Audit of Accounting Estimates: Procedures and Importance

Introduction: This article delves into the intricacies of auditing accounting estimates, focusing on the concept, procedures, and crucial importance in financial reporting. Defined as an approximation in the absence of precise measurement means, accounting estimates play a pivotal role in financial statements. This exploration encompasses their definition, understanding, and differentiation from accounting principles.

Accounting Estimates Defined: “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 where there is uncertainty, as well as for other amounts that require estimation. Where this SA addresses only accounting estimates involving measurement at fair value, the term  ‘fair value accounting estimates’ is used”. (As defined under SA 540)

Understanding Accounting Estimates: For entities of all size and nature, some or the other time management has to make accounting estimates. This happen particularly in a situation when monetary amounts in financial statements cannot be directly deduced. All Accounting estimates have some degree of estimation; this is due to uncertainties involved in quantification, this may be due to inherent limitations of management’s knowledge or due to nature of available data that give rise to inherent subjectivity and variation in the measurement outcomes. Along with being subjective, accounting estimates may also be complex. Thus accounting estimates have important implications over the financial statement audit, because the complexity, subjectivity or other inherent risk factors on the measurement of these monetary amounts makes them sensitive for misstatement. The accounting process often presents certain scenarios where an amount or item in the financial statements cannot be measured with precision. In financial reporting, when the amounts of assets, liabilities, income, or expenses for the period cannot be measured with precision, they are determined using accounting estimates. Accounting Estimate are estimated based on judgment and knowledge derived from experience, training and formal teaching. Estimation is involved in reporting certain elements of the financial statements – value of which cannot be determined using objective data.

Even though uncertainties and values are determined using historical estimates and approximations, they deserve to be a part of financial reporting. A prudent estimation will surely result into a transparent and reliable financial statement. The value of such element cannot be always fixed based of any specific data. They usually involve a lot of complexities & uncertainties and therefore expertise, skill and knowledge is required to determine the value, which will always be an approximation.

This also establishes the fact that there is some level of subjectivity in the process because the management and accountants require a very good level of skill, expertise and knowledge to make the assumption which can be acquired through experience, training and formal teaching. Sometimes there may be a considerable difference in values estimated by different persons. Management may derive value of an element of financial statement using certain assumptions which will completely different from value deduced by auditors.

Typically the notes on accounts contain the details of the basis or assumptions used in estimating elements of financial statements. ISA 540 (Revised), Auditing Accounting Estimates and Related Disclosures, deals with the auditor’s responsibilities relating to accounting estimates and related disclosures in an audit of financial statements. The auditor’s objective is to obtain sufficient, appropriate audit evidence about whether accounting estimates and related disclosures in the financial statements are reasonable in the context of the applicable financial reporting framework (AFRF).

Accounting Estimates V/s Accounting Principles:

These are two different financial concepts which are commonly used during preparation of financial statements. However, it is very much vital to distinguish between the two. Let us differentiate the same, as given below: 

Meaning: Accounting Estimate means an approximation of a value of Asset, Liability, Income or Expenditure for which a precise means of measurement is not available on the other hand Accounting Principles can be understood as Specific principles, bases, conventions, rules, and practices used by the management while preparing and presenting financial statements.

What is used in background: In accounting estimates, information related to historical data, opinions and knowledge of experts, etc are used for achieving useful results, whereas in case of the Accounting Principles, the guidelines are provided by various laws, Accounting Bodies and policymakers following which decisions are taken.

Subjectivity: Accounting Estimates are subjective in nature due to their dependence on expert knowledge, skill and experience, which also depends on the information available from various sources during a particular time. Accounting Principles are more objective in nature since rules and policies are fixed and in each Accounting Period  these should also be disclosed in notes to  financial statements.

Both of these are important and relevant in the world of finance and should be used to maintain Quality of financial reporting which is achieved by consistency, transparency and understandability of the financial condition of the business.

Concept of Audit of Accounting Estimates: Before going in detail we shall take a snapshot of audit procedure which should be adhered if any estimated figure is involved in financial statements. The primary objective of auditor is to gather “Sufficient and Appropriate Audit Evidence” in support of various assertions of the financial elements. To prepare financial statements is the primary responsibility of the management like any other figure, accounting estimate is also appear at the initiative of the management and not auditor. The auditor should obtain evidence as to a. That accounting estimate is reasonable as per the circumstances and b. that it has been appropriately disclosed. To disclose an estimate depends on various factors like legal requirement of disclosure, materiality of volume or nature, matching concept etc. Normally auditors apply following procedure while auditing accounting estimates:

• Review and test the process through which estimate are developed: including evaluation of date and evaluation of assumptions underlying the estimates; testing the calculations involved in the estimate; comparison of estimate and actual results of prior periods and evaluation of the approval procedure of the management.
• Comparison of the estimates developed by the management with estimates developed by auditors.
• Subsequent events (Events occurred after generation of estimates and up to submission of Audit Report) related with estimates must be reviewed.

Knowledge of client business and consistence of other audit evidences gathered with accounting estimates also plays vital role in the final assessment of reasonableness of an accounting estimate. If auditor is of the view that accounting estimates developed by the management are significantly different from the estimates assessed or developed by the auditor, he may request the management to carry out necessary changes. In case management refuses to revise it’s estimate it would be considered a misstatement and the auditor would need to consider it’s effect on the financial statement.

Conclusion:

In conclusion, the audit of accounting estimates is a critical aspect of financial reporting. The article underscores the importance of gathering evidence to ensure the reasonableness of estimates and appropriate disclosure. The procedures outlined guide auditors in evaluating the accuracy of estimates and addressing significant differences between management’s and auditors’ assessments. As a crucial element in financial statements, accounting estimates demand thorough scrutiny to maintain the quality and transparency of financial reporting.