The syllabus and study guide for Advanced Audit and Assurance (AAA) includes section G1a on professional and ethical developments which requires candidates to ‘discuss emerging ethical issues and evaluate the potential impact on the profession, firms and auditors’ and G1b ‘Discuss the content and impact of exposure drafts, consultations and other pronouncements issued by IFAC and its supporting bodies.’ This article is intended to provide insight into recent proposed changes to ISA 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures. The article is relevant to all versions of the AAA exam.
In April 2017, following outreach activities with regulators and other key stakeholders, the IAASB issued Proposed International Standard on Auditing 540 (Revised) Auditing Accounting Estimates and Related Disclosures (ED 540). The IAASB commenced a project in early 2015 to address issues relevant to the audits of financial institutions as well as to ISA 540 more generally. The project indicated that regulators and auditors of financial institutions believed that the IAASB needed to focus on the issues for audits of financial institutions arising from IFRS® 9 Financial Instruments prior to the effective date for the implementation of the standard for annual periods commencing on or after 1 January 2018.
The main catalyst for the revisions proposed by ED 540 therefore was the development and implementation of IFRS 9 Financial Instruments and the introduction of its expected losses model for assessing the impairment of financial assets. The expected losses model fundamentally changes the way that reporting entities will account for their loan assets and other credit exposures. The model involves a complex and subjective estimation process which presents a particular challenge to auditors in terms of developing a robust approach to appraising management’s prospective assessment of the credit risks associated with an entity’s portfolio of financial assets.
Feedback from the IAASB’s outreach projects also revealed a perceived lack of consistency in the extent to which auditors obtained an understanding of accounting estimates together with evidence of insufficient and inappropriate work effort by auditors in this area. The consultation process identified:
After consulting with key stakeholders, the IAASB therefore concluded that many of the issues identified with respect to IFRS 9’s expected credit losses model were also equally relevant when auditing other complex accounting estimates. As a result the IAASB concluded that a full revision of ISA 540 was required as a matter of priority. ED 540 proposes that the revised standard will apply to the audit of all accounting estimates and to all audits regardless of the size or status of the reporting entity.
The objective of ED 540 is to enable the auditor to obtain sufficient and appropriate audit evidence in order to evaluate whether accounting estimates and their related disclosures are reasonable in the context of the applicable financial reporting framework or whether they are misstated. ED 540 includes enhanced requirements for risk assessment procedures and the work effort required of the auditor in responding to the assessed risks of material misstatement.
Although it was IFRS 9 which triggered the need for change, the IAASB has sought to make ED 540 scalable and the revised standard will apply to all accounting estimates from the simplest depreciation calculation through to the most complex of derivative financial instruments and expected credit losses. While the simpler accounting estimates will not generally give rise to high audit risk, many measurements based on estimates, including fair value measurements and impairments in relation to financial instruments, are imprecise and subjective in nature and will give rise to high inherent risk. Such fair value and impairment assessments are likely to involve significant, complex judgements for example regarding market conditions, the timing of cash flows and the future intentions of the entity. The valuations will often involve complex models built on significant assumptions such as the predicted timing of cash flows, the most appropriate discount factor to use and judgements about probability weighted averages. Management may not always have sufficient knowledge and experience in making these judgements. Moreover, there may even be a deliberate attempt by management to manipulate the value of an estimate in order to window dress the financial statements. The IAASB recognises the central role that professional scepticism plays in the audit of accounting estimates and ED 540 contains key provisions which are designed to enhance the auditor’s application of professional scepticism and a consideration of the potential for management bias. The key provisions include the following:
The proposed approach requires the auditor to assess the inherent risk attached to accounting estimates as either low risk or not low risk.
When inherent risk is assessed as low, the auditor will follow a similar approach to that previously required by ISA 540. Here the auditor will determine whether one or more of the following further audit procedures would provide sufficient and appropriate audit evidence regarding the assessed risk of material misstatement:
When inherent risk is not low, ED 540 will require a more rigorous risk assessment. ED 540 states that an increased work effort is required in order to determine how three key factors have impacted on a specific accounting estimate. The three factors which the auditor must specifically consider are as follows:
Complexity in relation to accounting estimates can arise from both the estimation method used and the underlying data on which the estimate is based. Given the increased emphasis on the use of external sources in IFRS 13 Fair Value Measurement and in making accounting estimates such as fair values, ED 540 aims to improve and clarify the requirements on the use of such information as it is in the public interest to do so.
Where the reasons for an increased risk of material misstatement is due to management’s use of a complex method (including complex modelling) or the use of specialised skills and knowledge, ED 540 requires the auditor to obtain sufficient appropriate evidence in relation to a series of specific matters including:
(ii) Need for management judgement:
Where accounting estimates rely upon significant management judgement, the risk of material misstatement is increased due to intentional or unintentional management bias. When the risk of material misstatement relates directly to the use of management judgement (including the judgement used in management’s application of complex modelling), ED 540 gives detailed guidance on a series of specific matters on which the auditor must obtain sufficient appropriate audit evidence. These matters include whether management’s judgements and assumptions are in compliance with the measurement requirements of the applicable financial reporting framework; whether significant assumptions are consistent with those used in other areas of the entity’s business activities including any other accounting estimates; and whether management’s judgements about changes from previous periods are appropriate.
(iii) Estimation uncertainty:
ED 540 emphasises the need to understand and address estimation uncertainty and the impact that this has on the auditor’s evaluation of the reasonableness of management’s estimates and related disclosures. As with the previous two factors, ED 540 again contains requirements for the auditor to obtain sufficient appropriate audit evidence by addressing key matters in the context of the applicable financial reporting framework. These key matters include whether management has taken the necessary steps in order to understand the source of the estimation uncertainty and whether its estimates and disclosures in this regard are reasonable. Where the auditor concludes that management has not taken adequate steps, ED 540 requires the auditor to develop their own estimates to be based on data which is supported by the audit evidence and which complies with the applicable financial reporting framework.
ED 540 highlights a number of other matters which should be considered in the audit of accounting estimates and related disclosures. These other matters include the following:
The IAASB has noted the increasing importance of the role of disclosures in financial reporting and particularly in relation to accounting estimates. The IAASB believes that disclosures relating to accounting estimates are critical to users’ understanding of the accounting policies applied, the nature and extent of estimation uncertainty and the key judgements made by management. ED 540 therefore requires the auditor to obtain sufficient appropriate audit evidence about whether the disclosures relating to accounting estimates are reasonable in the context of the applicable financial reporting framework. In the context of a compliance based framework, the auditor must ensure that sufficient appropriate audit evidence has been obtained to confirm that the disclosures included are those necessary for the financial statements not to be misleading. In the case of a framework based on fair presentation principles, the auditor must obtain sufficient appropriate audit evidence that management has provided the additional disclosures beyond those specifically required by the framework that are necessary in order to achieve the fair presentation of the financial statements as a whole.
The IAASB recognises the importance of a two-way dialogue between the auditor and those charged with governance (TCWG). ED 540 therefore includes a new requirement to place more emphasis on communications with TCWG in relation to the auditor’s views about accounting estimates. ISA 260 (Revised) Communication with Those Charged with Governance and ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and Management already require the auditor to communicate with TCWG about significant qualitative aspects of the reporting entity’s accounting practices and significant deficiencies in internal controls. ED 540 additionally requires the auditor to communicate whether the accounting estimates and their related disclosures are impacted by the key factors identified by the standard including complexity, the need for management judgement and estimation uncertainty.
The documentation requirements of ISA 230 Audit Documentation already apply to many of the auditor’s judgements but ED 540 also includes additional application material which highlights aspects of the auditor’s work on accounting estimates and related disclosures which would be likely to give rise to judgements which would require documentation under ISA 230. ED 540 also extends the existing documentation requirements of ISA 540 to include documentation of indicators of management bias where applicable and the auditor’s evaluation of any such bias in forming his opinion on the financial statements as a whole.
Overall there has been much support for the IAASB’s objectives in revising ISA 540. Respondents to ED 540 have been generally supportive of its additional focus on the role of professional scepticism in the audit of accounting estimates and related disclosures and have been sympathetic to the need to finalise the standard quickly given the implementation of IFRS 9 for annual periods commencing on or after 1 January 2018. Some commentators have, however, expressed concerns about the clarity and operability of the proposed standard and have questioned whether its approach is over-complicated in relation to simple accounting estimates. Some have maintained, for example, that more guidance is needed on how to distinguish between ‘low inherent risk’ and ‘non-low inherent risk’ and have asked for greater development of ED 540’s scalability concept through the inclusion of further examples in the application material. Respondents have also commented more generally on a perceived lack of specificity in the audit procedures to be performed and have requested more guidance from the IAASB on how to test valuation models and the internal controls which management have utilised in developing their accounting estimates.
At the time of writing, the IAASB is in the process of completing its deliberations in response to the feedback received before finalising its revision of ISA 540 on a timely basis for the audit of financial statements prepared under IFRS 9.
Written by a member of the Advanced Audit and Assurance examining team