How does an auditor check a figure estimated by management: auditing accounting estimates (ISA 540, revised) and three approaches

Most figures in financial statements come from documents: a bank statement, an invoice, a payroll sheet. But no document will tell you some figures. Will the customer pay its debt? How much repair will the products sold need during the warranty period? What will the old collection sitting in the warehouse sell for? Management answers these questions with an estimate. Such figures are called accounting estimates, and the procedure for checking them is set out in ISA 540 (ISA 540 (Revised) "Auditing Accounting Estimates and Related Disclosures").

In Uzbekistan international standards on auditing apply as the standards of auditing activity (Law "On Auditing Activity", ZRU-677, Article 9). The revised version of the standard was issued by the IAASB in 2018 and applies to audits of periods beginning on or after 15 December 2019.

Why is an estimated figure checked under a separate standard?

For an ordinary figure, comparing it with a document is enough. With an estimate, the "right answer" does not yet exist at the reporting date. That is why ISA 540 directs the auditor's attention not to the figure itself but to how it was arrived at: which method, which data and which assumptions were used.

In assessing risk the standard singles out three main inherent risk factors:

Factor	Meaning	How it shows up in tile trading
Estimation uncertainty	The outcome cannot be measured precisely	Nobody knows yet whether a construction firm will go bankrupt
Complexity	Complexity of the method or data	Hundreds of customers, each with a different payment history
Subjectivity	Reliance on judgment because knowledge or data are limited	The view that "this customer will pay half its debt"

The standard says there may also be other inherent risk factors and names two of them: change, and susceptibility to misstatement due to management bias or fraud. The stronger the factors, the deeper the auditor's work: the same standard is applied to small and large estimates on a different scale.

In which three ways does the auditor check?

"Bahor Kafel" LLC sells tiles to construction firms. At year end there are a lot of receivables; management estimated the allowance for doubtful debts at 45 000 000 soum and made the entry Dt 9430 – Ct 4910 (NAS No. 21, paragraph 221, line 1). Under paragraph 218 of NAS No. 21, the allowance is determined separately for each doubtful debt by assessing the debtor's solvency and the likelihood of the debt being repaid. An ideal example of an estimate.

ISA 540 gives the auditor three approaches, used separately or in combination:

Approach	What is done	At "Bahor Kafel" (hypothetical)
1. Obtaining evidence from events up to the date of the auditor's report	Looking at what happened after the year ended	The bank statement is used to check which debtors paid in January–February. "Tosh Qurilish", whose debt was provided for, has paid in full: that part of the allowance is excessive
2. Testing how management made the estimate	The method, data and assumptions are reviewed	The ageing list of debts (days of payment delay) is checked against source documents; the reasonableness of the notes written for each debtor is assessed
3. Developing the auditor's own estimate or range	The auditor calculates independently and compares with management's figure	Using its own data, the auditor estimates the allowance in the range 52 000 000 – 60 000 000 soum; management's 45 000 000 soum is below the range

The result of the third approach gives an important signal. If management's figure is outside the auditor's range, the misstatement is assessed as at least the difference between management's figure and the nearest end of the range: at "Bahor Kafel" this is 52 000 000 − 45 000 000 = 7 000 000 soum. The first approach, on the other hand, is convenient in many cases: the future has partly happened already.

Why look back at last year's estimates?

The revised standard requires the auditor to also review the outcome of the previous period's estimates (a retrospective review). The aim is not to find that last year's estimate was wrong and assign blame. The aim is to understand how reliable management's estimation process is.

At "Bahor Kafel" last year the allowance was 30 000 000 soum, but the debts later written off as bad turned out to be much larger. This year too the figure is below the auditor's range. Deviation in the same direction two years in a row is a matter the standard addresses specifically: possible indicators of management bias. Each estimate taken on its own may look reasonable, but if they all lean in the direction of higher profit, the auditor evaluates this in aggregate and heightens professional skepticism.

How can management and the accountant prepare for the audit?

In an audit of estimates most time goes on undocumented estimates. The following shortens it considerably:

for each significant estimate, a short explanatory note: which method, which data and which assumption were used;
a table of doubtful debts broken down by each debtor (paragraphs 218 and 220 of NAS No. 21 require this too);
a comparison of last year's estimate with the actual outcome and the reason for the difference;
a list of payments and letters received after year end, because these are exactly what the auditor asks for under the first approach;
if assumptions have changed (for example, payment discipline has worsened), the reason for the change in writing.

How does an auditor check a figure estimated by management: auditing accounting estimates (ISA 540, revised) and three approaches

Why is an estimated figure checked under a separate standard?

In which three ways does the auditor check?

Why look back at last year's estimates?

How can management and the accountant prepare for the audit?

Test yourself

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