different financial reporting frameworks may also define fair value differently, and they may treat changes in fair value measurements that occur over time in different ways. The text explains that some financial reporting frameworks may require specific fair value measurements and disclosures in financial statements, while others may permit them at the option of an entity or only when certain criteria have been met.

SA 540 also discusses how financial reporting frameworks may presume that fair value can be measured reliably for assets or liabilities as a prerequisite to either requiring or permitting fair value measurements or disclosures. However, if an asset or liability does not have a quoted market price in an active market, and other methods of estimating fair value are clearly inappropriate or unworkable, this presumption may be overcome.

In most financial reporting frameworks, the concept of fair value measurements assumes that the entity is a going concern without any intention or need to liquidate, curtail materially the scale of its operations, or undertake a transaction on adverse terms. However, general economic conditions or economic conditions specific to certain industries may cause illiquidity in the marketplace and require fair values to be predicated upon depressed prices.

Overall, SA 540 highlights the importance of understanding the specific fair value measurements and disclosures required or permitted by a particular financial reporting framework, as well as any guidance provided by the framework for determining fair value and accounting for changes in fair value over time.

Quiz: Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures

1. What are accounting estimates according to SA 540?

a) Precisely measured financial statement items

b) Estimated financial statement items

c) Determined financial statement items

d) Calculated financial statement items

Answer: b)

2. Which factor affects the degree of estimation uncertainty associated with accounting estimates?

a) Management bias

b) Financial reporting framework

c) Availability of reliable data

d) Internal control procedures

Answer: c)

3. What is the responsibility of auditors regarding management bias in accounting estimates?

a) Ignoring management bias

b) Assessing risks of material misstatement associated with management bias

c) Supporting management bias

d) Outsourcing the assessment of management bias

Answer: b)

4. When should auditors review the accounting estimates included in the prior period financial statements?

a) Only if the current period accounting estimates are uncertain

b) When there are changes in the financial reporting framework

c) During the risk assessment procedures

d) For the purpose of identifying and assessing risks of material misstatement

Answer: d)

5. How should auditors respond to the assessed risks of material misstatement in accounting estimates?

a) Rejecting management’s accounting estimates

b) Reviewing subsequent events and recalculating the accounting estimates

c) Developing their own accounting estimates

d) Ignoring the risks and relying solely on management’s judgment

Answer: b)

6. What should auditors evaluate regarding management’s assessment of the effect of estimation uncertainty on accounting estimates?

a) Compliance with applicable financial reporting framework

b) The use of sensitivity analysis in the estimation process

c) The adequacy of related disclosures

d) The expertise of management in making accounting estimates

Answer: c)

7. How should auditors evaluate significant assumptions used by management in accounting estimates?

a) Engage an external specialist to assess the assumptions

b) Review written plans and documentation provided by management

c) Rely solely on management’s judgment and expertise

d) Evaluate the consistency of assumptions with industry benchmarks

Answer: b)

8. When may auditors develop a range to evaluate the reasonableness of an accounting estimate?

a) When the accounting estimate has been recognized in the financial statements

b) When management’s process for determining accounting estimates is effective

c) When management has not adequately addressed estimation uncertainty

d) When the auditors’ point estimate differs from management’s point estimate

Answer: c)

9. What should auditors evaluate when determining the reasonableness of accounting estimates in the financial statements?

a) Compliance with recognition criteria of the applicable financial reporting framework

b) Factual misstatements associated with the accounting estimates

c) Management’s intent and ability to carry out specific courses of action

d) The accuracy of assumptions used in making the accounting estimates

Answer: a)

10. What is the auditor’s responsibility regarding disclosures related to accounting estimates?

a) Ensuring that all possible outcomes are disclosed in the financial statements

b) Encouraging management to provide additional information about estimation uncertainty

c) Reviewing subsequent events to assess the accuracy of disclosures

d) Determining the appropriateness of the measurement basis for accounting estimates

Answer: b)

Additional question:

11. Which factor may indicate the presence of possible management bias in accounting estimates?

a) Reliability of data used in the estimates

b) Availability of external sources for reference

c) Contradictory events that arise after the financial statements are finalized

d) Compliance with the applicable financial reporting framework

Answer: c)

12. What is the auditor’s responsibility when assessing risks of material misstatement associated with accounting estimates with high estimation uncertainty?

a) Conducting an in-depth review of the entity’s controls and control activities

b) Seeking external expert validation of the accounting estimates

c) Evaluating the effectiveness of management’s processes for making accounting estimates

d) Recalculating the accounting estimates using the auditor’s own assumptions

Answer: c)

13. When should the auditor use a range instead of a point estimate to evaluate management’s accounting estimate?

a) When the accounting estimate is based on routine data processing

b) When the entity’s controls over accounting estimates are well designed and properly implemented

c) When the accounting estimate is derived from recognized measurement techniques

d) When the auditor concludes that a range would encompass all reasonable outcomes

Answer: d)

14. How does the auditor evaluate the reasonableness of management’s assumptions underlying fair value accounting estimates?

a) By comparing the assumptions to industry benchmarks

b) By reviewing written plans and documentation provided by management

c) By engaging an external specialist to assess the assumptions

d) By relying solely on management’s judgment and expertise

Answer: b)

15. What does the auditor consider when deciding the appropriate response to the risks of material misstatement associated with accounting estimates?

a) The size of the accounting estimate recognized in the financial statements

b) The availability of reliable data to support the accounting estimate

c) The nature of the accounting estimate and its estimation uncertainty

d) The level of management bias identified in the accounting estimate

Answer: c)

16. What is the auditor’s responsibility regarding indicators of possible management bias in accounting estimates?

a) Correcting the misstatements resulting from management bias

b) Identifying indicators of possible bias and assessing their impact on the accounting estimates

c) Ignoring indicators of management bias if the financial statements are materially accurate

d) Relying solely on management’s expertise in making accounting estimates

Answer: b)

17. When should auditors consider encouraging management to provide additional information about estimation uncertainty?

a) When the accounting estimates have high estimation uncertainty

b) When the financial statements are already adequately disclosed

c) When the auditors have a significant difference in opinion with management on the estimates

d) When the applicable financial reporting framework requires additional disclosures

Answer: a)

18. How should auditors assess the reliability and objectivity of accounting estimates?

a) By relying on management’s representation of their reasonableness

b) By conducting an independent assessment of the accounting estimates

c) By reviewing external expert opinions on the estimates

d) By evaluating the process and documentation used by management in making the estimates

Answer: d)

19. What is the purpose of obtaining written representations from management regarding accounting estimates?

a) To hold management accountable for the accuracy of the estimates

b) To provide additional evidence supporting the auditor’s assessment of the reasonableness of the estimates

c) To shift responsibility for the estimates from management to the auditor

d) To satisfy regulatory requirements for audit documentation

Answer: b)

20. What is the auditor’s responsibility regarding misstatements arising from accounting estimates?

a) To correct all misstatements identified, regardless of their materiality

b) To determine if misstatements exist and assess their impact on the financial statements

c) To rely solely on management’s judgment in assessing the impact of misstatements

d) To report all misstatements to the entity’s governing body for further action

Answer: b)

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