The following auditing standard is not the current version and does not reflect any amendments effective on or after December 31, 2016. The current version of the auditing standards can be found here.
AU Section 342
Auditing Accounting Estimates
- (.01 - .04)
- (.05 - .06) Developing Accounting Estimates
- (.07 - .14) Evaluating Accounting Estimates
- (.15) Effective Date
- (.16) Appendix — Examples of Accounting Estimates
Source: SAS No. 57.
See section 9342 for interpretations of this section.
Effective for audits of financial statements for periods beginning on or after January 1, 1989, unless otherwise indicated.
This section provides guidance to auditors on obtaining and evaluating sufficient appropriate evidential matter to support significant accounting estimates in an audit of financial statements in accordance with generally accepted auditing standards. For purposes of this section, an accounting estimate is an approximation of a financial statement element, item, or account. Accounting estimates are often included in historical financial statements because—
- The measurement of some amounts or the valuation of some accounts is uncertain, pending the outcome of future events.
- Relevant data concerning events that have already occurred cannot be accumulated on a timely, cost-effective basis.
Accounting estimates in historical financial statements measure the effects of past business transactions or events, or the present status of an asset or liability. Examples of accounting estimates include net realizable values of inventory and accounts receivable, property and casualty insurance loss reserves, revenues from contracts accounted for by the percentage-of-completion method, and pension and warranty expenses. fn 1
Management is responsible for making the accounting estimates included in the financial statements. Estimates are based on subjective as well as objective factors and, as a result, judgment is required to estimate an amount at the date of the financial statements. Management's judgment is normally based on its knowledge and experience about past and current events and its assumptions about conditions it expects to exist and courses of action it expects to take.
The auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole. As estimates are based on subjective as well as objective factors, it may be difficult for management to establish controls over them. Even when management's estimation process involves competent personnel using relevant and reliable data, there is potential for bias in the subjective factors. Accordingly, when planning and performing procedures to evaluate accounting estimates, the auditor should consider, with an attitude of professional skepticism, both the subjective and objective factors.
Management is responsible for establishing a process for preparing accounting estimates. Although the process may not be documented or formally applied, it normally consists of—
- Identifying situations for which accounting estimates are required.
- Identifying the relevant factors that may affect the accounting estimate.
- Accumulating relevant, sufficient, and reliable data on which to base the estimate.
- Developing assumptions that represent management's judgment of the most likely circumstances and events with respect to the relevant factors.
- Determining the estimated amount based on the assumptions and other relevant factors.
- Determining that the accounting estimate is presented in conformity with applicable accounting principles and that disclosure is adequate.
The risk of material misstatement of accounting estimates normally varies with the complexity and subjectivity associated with the process, the availability and reliability of relevant data, the number and significance of assumptions that are made, and the degree of uncertainty associated with the assumptions.
An entity's internal control may reduce the likelihood of material misstatements of accounting estimates. Specific relevant aspects of internal control include the following:
- Management communication of the need for proper accounting estimates
- Accumulation of relevant, sufficient, and reliable data on which to base an accounting estimate
- Preparation of the accounting estimate by qualified personnel
- Adequate review and approval of the accounting estimates by appropriate levels of authority, including—
- Review of sources of relevant factors
- Review of development of assumptions
- Review of reasonableness of assumptions and resulting estimates
- Consideration of the need to use the work of specialists
- Consideration of changes in previously established methods to arrive at accounting estimates
- Comparison of prior accounting estimates with subsequent results to assess the reliability of the process used to develop estimates
- Consideration by management of whether the resulting accounting estimate is consistent with the operational plans of the entity.
The auditor's objective when evaluating accounting estimates is to obtain sufficient appropriate evidential matter to provide reasonable assurance that—
- All accounting estimates that could be material to the financial statements have been developed.
- Those accounting estimates are reasonable in the circumstances.
- The accounting estimates are presented in conformity with applicable accounting principles fn 2 and are properly disclosed. fn 3
In evaluating whether management has identified all accounting estimates that could be material to the financial statements, the auditor considers the circumstances of the industry or industries in which the entity operates, its methods of conducting business, new accounting pronouncements, and other external factors. The auditor should consider performing the following procedures:
- Consider assertions embodied in the financial statements to determine the need for estimates. (See paragraph .16 for examples of accounting estimates included in financial statements.)
- Evaluate information obtained in performing other procedures, such as—
- Information about changes made or planned in the entity's business, including changes in operating strategy, and the industry in which the entity operates that may indicate the need to make an accounting estimate (Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement).
- Changes in the methods of accumulating information.
- Information concerning identified litigation, claims, and assessments (section 337, Inquiry of a Client's Lawyer Concerning Litigation, Claims, and Assessments), and other contingencies.
- Information from reading available minutes of meetings of stockholders, directors, and appropriate committees.
- Information contained in regulatory or examination reports, supervisory correspondence, and similar materials from applicable regulatory agencies.
- Inquire of management about the existence of circumstances that may indicate the need to make an accounting estimate.
In evaluating the reasonableness of an estimate, the auditor normally concentrates on key factors and assumptions that are—
- Significant to the accounting estimate.
- Sensitive to variations.
- Deviations from historical patterns.
- Subjective and susceptible to misstatement and bias.
The auditor normally should consider the historical experience of the entity in making past estimates as well as the auditor's experience in the industry. However, changes in facts, circumstances, or entity's procedures may cause factors different from those considered in the past to become significant to the accounting estimate. fn 4
In evaluating reasonableness, the auditor should obtain an understanding of how management developed the estimate. Based on that understanding, the auditor should use one or a combination of the following approaches:
- Review and test the process used by management to develop the estimate.
- Develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate.
- Review subsequent events or transactions occurring prior to the date of the auditor's report.
Note: When performing an integrated audit of financial statements and internal control over financial reporting, the auditor may use any of the three approaches. However, the work that the auditor performs as part of the audit of internal control over financial reporting should necessarily inform the auditor's decisions about the approach he or she takes to auditing an estimate because, as part of the audit of internal control over financial reporting, the auditor would be required to obtain an understanding of the process management used to develop the estimate and to test controls over all relevant assertions related to the estimate.
Review and test management's process. In many situations, the auditor assesses the reasonableness of an accounting estimate by performing procedures to test the process used by management to make the estimate. The following are procedures the auditor may consider performing when using this approach:
- Identify whether there are controls over the preparation of accounting estimates and supporting data that may be useful in the evaluation.
- Identify the sources of data and factors that management used in forming the assumptions, and consider whether such data and factors are relevant, reliable, and sufficient for the purpose based on information gathered in other audit tests.
- Consider whether there are additional key factors or alternative assumptions about the factors.
- Evaluate whether the assumptions are consistent with each other, the supporting data, relevant historical data, and industry data.
- Analyze historical data used in developing the assumptions to assess whether the data is comparable and consistent with data of the period under audit, and consider whether such data is sufficiently reliable for the purpose.
- Consider whether changes in the business or industry may cause other factors to become significant to the assumptions.
- Review available documentation of the assumptions used in developing the accounting estimates and inquire about any other plans, goals, and objectives of the entity, as well as consider their relationship to the assumptions.
- Consider using the work of a specialist regarding certain assumptions (section 336,Using the Work of a Specialist).
- Test the calculations used by management to translate the assumptions and key factors into the accounting estimate.
Develop an expectation. Based on the auditor's understanding of the facts and circumstances, he may independently develop an expectation as to the estimate by using other key factors or alternative assumptions about those factors.
Review subsequent events or transactions. Events or transactions sometimes occur subsequent to the date of the balance sheet, but prior to the date of the auditor's report, that are important in identifying and evaluating the reasonableness of accounting estimates or key factors or assumptions used in the preparation of the estimate. In such circumstances, an evaluation of the estimate or of a key factor or assumption may be minimized or unnecessary as the event or transaction can be used by the auditor in evaluating their reasonableness.
Paragraphs 24 through 27 of Auditing Standard No. 14, Evaluating Audit Results, discuss the auditor's responsibilities for assessing bias and evaluating accounting estimates in relationship to the financial statements taken as a whole.
This section is effective for audits of financial statements for periods beginning on or after January 1, 1989. Early application of the provisions of this section is permissible.
Examples of Accounting Estimates
The following are examples of accounting estimates that are included in financial statements. The list is presented for information only. It should not be considered all-inclusive.
|Airline passenger revenue
|Allowance for loan losses
|Freight and cargo revenue
|Losses on sales contracts
|Net realizable value of inventories where future
selling prices and future costs are involved
|Losses on purchase commitments
|Revenue to be earned
|Costs to be incurred
|Percent of completion
|Valuation of securities
|Trading versus investment security classification
|Probability of high correlation of a hedge
|Initial direct costs
|Sales of securities with puts and calls
|Productive facilities, natural resources and intangibles:
|Useful lives and residual values
|Depreciation and amortization methods
|Probability of loss
|Recoverability of costs
|Amount of loss
|Annual effective tax rate in interim reporting
|Property and casualty insurance company loss
|Imputed interest rates on receivables and payables
|Compensation in stock option plans and deferred
|Gross profit rates under program method of
|Taxes on real and personal property
|Losses and net realizable value on disposal of
segment or restructuring of a business
|Actuarial assumptions in pension costs
|Fair values in nonmonetary exchanges
|Interim period costs in interim reporting
|Current values in personal financial statements
Footnotes (AU Section 342 — Auditing Accounting Estimates):
fn 1 Additional examples of accounting estimates included in historical financial statements are presented in paragraph .16.
fn 2 Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles, discusses the auditor's responsibility for evaluating conformity with generally accepted accounting principles. [Title of section 411 amended, effective for reports issued or reissued on or after June 30, 2001, by Statement on Auditing Standards No. 93.]
fn 3 See paragraph 31 of Auditing Standard No. 14, Evaluating Audit Results.
fn 4 In addition to other evidential matter about the estimate, in certain instances, the auditor may wish to obtain written representation from management regarding the key factors and assumptions.