Accounting estimates are an important part of financial reporting, as they are used to reflect the company’s management’s best judgment about uncertain events and conditions that may have a significant impact on the financial statements. Examples of accounting estimates include revenue recognition, asset impairment, and provisions for doubtful debts.
Accounting Treatment
Accounting estimates are subject to specific accounting standards and principles, such as International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP). These standards provide guidance on the recognition, measurement, and disclosure of accounting estimates in the financial statements.
When preparing accounting estimates, management must use a reasonable and consistent approach, and must make estimates that are based on available information and the best judgment of the company’s management. It is important to regularly review and update accounting estimates as necessary to reflect changes in circumstances or new information.
Audit Risks:
The following are ten audit risks associated with accounting estimates:
- Bias: Management may have a bias in estimating that is not in line with the company’s best interest, which could result in an incorrect estimate.
- Inadequate data: Management may not have access to sufficient or reliable data to make accurate estimates.
- Inadequate procedures: Management may not have established adequate procedures for estimating, or the procedures may not be consistently followed.
- Inadequate documentation: Management may not have adequately documented the estimates, making it difficult for the auditor to understand the basis for the estimate.
- Inadequate review: Management may not have adequately reviewed the estimates, which could result in incorrect estimates.
- Inconsistent application: Management may apply different estimating methods to similar transactions, which could result in inconsistent estimates.
- Change in estimates: The estimates may change due to changes in circumstances or new information, which could result in a material impact on the financial statements.
- Incorrect assumptions: Management may make incorrect assumptions when estimating, which could result in incorrect estimates.
- Subjectivity: Estimates may be subject to a significant degree of subjectivity, which could result in differing opinions about the appropriate estimate.
- Lack of internal control: The company may have a lack of internal control over the estimating process, which could result in incorrect estimates.
Audit Assertions
The following are audit assertions related to accounting estimates:
- Existence: The estimate exists and is recorded in the financial statements.
- Valuation and allocation: The estimate is recorded at the correct amount and is allocated to the correct account in the financial statements.
- Completeness: All estimates that should be recorded in the financial statements are recorded.
- Rights and obligations: The company has the right to the benefit or obligation associated with the estimate.
- Accuracy: The estimate is based on accurate information and reflects the best judgment of the company’s management.
- Cutoff: The estimate is recorded in the correct period in the financial statements.
- Classification: The estimate is recorded in the correct account in the financial statements.
- Understandability: The estimate is adequately disclosed in the financial statements so that it can be understood by a reader.
Walkthrough Testing:
Walkthrough testing is a key audit procedure used to understand the entity’s system of internal control and to identify any potential weaknesses in the system. During walkthrough testing, the auditor will review the flow of transactions and processes related to accounting estimates and observe how these processes are performed.
The auditor will also ask questions of key personnel involved in the process and examine relevant documentation to gain an understanding of the process. This allows the auditor to identify any potential areas of risk or control weaknesses that may affect the accuracy and reliability of the accounting estimates.
Test of Control:
Test of control is another important audit procedure that helps the auditor assess the effectiveness of the entity’s internal control over the accounting estimates process.
During this procedure, the auditor will test the entity’s control activities, such as authorizations, approvals, and documentation, to determine if they are operating effectively.
The auditor will also test the accuracy and completeness of the data that is being used to calculate the accounting estimates to ensure that it is accurate and complete.
This helps the auditor identify any control weaknesses that could lead to incorrect accounting estimates and provides valuable information to help improve the control environment.
Substantive Audit Procedures:
Substantive audit procedures are a critical component of the audit process and are performed to provide evidence to support the auditor’s conclusion about the accuracy and reliability of the accounting estimates.
These procedures are designed to test the entity’s financial records, transactions, and systems to identify any material misstatements or irregularities in the accounting estimates.
The substantive audit procedures performed will depend on the specific accounting estimate being audited and the auditor’s overall audit strategy. However, some common substantive audit procedures include:
- Test of transactions: This involves performing audit procedures to test the accuracy and completeness of the transactions used to calculate the accounting estimate. For example, this may involve performing substantive audit procedures on a sample of transactions related to expected credit losses to determine if the entity’s assumptions are accurate and the expected credit losses are calculated correctly.
- Comparison of actual results with expected results: This involves comparing actual results with the entity’s expectations or projections to determine if the entity’s assumptions are accurate. For example, this may involve comparing actual losses incurred with the entity’s estimated credit losses to determine if the assumptions used in the calculation of expected credit losses are accurate.
- Recalculation of estimates: This involves recalculating the accounting estimate to determine if the entity’s calculations are accurate. For example, this may involve recalculating the expected credit losses using the entity’s assumptions and methods to determine if the calculation is accurate.
- Review of third-party reports: This involves reviewing reports, such as credit reports, to validate the entity’s assumptions used in the calculation of expected credit losses. This helps the auditor determine if the entity’s assumptions are based on reliable and relevant information.
- Analytical procedures: This involves performing analytical procedures, such as trend analysis or ratio analysis, to identify any unusual or unexpected results in the accounting estimates. This helps the auditor identify any areas of potential risk or misstatement that may require further investigation.
- Confirmation of information: This involves obtaining independent verification of information used in the calculation of the accounting estimate. For example, this may involve obtaining confirmation of the expected credit losses from a third party to verify the entity’s assumptions.
The objective of substantive audit procedures is to obtain sufficient appropriate evidence to support the auditor’s conclusion about the accuracy and reliability of the accounting estimates.
The specific substantive audit procedures performed will depend on the auditor’s overall audit strategy, the nature of the accounting estimate, and the level of risk associated with the estimate.