SA 540 Accounting Estimates

An accounting estimate is defined as an approximation of the amount of an item in the absence of a precise means of measurement. There are various items in the Financial Statements that cannot be measured with precision and therefore are required to be estimated. SA 540 describes the auditor’s responsibility with respect to the auditing of accounting estimates and related disclosures made by the management. Read on to know more about SA 540 with respect to the objective of the auditor, procedure to be followed, analysis to be done, approach to be used while auditing accounting estimates with the help of two case studies.

An estimate is made when there is an absence of a precise means to measure. This applies in accounting parlance as well, whereby certain items of financial statements cannot be measured with precision and are therefore required to be estimated based on reliable information and justifiable assumptions available at a point in time.

An accounting estimate is defined as an approximation of the amount of an item in the absence of a precise means of measurement. An illustrative list of financial statement captions where estimates are used is summarised below:

SA 540 describes the auditor’s responsibility with respect to the auditing of accounting estimates, including fair value accounting estimates, and related disclosures made by the management, wherein the objective of the auditor is to obtain sufficient appropriate audit evidence as to whether in the context of the applicable financial reporting framework:

a) accounting estimates, including fair value accounting estimates, in the financial statements, whether recognised or disclosed, are reasonable; and

b) related disclosures in the financial statements are adequate.

In order to evaluate the reasonableness of recognition of accounting estimates, the auditor shall:

a) obtain an understanding of how management identifies those transactions, events and conditions that may give rise to the need for accounting estimates to be recognised or disclosed in the financial statements and

b) understand how the estimates have been made and what data and assumptions have been used to make such estimates

The understanding so obtained will enable the auditor to assess:

a) for recurring estimates, the historical reliability of the entity’s estimates and the appropriateness of changes, if any, in the existing accounting estimates or in the method or assumptions for making them from the prior period;

b) the completeness and accuracy of key data used in making the estimate;

c) evaluation of management’s use of an expert;

d) the reasonableness of management’s significant assumptions, including any indication of management bias and, where relevant, management’s intent to carry out specific courses of action and its ability to do so;

e)    the reasonableness of management’s estimate, including whether the selected measurement basis for the accounting estimate and management’s decision to recognise or not recognise the estimate is in accordance with the require-ments of the applicable financial reporting framework;
f)    subsequent events or other subsequent information, if any, that may affect the estimate;
g)    the consistency of application of judgments or estimates to similar transactions;
h)    business or industry specific factors that may have significant effect on the assumptions

For accounting estimates that give rise to significant risks at the financial statement assertion level, the auditor needs to evaluate how management has considered alternative assumptions and their outcomes on accounting estimates and reasons for their rejection/acceptance. Such examples include estimates pertaining to useful life of tangible assets particularly for entities operating in specialised sectors such as aviation, oil exploration, power generation, infrastructure etc, estimate of useful life of intangible assets such as toll collection rights purchased by a toll operating company, cash flows from a cash generating unit for the purpose of impairment testing, allowances for doubtful debts, inventory obsolescence in technology driven industries, etc.

Sensitivity analysis is one of the methods that can be used to evaluate how an accounting estimate varies with different assumptions. The objective of this evaluation is to obtain sufficient appropriate audit evidence to ensure that management has assessed the effect of estimation uncertainty on accounting estimates. Where management has not considered alternative assumptions or outcomes, the auditor would need to discuss with the man-agement as to how it has addressed the effects of estimation uncertainty and where empirical external evidence is available, evaluate the appropriateness of the estimate considered by the management.

Once the auditor understands the process, there are generally two approaches that the auditor can use:
a)    test the process used by management to make the estimate, including testing the reliability of the underlying data, or alternatively
b)    develop an independent expectation of the estimate and compare this with the estimate developed by the management.

The choice between these two approaches will depend on the magnitude and complexity of the account balance. An example of the latter ap-proach is the comparison of provision for warranty costs with the estimates made by the management in recent past to determine its reasonableness.

While assessing the methods and assumptions used, the auditor may also need to consider whether management has engaged an expert having specialised knowledge or skills in determining an accounting estimate. Actuarial valuation of employee benefits by an actuary, surveyor’s estimation of the quantum of inventory in certain specialised industries using items such as coal, natural gypsum etc., certification of completion of project work by project engineers to facilitate revenue recognition in construction contracts are some of the elementary examples of involvement of an expert to determine an accounting estimate. The auditor would need to review the appropriateness of estimates made by the expert. For e.g., in case of actuarial valuation of retirement benefits, the auditor would need to evaluate the appropriateness of the estimate of discount rate by reviewing economic reports for interest rates, estimate of salary growth and attrition by reviewing industry reports, estimate of mortality by reviewing annuity/life tables used by insurance companies etc. Similarly for estimation of inventory by surveyors, the auditor would need to assess the estimation methodology used by the surveyor, quantum of inventory holding vis-à-vis consumption pattern, subsequent production of finished goods and other related factors to obtain assurance over the appropriateness of the inventory estimated by the surveyor.

Another pertinent area where estimates are used is for impairment testing for fixed assets. Asset impairment is based either on appraisal of current market value of the asset or based on estimated cash flows from the continuing use of such asset for its remaining useful life. Estimates of future cash flows provided by the management need to be analysed for the reasonableness of the assumptions and consistency with current and predicted future results.

Management may be satisfied that it has adequately addressed the effects of estimation uncertainty in accounting estimates that give rise to significant risks in the preparation of financial statements, however, the auditor may consider this to be inadequate due to non- availability of sufficient appropriate audit evidence or where the auditor believes there exists an indication of management bias in making the estimates. The auditor in such a case may evaluate the reasonableness of the accounting estimate by developing a point estimate or a range. This can be understood with the help of the following example:

Case study 1 (Accounting estimates):

XYZ Ltd (‘XYZ’) is a reputed watch manufacturer and has been in this business for the last 5 years. XYZ commenced its operations during the year ended 31st March 20X0. XYZ formulated a policy of providing free repairs to its customers for a period of 1 year from the date of sale. The sale contract gives the customer, a right to have the watches repaired free of cost for defects that get contracted within a period of one year from the date of purchase of the product. Since inception, XYZ has been providing for warranty costs @ 3% of the value of watches sold during the year.

During the year ended 31st March 20X6, XYZ upgraded its quality testing equipment enabling introduction of certain additional quality checks in the manufacturing process. Management expects that these additional checks would result in more stringent quality clearance of finished products for ultimate sale to customers. Therefore for the year ended 31st March 20X6, management decided to provide for warranty costs at a lower rate of 1% of the value of sales made during the year.

Let us examine the procedures that auditors would need to follow in terms of the requirements of SA 540:

Though the accounting framework does not prescribe a method or model to provide or compute warranty provision, management is required to make a best estimate of the warranty cost based on cumulative experience of the industry, customer base and the likely cost of repairs.

Auditors would need to review the outcome of accounting estimates included in the prior period financial statements and their subsequent re-estimation for the purpose of the current period. Auditors would need to perform a subsequent period testing to deduce actual costs incurred against the provision and effectiveness of controls on accounting of such costs.

Auditors would need to review the trend of actual repair costs incurred over the years and evaluate whether the basis of measurement (as a percentage of sales) needs modification.

Auditor would compare the nature of the earlier warranty claims and how the new machines would take care of these complaints to reduce the warranty costs.

Obtain written representations from management whether they believe significant assumptions used in making accounting estimates are reasonable.

Auditors would need to evaluate whether the management decision to change the estimate basis is indicative of a possible management bias.

Case study 2 (Fair value accounting estimate):

Double Dip Ltd. (DDL) has given 100 options to its employees to receive remuneration in the form of equity settled instruments, for rendering services over a defined vesting period of three years.

The options will vest in three tranches over a period of three years as follows:

Period within which options    % of options
will vest to the participant    that will vest

DDL measures options granted by reference to the fair value of the instrument at the date of grant. The expense is recognised in the statement of income with a corresponding increase to the share based payment reserve, a component of equity.

The fair value determined at the grant date is ex-pensed over the vesting period of the respective tranches of such grants. The stock compensation expense is determined based on DDL’s estimate of equity instruments that will eventually vest over a period of three years.

The key assumptions used to estimate the fair value of options are given below:

The options were granted on 31st December 20XX and DDL has recognized Rs. 10 crore as fair value cost of options granted.

Analysis

In the given example, the fair value of options as arrived by the management is an estimate and the same has been derived on the basis of various assumptions considered by the management.

The auditors of the Company would need to verify whether the fair value of the options as estimated by the management is reasonable. For this purpose, various assumptions considered by the management would need to be evaluated and assessed independently i.e., completeness and accuracy of data considered for arriving at business and industry specific factors like risk free interest rate etc.

The auditors would also need to consider estimation uncertainty i.e. possible effects of the various alternatives. In the given case, expected volatility is the factor wherein the auditor would need to assess various assumptions and data used to compute the volatility benchmark and what would be the possible effects on the expected volatility if there is a change in the underlying assumptions as well as the overall effect on the fair value of the options because of change in expected volatility.

The auditor needs to ensure that work done by management to mitigate the risk of estimation uncertainty is sufficient enough to support the appropriateness of the estimate. In the event where work done by management is inadequate, the appropriateness of the estimate would have to be assessed independently by the auditors, if required, through point of estimation or range. The auditor may obtain assurance on the expected volatility, based on an analysis of data of entities in similar industry having issued similar options.

Conclusion

An estimate can be significantly affected by management bias and estimation uncertainty. An estimate is a complex process of arriving to an answer where we do not have precise measure of calculating an item of provision. There are accounting estimates as well as as fair value estimates that requires thorough review by an auditor of the process and assumptions used by the management of arriving the same. As such, significant estimates require the exercise of signifi-cant judgment by the auditor and documentation of those judgments is critical to understanding how conclusions were reached. In some cases, even small changes in inputs can result in large changes in value. Hence, an estimate is an estimate; it is not a precise answer.