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The revisions to ISA (Ireland) 540 (Revised) will have important implications for chief financial officers, financial controllers and management responsible for financial statement preparation and the determination of accounting estimates.

Its impact may be felt outside finance functions where others contribute to the calculation of estimates – for example, valuation specialists, taxation teams or pension specialists.

It will also give rise to additional considerations for audit committees recommending financial statements for approval.

What are the implications?

The new standard requires the auditor to perform additional understanding and risk assessment procedures over estimates, along with other new requirements. This means that:

  • More time is needed from management to help the auditor perform these procedures.
  • Management will need to articulate their processes and controls around estimates better.
  • There will be more dialogue between auditors, management, and those approving financial statements about the critical aspects of estimates.
  • There will be a better and more robust audit approach to auditing accounting estimates in the forthcoming financial reporting cycle.

Why was the standard revised?

The preparation of financial statements involves many different elements, but the preparation of estimates is perhaps more complex than others. Estimates are monetary amounts (recognised or disclosed), which are a fundamental part of entities’ financial statements. They are subject to estimation uncertainty due to inherent limitations in knowledge or data, and as a result, there may be a wide range of measurement outcomes for any estimate. In forming estimates, management applies methods or models where they make assumptions and use data. They exercise judgement involving complexity and subjectivity when measuring the estimate. Due to the nature of this process, estimation is susceptible to material misstatement, and for the users of financial statements, they are the main focus.

Over time, accounting estimates have become more prominent in financial statements. With increased importance and visibility, however, they have also garnered additional scrutiny. Increasingly complex business environments (now made more complicated due to the COVID-19 pandemic) and the introduction of new accounting standards have given rise to greater use of accounting estimates. Recent changes in accounting standards include dealing with expected credit losses, taxation, revenue recognition, and leases. These management estimates could be complicated and involve judgements; they must, therefore, be reported appropriately and challenged robustly.

The previous version of the ISA 540 standard was written before these changes. In response to these challenges, the Irish Auditing and Accounting Supervisory Authority (IAASA) issued ISA 540 (Revised). It is effective for audits of financial statements for accounting periods beginning on or after 15 December 2019.

What is the aim of the new standard?

The new standard aims to:

  1. Address changes in financial reporting standards and business environments that make estimation more difficult.
  2. Enhance auditors’ professional scepticism, considering recurring audit inspection findings criticising the quality of audits of accounting estimates.
  3. Realise public interest benefits through better two-way dialogue between the auditor and management concerning estimates.

What is new?

Enhancements contained in the new standard include:

  • Enhanced risk assessment: the standard requires a robust risk assessment of estimates. The aim is to heighten auditors’ understanding of processes and controls around the identification of estimates and the determination of the related monetary amounts. This risk assessment is performed at a granular level and focuses on the models, assumptions, and data used to determine the estimate. The assessment is made with reference to inherent risk factors, including the complexity of the estimate, its subjectivity, and estimation uncertainty.
  • Scalability of testing approach: the testing approach options in the old ISA 540 are maintained. These include testing management’s calculations of the estimate, developing an independent estimate, or using events after the year-end as audit evidence for the estimate. However, the new standard focuses on aligning the level of procedures performed to the assessed risk. This gives the standard scalability, where the level of audit effort is dictated by the complexity and risk associated with the estimate.
  • Professional scepticism: ISA(Ireland) 540 Revised has several provisions designed to enhance the application of professional scepticism. These include:
    • A requirement to design and perform further audit procedures in a manner that gives more focus to evidence that may be contradictory.
    • A requirement to evaluate the audit evidence obtained regarding the accounting estimates, including both corroborative and contradictory audit evidence.
    • Changing the language in the standard to use purposeful words like “challenge”, “question”, and “reconsider”, thus reinforcing the importance of exercising professional scepticism.
  • Disclosures: there are enhanced requirements to assess whether the estimate disclosures are “reasonable”.
  • Communication and representations: there are new requirements to consider matters regarding accounting estimates when communicating with those charged with governance. There is a requirement to request written representations regarding the reasonableness of methods, significant assumptions, and the data used.

Key change

Impact on the auditor

Impact on management

More emphasis on the need for the auditor to exercise professional skepticism

The auditor will perform audit procedures in a manner that is not biased toward obtaining audit evidence that may be corroborative or toward excluding audit evidence that may be contradictory. The auditor will carefully consider all information obtained and whether it corroborates or contradicts judgements and decisions regarding accounting estimates.

The auditor may increasingly challenge aspects of how management derive the accounting estimates.

More granular assessments regarding the risk accounting estimates are materially misstated  The auditor will first consider the conditions and events that are likely to cause accounting estimates to be materially misstated. The auditor will then consider whether the system of internal control you have designed and implemented is likely to prevent material misstatements, or if a material misstatement occurs, is likely to detect and correct it. 

The auditor may place more emphasis on obtaining an understanding of the nature and extent of the estimation process and key aspects of the related policies and procedures.

 

Focus on appropriately responding to the levels of estimation uncertainty, complexity and subjectivity in accounting estimates  The extent of the auditor’s required work effort depends on the risk the accounting estimate is materially mis-stated. This risk is impacted by the degree of estimation uncertainty, complexity, and subjectivity involved in making that accounting estimate. If the auditor determines the risk of your accounting estimate being materially misstated is higher, the work effort will increase, which in turn will likely impact how much, and the type of, information management needs to provide the auditor.

Audit work effort based on the selected approach(es) (testing management’s process, developing own estimate, subsequent events), including a more detailed understanding of the significant matters considered in making key judgements and decisions affecting accounting estimates

 

ISA 540 includes revised audit requirements that are more specifically directed at the components of an accounting estimate. These include methods including models), assumptions and data, including the auditor’s understanding and documentation of key elements of the entity and its environment, the linkage of audit procedures to the assessed risks, and significant judgements related to the auditor’s determination of whether the accounting estimates and related disclosures are reasonable.

Management may receive more focused requests from the auditor on each of these matters.

Management may wish to consider retaining experts to assist with the related work. They may also consider documenting key judgements and decisions in anticipation of auditor requests. Such documentation is likely to provide a basis for more efficient and effective discussions between management and the auditor.

More emphasis on auditing accounting estimate disclosures in the financial statements

In particular, the sufficiency of disclosures regarding estimation uncertainty may receive more scrutiny.

If the auditor determines the risk of material misstatement is higher for certain disclosures, the work effort will increase, which in turn will impact how much, and the type of, information management will need to provide  the  auditor.

More detailed written representations

The auditor is required to request written representations from management regarding the reasonableness of the methods, significant assumptions and the data used in determining the monetary amounts of accounting estimates, including the related disclosures, in accordance with the applicable financial reporting framework.

The auditor is also required to consider the need to obtain representations about specific accounting estimates, including in relation to the methods, assumptions, or data used.

Management may receive requests for new or changed representations compared to previous years. Therefore, management may wish to ask the auditor to let them know as soon as practicable the details of the written representations they will request.


Source: IAASB’s audit client briefing - Considerations for Management Determining Accounting Estimates and Related Disclosures – November 2019. 

The impact of new accounting standards on accounting estimates

The change from IAS 39 to IFRS 9 has had a huge impact on accounting for credit losses in banking. The old standard, IAS 39, required that for lending transactions, entities apply the incurred loss approach, that is, to provide for only losses that were incurred at the reporting date. IFRS 9 took a different view. It requires that entities apply the expected credit loss model, or to estimate all future expected credit impairments on lending at the reporting date. In 2017, in preparation for the new standard, there was a flurry of activity within the banking sector to model the new estimate (future expected losses on lending) for recognition in financial statements.

What is the impact on management?

The table above sets out the key changes required by ISA (Ireland) 540 Revised and their impact on auditors and management. This summary was prepared by Chartered Professional Accountants Canada and was adopted by the IAASB (International Auditing and Assurance Standards Board) for its client briefing document dated November 2019.

What happens after implementation?

The standard-setters intend to undertake a post-implementation review after the effective date of ISA (Ireland) 540 Revised to see if the revised standard has achieved its intended objective. They will focus on whether the standard is sufficiently scalable and whether it enhances the exercise of professional scepticism.

Example of accounting estimates

  • Variable revenue consideration
  • Share-based payment expense
  • The recoverability of deferred tax assets
  • The useful life of property, plant and equipment
  • Impairment of intangible assets
  • The value of intangible assets acquired in business combinations
  • Provisions
  • Defined benefit pension liabilities 
  • Uncertain tax positions

First impressions

Having read the new standard and prepared illustrative audit work papers to see it in practice, it is clear that this is a significant change to how auditors will approach the audit of estimates. The key message is that auditors will need to prepare early to perform the detailed understanding and risk assessments procedures. Management will have more to do to help the auditor in their risk assessments, but early communication and engagement between the auditor and management will ensure successful adoption.

In addition to the above, due to the COVID-19 pandemic, developing estimates for expected credit losses, going concern analysis, and related disclosures in particular is more challenging. A focus on the audit of estimates is therefore paramount. 

Overall, in a financial reporting environment that is evolving due to changing business environments and accounting frameworks, ISA (Ireland) 540 Revised provides audit practitioners with a good basis to audit estimates and to serve the public interest by fostering audit quality.  

This article first appeared in Accountancy Ireland and is reproduced here with their kind permission.

Get in touch

For more information on these changes to accounting standards, please contact Liam McNallyBrian McSweeney or Gary Fitzpatrick of our Audit practice.

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