The AICPA’s Auditing Standards Board (ASB) announced it will propose revisions to audit standards for accounting estimates. Financial statements contain estimates that are difficult to measure and verify and do so increasingly, which is why the ASB wants to improve the standards.
Continue reading for helpful information on how and when estimates are used in financial reporting, and why the ASB is revising its standards.
What Are Accounting Estimates, Exactly?
Accounting estimates are approximations of amounts to be debited or credited on items when there are no other precise measurements available. These may be based on subjective information, objective information or both, and their measurements may be uncertain. Though many estimates are inherently subjective or complex, some may be easily determinable.
Accounting estimates vary in type. Examples include allowances for doubtful accounts and long-lived assets impairments. Another type of accounting estimate is fair value measurement; this type represents “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” under U.S. generally accepted accounting principles (GAAP). These may be more susceptible to misstatement, so they are subject to a high degree of subjectivity and judgment and therefore require more auditor focus.
When Auditing Your Estimates
Auditing standards provide three primary approaches for substantively testing accounting estimates and fair value measurements. The auditor selects one or a combination of these approaches when performing an audit:
- Testing management’s process. Auditors evaluate the reasonableness and consistency of management’s assumptions, as well as testing whether the underlying data is complete, accurate and relevant.
- Developing an independent estimate. Using management’s assumptions (or alternative assumptions), auditors come up with an estimate to compare with what’s reported on the internally prepared financial statements.
- Reviewing subsequent events or transactions. The estimates’ reasonableness can be gauged by looking at events or transactions that happen after the balance sheet date, but before the auditor’s report date.
On Updating the Standards
To help auditors better address increasingly complex financials, the AICPA wants to improve the standards on auditing accounting estimates. This involves addressing issues such as factors driving estimate uncertainty and potential management bias. Company management has an incentive to record estimates — to better their books — and inspection findings have shown that this is an area needing improvement.
The ASB’s proposal would supersede Statement on Auditing Standards (SAS) No. 122, Clarification and Recodification: AU-C Section 540, “Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures.” The proposal would seek to enhance risk assessment procedures, shifting them from difficult to relatively simple estimates.
“The proposed SAS is intended to address the challenges auditors face when auditing accounting estimates by providing risk assessment requirements that are more specific to estimates, and that address the increasingly complex business environment and complexity in financial reporting frameworks,” states a draft version of the proposal. “The proposed SAS focuses on how complexity, subjectivity and estimation uncertainty are taken into account when identifying and assessing risks of material misstatement.”
The ASB’s effort to revise the estimates auditing standards is part of a broader strategy to merge its standards with guidance published by the International Auditing and Assurance Standards Board (IAASB). The IAASB finalized new auditing standards last year that address the auditor’s responsibilities during financial statements auditing of accounting estimates.
Keeping an Eye on Estimates
The AICPA’s Enhancing Audit Quality Initiative identified accounting estimates as a focus area in 2019. In fact, lack of consistency in this area is the most common audit issue detected by worldwide practice monitoring programs. As well as reducing errors and restatements, the revised auditing standards strives to bring consistency and clarity to this complex financial reporting aspect.
A Closer Look: Using Specialists to Make Estimates
To help them make subjective estimates under GAAP, auditors and managers often call on specialists. Examples of specialists who prepare public company financial information include:
- Actuaries to determine employee benefit obligations
- Engineers to determine environmental remediation obligations
- Appraisers to determine intangible assets or real estate values
- Geologists to estimate mineral deposits or oil reserves for mining and energy companies
- Lawyers to forecast the potential losses from a legal proceeding
The Securities and Exchange Commission (SEC) approved a revised standard in July that aims to better reflect how an auditor may utilize these specialists. The requirements for evaluating the company specialist’s work will also be stronger. This standard goes into effect for public company financial statement audits of fiscal years ending on or after December 15, 2020.
For questions about these proposed revisions to audit standards on accounting estimates, contact us; we can help explain how and when estimates are used in financial reporting, and why the AICOA is revising its standards.
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