An accounting estimate is defined in ISA 540 Audit of Accounting Estimates as ‘anapproximation ofthe amount of an item in the absence of a precise means of measurement’.
Estimates include amounts for accumulated depreciation, deferred tax; write downs to net realizable value, losses on long term contracts, legal claims against the company, other contingent liabilities and other areas which a significant element of judgment is required.
Such items are inherently more risky than non-judgmental items and control risk is usually higher as these are non-routine transactions. Management is responsible for making estimates.
The audit of accounting estimates under ISA 540 involves the following three steps:
- Review and testing of the process used by management to develop the estimate
This will involve evaluation of the data and consideration of assumptions on which the estimate is based. Management’s estimates as to warranty costs, for example should be based on past experience as to the level of claims and be in based. Management’s estimates as to warranty costs, for example should be based on past experience as to the level of claims and be in line with the auditor’s knowledge of the business. It will also involve checking of the mechanical calculations, comparison with estimates made in prior periods and consideration of management’s approval procedures.
- Use an independent estimate (generated by the auditor) to compare with management’s estimate
- Review subsequent events which confirm the estimate
Where in the case of contingent liabilities, subsequent events ‘crystallize’ the liability there will be no need to review management’s processes or use independent estimates.
The auditor will normally test the calculations of the estimate, asses the assumptions made (e.g. the court is 90% likely to find in our favour) compare estimates with those made in previous periods and ensure that the estimate is in accordance with the auditor’s knowledge of the business and the other audit evidence obtained.