Auditing Estimates. Copyright 2015 Surgent McCoy Self-Study CPE, LLC A4M5/15/S1

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1 Auditing Estimates READING MATERIAL 1 I. Introduction 1 II. Relation to risk assessment procedures 2 III. Obtaining an understanding of the process for identifying accounting estimates 3 IV. Presumptively required further audit procedures 3 V. Management bias 4 VI. Estimation uncertainty 5 VII. Focus on the estimation process 6 VIII. Relevant internal control 8 IX. Importance of quality of underlying data and assumptions 8 X. Testing reasonableness of estimates 9 XI. Management s use of a model 10 XII. Common auditing techniques for point estimates or ranges 11 XIII. Fair value accounting estimates 12 XIV. Disclosures 13 XV. Evaluating differences 13 XVI. Required audit documentation 13 LEARNING QUESTIONS 15 HOMEWORK 17 i

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3 I. Introduction Auditing Estimates READING MATERIAL AU Section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures, codifies generally accepted auditing standards related to auditing estimates. Accounting estimates are an approximation of a monetary amount in the absence of a precise means of measurement, including fair value measurement. Some financial statement areas simply cannot be precisely measured. Auditors have specific responsibilities relating to accounting estimates, including fair value accounting estimates and related disclosures. Applicable financial reporting frameworks will prescribe certain conditions for the recognition or measurement of estimates, specify certain conditions that permit or require measurement at fair value, or specify required or permitted disclosures. In addition, financial reporting frameworks may provide guidance for managers in determining point estimates when alternatives exist. Financial reporting frameworks also may require the disclosure of information concerning the significant assumptions to which the accounting estimate is particularly sensitive. The measurement objective of accounting estimates can vary with the applicable financial reporting framework. Some estimates forecast the outcome of one or more transactions, events, or conditions. Other estimates relate to assessing the fair value of current transactions or financial statement line items based on measurement date conditions. The specific characteristics of an asset, liability, or component of equity, or the method of measurement may give rise to the need to estimate a financial statement line item. Typical estimates include the following: Fair value of assets and liabilities. Allowance for doubtful accounts. Warranty obligations. Depreciation method or asset useful life. Provision against the carrying amount of an investment where uncertainty regarding its recoverability exists. Outcome of long-term contracts. Costs arising from litigation settlements and judgments. Complex financial instruments not traded in an open and active market. Share-based payments. Property or equipment held for disposal. Certain assets and liabilities acquired in a business combination, including goodwill and intangible assets. Transaction involving the exchange of assets or liabilities between independent parties without monetary consideration. Estimation uncertainty is the susceptibility of an accounting estimate and related disclosures to an inherent lack of precision in its measurement. Estimates are also directly impacted by management bias or a lack of neutrality by management in the preparation and presentation of information, both 1

4 intentionally and unintentionally. This degree of uncertainty impacts assessed risk of material misstatement in financial statements, including the susceptibility of estimates to intentional or unintentional management bias. The auditor s ultimate objective is to obtain sufficient appropriate audit evidence about whether accounting estimates are reasonable (whether recognized or disclosed), and whether related disclosures are adequate in the context of the applicable financial reporting framework. Estimation involves judgments based on information available when the financial statements are prepared. This may include making assumptions about matters uncertain at the time of estimation. A difference between the outcome of an accounting estimate and the original amount recognized or disclosed in the financial statements does not necessarily represent a financial statement misstatement. Rather, differences may result simply from the outcome of estimation being different than anticipated based on the best information at the time. Therefore, it is inherent that there is some level of estimation uncertainty in financial reporting, even absent fraud. For some estimates in particular, such as fair value accounting estimates, the measurement objective is related to current value based on prevalent conditions at the measurement date. This may be an assumed hypothetical current transaction between knowledgeable, willing market participants in an arm slength transaction. In this case, any observed outcome may be affected by events or conditions subsequent to the date at which the estimate is measured for financial reporting purposes. II. Relation to risk assessment procedures The auditor should obtain an understanding of certain key areas in order to provide a basis for the identification and assessment of the risks of material misstatement for accounting estimates. These procedures assist the auditor in developing an expectation of the nature and type of accounting estimates that an entity may have. They also provide a basis for planning the nature, timing, and extent of further audit procedures. Relevant procedures include the following: Understand the requirements of the applicable financial reporting framework relevant to accounting estimates, including related disclosures. Understand management s process for identifying transactions, events, and conditions that may give rise to the need for accounting estimates to be recognized or disclosed. Make inquiries to management about changing circumstances that may give rise to new, or the need to revise existing, accounting estimates. Gain an understanding of management s process for making accounting estimates, including an understanding of the data on which they are based and the following: The method and/or model used. Relevant controls. Any use of a specialist. Underlying assumptions. Whether there has been or ought to have been a change from the prior period in the methods for making the accounting estimates and, if so, why. Whether and how management has assessed the effect of uncertainty in estimates. Review the outcome of prior period accounting estimates or, when applicable, subsequent re-estimation for current period purposes. (Note: This review is not intended to call into question the auditor s professional judgments made in prior periods based on the best information available at the time, but to evaluate the estimation process.) 2

5 III. Obtaining an understanding of the process for identifying accounting estimates The preparation of financial statements requires determining whether accounting estimates have been identified, evaluated for proper recognition or disclosure, and reasonably measured in accordance with the applicable financial reporting framework. The auditor may obtain an understanding of how management identifies the need for accounting estimates through inquiry or other more structured procedures. The completeness assertion of accounting estimates is often one of the most important considerations of the auditor, as it often translates to liabilities. Management s identification of transactions, events, and conditions that give rise to the need for accounting estimates is likely to be based on the following: Management s knowledge of the entity s business and the industry in which it operates. Management s knowledge of the implementation of business strategies in the current period. Where applicable, management s cumulative experience of preparing the entity s financial statements in prior periods. Specific inquiries the auditor may make of management includes the following: Whether the entity has engaged in new types of transactions that may give rise to accounting estimates. Whether terms of transactions that gave rise to accounting estimates have changed. Whether accounting policies relating to accounting estimates have changed as a result of changes to the requirements of the applicable financial reporting framework or otherwise. Whether regulatory or other changes outside the control of management have occurred that may require management to revise, or make new, accounting estimates. Whether new conditions or events have occurred that may give rise to the need for new or revised accounting estimates. Smaller entities often have less estimation uncertainty because their business activities are often limited and transactions are less complex. Therefore, inquiries may be limited to a single person (such as an owner-manager) who makes the identification of the need to make an accounting estimate. IV. Presumptively required further audit procedures The auditor should evaluate the degree of estimation uncertainty associated with an accounting estimate, and determine whether any identified accounting estimates have a significant risk of material misstatement. Based on that assessed risk, the auditor should determine whether management has appropriately applied relevant financial reporting framework requirements, including management s decision to recognize or not recognize the accounting estimates in the financial statements, and the selected measurement basis for the accounting estimate. In addition, the auditor should assess whether the methods for making the accounting estimates are appropriate and consistently applied. This includes considering whether any prior period changes are appropriate under the given circumstances. 3

6 In addition, considering the nature of the accounting estimate, the auditor should perform one or more of the following for significant accounting estimates: Determine whether events occurring up to the date of the auditor s report provides audit evidence regarding the accounting estimate. Test management s estimation process, including the data on which it is based, to evaluate whether: The measurement method is appropriate given the circumstances. The reasonableness of assumptions considering the framework s measurement objective. The underlying data is sufficiently reliable to serve the auditor s purposes. Test the operating effectiveness of the controls over the estimation process, coupled with sufficient appropriate substantive audit procedures. Develop a point estimate or range to evaluate management s point estimate: If the auditor uses different assumptions or methods from management s, the auditor should obtain an understanding of management s assumptions or methods to ensure all relevant variables are taken into account. If the auditor concludes that a range estimate is appropriate, the range should be narrowed based on available audit evidence to be deemed reasonable. V. Management bias The auditor should consider whether there are indicators of possible management bias in judgments and decisions made by management. Indicators of possible management bias do not necessarily constitute misstatements for the purposes of drawing conclusions on the reasonableness of individual accounting estimates. The auditor should document the basis for auditor s conclusions about the reasonableness of accounting estimates and their disclosure, and indicate any possible management bias. The susceptibility of an accounting estimate to management bias increases with the subjectivity involved in making the estimate itself. Bias can be difficult to detect, and may only be identified when considering the aggregate of groups of accounting estimates, or estimates over a period of time. For continuing audits, indicators of possible bias in the preceding period audit may influence the planning and risk assessment in the current period. Consistency in methods for determining estimates is important. Arbitrary changes result in inconsistent financial statements over time. Management is often able to demonstrate good reason for a change in estimate, or the method for making an alteration from one period to another based on changing circumstances. Reasonableness of any inconsistencies is a matter of judgment. The following are examples of circumstances which may indicate possible management bias: Subjective changes in accounting estimate, or the method for making it. Use of internal assumptions when they are inconsistent with observable market assumptions. Selection or construction of significant assumptions that yield a point estimate favorable for management objectives. Selection of a point estimate that may indicate a pattern of optimism or pessimism. 4

7 VI. Estimation uncertainty The degree of estimation uncertainty will vary based on the following factors: Sensitivity of estimate to changing assumptions. Extent of judgment involved in the estimate. Existence of recognized measurement techniques that may mitigate estimation uncertainty. Length of the forecast period and the relevance of data drawn from past events to forecast future events. Availability of reliable data from external sources. Extent to which the accounting estimate is based on observable or unobservable inputs. Some accounting estimates have lower estimation uncertainty than others, which results in lower risk of material misstatement. Examples of such estimates include the following: Estimates arising in entities that engage in non-complex business activities. Routine estimates frequently made and updated. Estimates derived from readily available or observable data. Simple and easily applied fair value estimates. Well-known and generally accepted models based on observable assumptions or inputs. Other estimates may carry a higher risk of estimation uncertainty when based on significant assumptions, such as the following: Accounting estimates relating to pending litigation outcomes. Fair value accounting estimates for derivatives not publicly traded. Fair value accounting estimates for which a highly-specialized entity-developed model is used, or when assumptions or inputs cannot be observed in the marketplace. Accounting estimates that are not calculated using recognized measurement techniques. Accounting estimates in which results of review of similar prior period estimates indicate a substantial difference between the original estimate and the actual outcome. Additional factors that may influence risks of material misstatement includes the following: Actual or expected magnitude of an estimate. Recorded amount of the estimate in relation to the amount expected by the auditor. Whether management has used a specialist in making the estimate. Outcome of the review of prior period estimates. In some cases, the degree of estimation uncertainty may be so great that the recognition criteria may not be met, and the accounting estimate cannot be made. However, the applicable financial reporting framework may require disclosure of the accounting estimates and the high degree of estimation uncertainty. The auditor may consider whether such estimation uncertainty indicates that substantial doubt could exist about the entity s ability to continue as a going concern. A seemingly immaterial accounting estimate may have the potential to result in material misstatement in the financial statements because of the uncertainty. The amount of the estimate recognized in the financial statements may not provide a clear reflection of the possible material misstatement due to estimation uncertainty, particularly if the estimate is understated. 5

8 Estimation uncertainty may exist, even if the valuation technique and underling data are well-defined. Valuation of a security quoted at a listed market price in an open and active market may require adjustment if the holding is significant in relation to the market or is subject to restrictions in marketability. General economic consequences, like liquidity to a particular market, may affect estimation uncertainty. The auditor should evaluate the following estimation uncertainty factors for any accounting estimates that give rise to significant risk of material misstatement: How management considered alternative assumptions or outcomes and why they were rejected, or other analysis of estimation uncertainty: If management has not appropriately addressed estimation uncertainty, the auditor should, if considered necessary, develop a range to evaluate the reasonableness of the accounting estimate. The reasonableness of significant assumptions used by management. Management intent to carry out specific courses of action and its ability to do so, as relevant. The adequacy of the disclosure of estimation uncertainty in the financial statements. The following may be considered in assessing the effect of estimation uncertainty: Whether and how management considered alternative assumptions or outcomes (e.g., sensitivity analysis to determine the effect of changes in the assumptions on an accounting estimate). How management determines the accounting estimate when analysis indicates a number of outcome scenarios. Whether management monitors the outcome of accounting estimates made in the prior period, and whether management has appropriately responded to the outcome of that monitoring procedure. VII. Focus on the estimation process Estimates often lack objective information. They are not based on historical transactions for which documentation is readily available. Therefore, auditing estimates is often difficult. The focus is often more on the process for making the estimate, and whether the key assumptions are reasonable. Factors that may increase risk of material misstatement related to estimates includes the following: The client makes estimates on an ad hoc basis, with no established process. There is little history of providing the product or service. There is little experience with the target customer base. For an estimate, the client gathers relevant information and makes certain assumptions, which are then entered into an estimation process to produce an amount that is recorded in the financial statements. The audit procedure is focused on assessing the quality of the estimation process, and the reasonableness of the inputs into the process. It is important that the estimate be prepared by the client in good faith, making a diligent effort to not mislead financial statement users. 6

9 Processes for making accounting estimates typically include the following: Selecting appropriate accounting policies and estimation models. Developing or identifying relevant data and assumptions. Periodically reviewing the circumstances that give rise to estimates and making changes, as necessary. The applicable financial reporting framework may prescribe the method for accounting estimate measurement (e.g., fair value estimate model). However, in most cases, the framework provides alternative methods for measurement, or does not prescribe a method of measurement at all. Management may use an internally developed model, or may depart from a model commonly used in a particular industry. Therefore, it is even more important for the auditor to understand the method or model used, including: How management considers the nature of the estimated asset or liability when selecting a particular method. Whether the entity operates in a particular business, industry, or environment where common methods of estimation are used. An auditor is required to obtain an understanding about whether there has been (or ought to have been) a change from the prior period in the methods or assumptions for making the accounting estimates. A specific estimation method may be changed in response to environmental or other circumstances affecting the entity or financial reporting requirements. If management has changed the method for making an accounting estimate, it is important that management demonstrate that the new method is more appropriate, or is a direct response to such changes in and of itself. Changes and new inputs should be reasonable in light of the circumstances. A key point of concern is that the auditor s evaluation of the assumptions used by management is based only on information available at the time of the audit. Audit procedures dealing with management s assumptions are performed in the context of the audit the financial statements as a whole, and not for the purpose of providing an opinion on assumptions themselves. The outcome of an accounting estimate will often differ from projections. Risk assessment procedures will help the auditor identify and understand the reasons for these resulting differences, for example: Information regarding the effectiveness of management s prior period estimation process, from which the auditor can judge the likely effectiveness of management s current process. Audit evidence that is pertinent to re-estimation in the current period, of a prior period accounting estimate. Audit evidence that matters that may require disclosure, such as estimation uncertainty. A difference between the outcome of an accounting estimate and the amounts recognized in the prior period financial statements does not necessarily represent a misstatement of the prior period financial statements. However, it may do so if, the difference arises from information that was available to management at the time the prior period financial statements were finalized, or reasonably have been expected to have been obtained and taken into account. 7

10 VIII. Relevant internal control Matters that an auditor may consider in gaining an understanding about relevant internal control include the following: Experience and competence of personnel involved in making an accounting estimate. How management determines completeness, relevance, and accuracy of the data used. Review and approval of accounting estimates, including the assumptions or inputs used in development by appropriate levels of management and those charged with governance. Segregation of duties of estimation, validation, recording, and approval, to the extent possible. Extent to which the entity s process relies on a service organization to provide fair value or other estimate measurements, or the data that supports the measurement. Design and development, or selection, of a particular estimation model for a particular purpose, use of the model, periodic validation of the model s integrity, and security controls to prevent unauthorized changes. IX. Importance of quality of underlying data and assumptions The quality of an accounting estimate is only as good as the quality of the underlying data and assumptions. Assumptions that are sensitive to variation, are inconsistent with historical patterns, or are subjective and susceptible to misstatement and bias are higher risk. The auditor should be alert for assumptions that treat all situations the same or use broad generalizations. Finally, it is important to remember that history may not be an accurate predictor of future events. Assumptions appropriately consider planned changes or trends in the business or industry, as well as reflect management s plans for the future (which is management s positive intent to take action). Assumptions are important elements of the estimation process. Important considerations when gaining an understanding of the underlying assumptions may include the following: Nature of the assumptions, including which are significant assumptions. How management assesses relevance and completeness of assumptions. How management determines consistency of internal assumptions, when applicable. Whether assumptions relate to matters within management control (e.g., maintenance of long-lived assets). How assumptions conform to business plans. Whether assumptions are outside the entity s control (e.g., interest rates, mortality rates, regulatory actions, etc.). Nature and extent of supporting documentation. The extent of objectivity, such as whether an assumption or input is observable, has a tremendous influence on the degree of estimation uncertainty. Observable inputs are based on market data obtained from sources independent of the reporting entity. An entity s own judgments using the best information available in the circumstances are commonly referred to as unobservable inputs. 8

11 X. Testing reasonableness of estimates There are three basic techniques for testing the reasonableness of estimates: Using post-balance sheet information to refine estimates and corroborate the reasonableness of assumptions and estimates. Develop a range of reasonableness, and determine that the client s estimate falls within that range. Reconcile two or more amounts produced by different models. The auditor should review the outcome of accounting estimates included in the prior period financial statements or, where applicable, their subsequent re-estimation for the purpose of the current period. The nature and extent of the auditor s review takes account of the nature of the accounting estimates and whether the information obtained from the review would be relevant to identifying and assessing risks of material misstatement of accounting estimates made in the current period financial statements. The review is not intended to call into question the judgments made in the prior periods that were based on information available at the time. Performing risk assessment procedures to identify an understanding of reasons for differences between projections and actual results includes the following: Information regarding the effectiveness of management s prior period estimation process, from which the auditor can judge the likely effectiveness of management s current process; Audit evidence that is pertinent to the re-estimation, in the current period, of prior period accounting estimates; or Audit evidence of matters that may be required to be disclosed in the financial statements, such as estimation uncertainty. Auditing standards related to fraud considerations require a retrospective review of management judgments and assumptions related to significant accounting estimates. A more detailed review may be required for estimates identified in the prior period audit as having high estimation uncertainty, or for those that changed significantly from the prior period. An auditor s consideration of the outcome of prior period estimates may provide an understanding of the effectiveness of management s prior estimation process (i.e., management s track record from which to judge the likely effectiveness of management s current process). The nature and extent of the outcome review is a matter of professional judgment. It is not necessary to review the outcome of every accounting estimate included in the prior period. However, a retrospective review is required of significant accounting estimates. Subsequent events and subsequently discovered facts may be relevant to testing the propriety of estimates. Events occurring up to the date of the auditor s report may provide audit evidence regarding the accounting estimate if: (i) the events are expected to occur; and (ii) the events provide audit evidence that confirms or contradicts the accounting estimate. There may be no need to perform additional audit procedures if sufficient appropriate audit evidence about the events is obtained. If conditions or events relating develop over an extended period, it may be less likely that audit evidence is provided for the estimate and additional procedures are likely to be appropriate. In addition, information after period end may not reflect the events or conditions existing at the balance sheet date, so they may be irrelevant to the estimate as of the balance sheet date (e.g., fair value measurements). In other cases, subsequent events may contradict management s assumptions or uncover a bias. 9

12 Testing of an estimate made by management may include the following: Testing the extent to which underlying data is accurate, complete, and relevant. Considering the source, relevance, and reliability of external data or information. Determining how management has taken into account the effect of events, transactions, and changes in circumstances occurring after the date the estimate was made. Recalculating the estimate and reviewing for internal consistency. Considering management s review and approval process. (Note: Even if the entity has no formal established process, it does not mean that management is not able to provide a basis upon which the auditor can test the accounting estimate.) XI. Management s use of a model If management uses a model to generate an estimate, the following procedures may be appropriate: The rationale for the selection of the method is reasonable. Management has sufficiently evaluated and appropriately applied the criteria, if any, provided in the applicable financial reporting framework to support the selected method. Method is appropriate. Sufficient data is available in the circumstances given the nature of the asset or liability being estimated and the relevant financial reporting framework requirements. Method is appropriate in relation to business, industry, and operational environment. Different methods may result in a range of significantly different estimates. Therefore, obtaining an understanding of how the entity has investigated the reasons for these differences may assist the auditor in evaluating the appropriateness of the selected method. The auditor may also consider testing the model, using procedures like the following: Validate the model prior to usage, with periodic reviews to ensure that is continues to be suitable for its intended use. Evaluate the theoretical soundness and mathematical integrity, including appropriateness of model parameters. Evaluate the consistency and completeness of inputs with market practices. Compare output to actual transactions. Verify the existence of appropriate change control policies and procedures. Periodically calibrate and test the model for validity (especially if the inputs are subjective). Consider whether adjustments made to the model s output reflect the assumptions that market participants would use similar circumstances. Adequately document the model, including intended applications, limitations, key parameters, required inputs, and validation analysis results. There are various techniques for auditing management s intent and ability to carry out plans that are key assumptions in the estimation process, including the following: Analyze the client s history and management s past behavior to determine if it corroborates or conflicts with intended future actions. Read and analyze any written plans. Determine the valid business purpose for management s plans. 10

13 Make inquiries regarding the specific details of the plan, including to those outside of management and the accounting department. Determine if the ability to carry out the plan is based on factors that management can exercise some control over. XII. Common auditing techniques for point estimates or ranges The auditor s point estimate or range is the amount, or range of amounts, derived from audit evidence for use in evaluating management s point estimate. Management s point estimate is the amount selected by management for recognition or disclosure in the financial statements as an accounting estimate. If the auditor uses assumptions or methods that differ from management s, the auditor should obtain an understanding of management s assumptions or methods sufficient to establish that the auditor s point estimate or rage takes into account relevant variables and to evaluate any significant differences from management s point estimate. If the auditor concludes that it is appropriate to use a range, the auditor should narrow the range, based on available audit evidence, until all outcomes within the range are considered reasonable. Some financial reporting frameworks may provide guidance for determining point estimates where alternatives exist (e.g., the selected point estimate among alternatives should reflect the most likely outcome per management s judgment, or use of a discounted probability-weighted expected value). The following circumstances may create the need for an auditor to develop a point estimate as part of its audit response: The estimate is not derived from routine data processing. Review of similar prior period estimates suggests that the current period process is not likely to be effective. The entity s controls within and over management s processes for determining accounting estimates are not well designed or properly implemented. Events or transactions between the period end and the audit report date contradict management s point estimate. There are alternative sources of relevant data available to the auditor which can be used to make a point estimate or a range. The auditor may develop a point estimate or a range in any of the following ways: Using a commercially available model for use in a particular industry, sector, etc. Using a proprietary or auditor-developed model. Further developing management s consideration of alternative assumptions or outcomes (e.g., by introducing a different set of assumptions). Making reference to other comparable conditions, transactions, events, or markets for comparable assets or liabilities. Sometimes both management and the auditor use equally valid assumptions, yet generate significantly different estimates. This may reveal that the estimate is highly sensitive to certain assumptions, subject to high estimation uncertainty, and properly treated as a significant risk requiring special audit consideration. Alternatively, differences may result because either party made a factual error. When 11

14 different assumptions are used, the auditor should discuss the basis for the assumptions, as well as their validity. When the auditor develops a range of estimate, it is important that it comprise all reasonable outcomes, not all possible outcomes. It should be sufficiently narrow to enable the auditor to conclude whether the estimate is materially misstated. Narrowing the range may be achieved by the following: Eliminating from the range those outcomes at the extremities of the range judged by the auditor to be unlikely to occur. Continuing to narrow the range until all outcomes are considered reasonable based on all audit evidence available. XIII. Fair value accounting estimates With respect to fair value accounting estimates, assumptions or inputs vary in terms of their source and bases. Some may be based on observable inputs or equivalent (based on market data obtained from independent sources), while others will be based on unobservable inputs or equivalent (based on the entity s own judgments using the best information available in the circumstances). Matters that the auditor may consider in evaluating the reasonableness of assumptions used by management underlying fair value accounting estimates may include the following: Whether management has incorporated market-specific inputs into developing assumptions. Whether the assumptions are consistent with observable market conditions and the characteristics of the fair value asset or liability. Whether the sources of market-participant assumptions are relevant and reliable, and how management has selected the assumptions to use when a number of different market participant assumptions exist. Whether management considered assumptions used in, or information about, comparable transactions, assets, and liabilities. When fair value accountings estimates are based on unobservable inputs, additional matters that the auditor may consider include the following: Identification of the characteristics of market participants relevant to the estimate. Modifications made to reflect view of assumptions market participants would use. Whether it has incorporated the best information available given the circumstances. How disclosures take into account comparable transactions, assets, or liabilities. Additional challenges exist when fair value estimates have unobservable inputs (e.g., illiquid markets). Therefore, management may lack the expertise to value illiquid or complex financial instruments, or there may simply be limited sources of information available to establish values. Management may use a broker quote to support fair value. However, it may need to be supplemented from one or more other brokers or information from a pricing service it the quote is obtained from the institution that initially sold the instrument. Because pricing services and brokers use valuation methods that are not known to management, it may be necessary for the auditor to understand the nature of such information and how it was developed (e.g., value is based on private trades, trades of similar instruments, cash flow model, or some combination of inputs). Inquiries should be directed at the reliability and consistency of fair value measurement. 12

15 XIV. Disclosures The auditor should obtain sufficient appropriate audit evidence about whether the accounting estimate disclosures are in accordance with the requirements of the applicable financial reporting framework. The auditor should also evaluate the adequacy of disclosure of estimation uncertainty in the context of the applicable financial reporting framework for significant risks requiring special audit consideration. Disclosures may include the following: Assumptions used. Method of estimation used, including any applicable model. Basis for selecting estimation method. Effect of any changes in the estimation method from prior periods. Sources and implications of estimation uncertainty. The auditor may determine that there is a need to draw the financial statement user s attention to the fact that there is significant uncertainty in the financial statements by adding a matter of emphasis paragraph to the auditor s report. XV. Evaluating differences A misstatement related to accounting estimates may arise from the following: Factual misstatements about which no doubt exists. Differences arising from management s judgments concerning accounting estimates that the auditor considers unreasonable. Selection or application of accounting policies that the auditor considers inappropriate. The auditor s best estimate of misstatements in populations involving the projection of a misstatement identified in audit samples to the entire populations from which the samples were drawn. When audit evidence supports a point estimate, the difference between the auditor s point estimate and management s point estimate is a likely misstatement. When audit conclusions have been supported by a range estimate, no less than the difference between management s point estimate and the nearest point of the auditor s range is a likely misstatement. If management s point estimate is within the auditor s range of acceptance, then no likely misstatements result. In addition, an arbitrary change in method or measurement of an accounting estimate made by management may also be a misstatement in the financial statements. XVI. Required audit documentation Required audit documentation includes the following: The basis for the auditor s conclusions about the reasonableness of accounting estimates and their disclosure that give rise to significant risk. Any indicators of possible management bias taken into consideration by the auditor. 13

16 The auditor should obtain written representations from appropriate management regarding the reasonableness of significant assumptions used in estimates. The auditor is required to determine that those charged with governance are adequately informed about the process used by management in formulating sensitive accounting estimates and the basis for conclusions about reasonableness. 14

17 Auditing Estimates LEARNING QUESTIONS 1. Which of the following is NOT an element of an accounting estimate? A. Precise determination of a monetary amount. B. Includes fair value measurement, as permitted or required. C. Dependent on the occurrence of a future event or intended action. 2. Which of the following is a TRUE statement related to the audit objective for accounting estimates? A. The auditor is required to obtain irrefutable evidence about the reasonableness of the estimate. B. The assessed risk of material misstatement is most likely to be low in areas of estimation. C. The auditor should evaluate whether related disclosures are adequate. 3. Which of the following would be an estimate with lower estimation uncertainty? A. Estimates relating to pending litigation outcomes. B. Estimates derived from readily available or observable data. C. Fair value estimates when assumptions cannot be observed, so an entity-developed model is used. 4. Which of the following scenarios would likely result in a higher risk of material misstatement for related estimates? A. No new accounting pronouncements adopted. B. No new products or services. C. Offering existing products or services to different customers. 5. Which of the following factors would decrease the persuasiveness of assumptions? A. Assumptions are sensitive to variation. B. Assumptions consistent with historical patterns. C. Assumptions not susceptible to management bias. 6. Which of the following could be an indicator of potential management bias in assumptions underlying an estimate? A. Internal assumptions used are consistent with observable market assumptions. B. Assumptions are selected that yield a point estimate favorable to management s objectives. C. Point estimates are not selected based on any desired pattern of optimism or pessimism. 7. Which of the following is an appropriate step that should be taken to test management s model for preparing estimates? A. Determine that the rationale for the method selected is unreasonable. B. Determine that the method is inconsistent with business, industry, and current operating environment. C. Determine whether sufficient data is available under the given circumstances. 15

18 8. Which of the following is NOT a true statement related to auditing point estimates or ranges? A. If auditor assumptions or methods differ from management s, then no special steps need to be taken. B. If a range estimate is deemed appropriate, the range should be narrowed until outcomes are deemed reasonable. C. Equally valid assumptions may yield significantly different results. 9. Which of the following is a TRUE statement related to evaluating differences resulting from auditing estimates? A. The difference between the auditor s and management s point estimates is a known misstatement. B. No likely misstatement exists if management s estimate is within the auditor s range of acceptance. C. The difference between management s point estimate and the furthest end of the auditor s range is a known misstatement. 16

19 Auditing Estimates HOMEWORK Real-Life Accounting Estimate Fraud Instructions: Read the following background information regarding a real-life fraudulent financial reporting fraud perpetrated through manipulating certain estimates. Answer the questions at the end relating to how this fraud could have been detected through the financial statement audit. Facts and Circumstances Waste Management Incorporated s primary source of business relates to collection, transfer, resource recovery, and disposal of solid waste for commercial, industrial, municipal, and residential customers, as well as other waste management companies. Services include paper, glass, plastic, and metal recycling services. Services include portable sanitation services. Services include hazardous waste and other chemical removal, treatment, storage, and disposal. According to the Form 10-K filed with the Securities and Exchange Commission, the company reported consolidated revenues of $9.19 billion, net income of $192 million, and total assets of $18.4 billion for the year ended December 31, For fiscal year ended December 31, 1995, the company reported consolidated revenues of $9.05 billion and net income of $604 million. For fiscal year ended December 31, 1994, the company reported consolidated revenues of $8.48 billion and net income of $784 million. Management Discussion & Analysis revealed concerns about changing environmental industry pressures and increased competition. This has impacted the pricing and rendering of services. Competing municipalities and counties are able to use tax revenues to supplement the services directly charged to the customer. 53 percent of the company s assets relate to net property and equipment, totaling $9.7 billion for the year ended percent of the company s assets relate to net property and equipment, totaling $9.7 billion for the year ended Gross property and equipment primarily consists of disposal sites (36 percent of total PP&E), buildings (11 percent), vehicles and equipment (53 percent), and leasehold improvements (< 1 percent) for the year ended Gross property and equipment primarily consists of disposal sites (35 percent of total PP&E), buildings (11 percent), vehicles and equipment (54 percent), and leasehold improvements (< 1 percent) for the year ended Disposal sites include approximately 66,400 acres with estimated remaining lives ranging from years based on management s site plans and estimated annual volumes of waste. Vehicles and equipment included approximately 21,400 collection and transfer vehicles, 1.6 million containers, and 25,100 stationary compactors. 17

20 Summary of significant accounting policies disclosed the following estimated useful lives on the straight-line method of depreciation: Buildings years. Vehicles and equipment 3-20 years. Leasehold improvements are amortized over the life of the lease. Fraud Scheme Perpetrated In the period from , press releases announced that a new chief financial officer (CFO) and chief executive officer (CEO) were being hired. In addition, amended and restated financial information was being filed for Revisions were related to various items of expense, including vehicle and equipment depreciation and landfill cost accounting. The cumulative charge of $3.5 billion pre-tax and $2.9 billion after-tax reduced stockholders equity by $1.3 billion for fiscal year ended Restatement of 1996 financial results alone took the company from a previously reported $192 million net income to a $39 million net loss. The company admitted to the use of incorrect vehicle and container salvage values and useful lives assumptions. In 1997, the company disclosed that it was adopting new policies that included shortening depreciable lives for certain asset categories to better reflect current anticipated useful lives. The company also eliminated salvage values for trucks and waste containers. The company also revised certain components of landfill cost accounting processes by adopting more specific criteria to determine whether currently unpermitted expansions to existing landfills should be included in the estimated capacity of sites for depreciation purposes. In 2002, the SEC announced completion in its investigation that resulted in lawsuits being filed against the founder and five other top company officers. The SEC charged that the defendants engaged in systematic fraud from to meet pre-determined earnings targets. The company improperly eliminated and deferred current period expenses to inflate earnings, including the following: Avoided depreciation expense on garbage trucks by both assigning unsupported and inflated salvage values and extending useful lives. Assigned arbitrary salvage values to other assets that previously had no salvage value. Failed to record expense for decrease in the value of landfills, as they were filled with waste. Refused to record expenses necessary to write off the costs of unsuccessful and abandoned landfill development projects. Established inflated environmental reserves (liabilities) in connection with acquisitions, so that excess reserves could be used to avoid recording unrelated operating expenses. Improperly capitalized a variety of expenses. Failed to establish sufficient reserves (liabilities) to pay for income taxes and other expenses. 18

21 The SEC alleged that the CEO set the fraudulent earnings targets, fostered a culture of fraudulent accounting, personally directed accounting changes to target earnings, and announced the company s fraudulent numbers. Chief executives used top-side adjustments to conform the company s actual results to earnings targets. The fraud was concealed by using a manipulation scheme called netting, which allowed reported results to appear better than actual. The scheme allowed the company to eliminate approximately $490 million in current period accounting misstatements by netting them against one-time gains on sale or exchange of assets. Another scheme called geography allowed the company to move tens of millions of dollars between various line items on the company s income statement to make the financial statements appear as management desired. In one case, the company excluded $1 million in truck-painting costs. The claim was that the trucks were painted early, making the paint job economically equivalent to a capital expenditure (an asset) rather than an operating expense. By exercising control over the largest subsidiary, the CFO ensured that required writeoffs were not recorded and overruled accounting decisions that could have a negative operational impact. The CFO ordered the destruction of damaging evidence, misled the internal accountant and the audit committee, and withheld information from the external auditors. During the period , Arthur Andersen LLP billed Waste Management approximately $7.5 million in audit fees and $11.8 million in other fees related to tax, attest work, regulatory issues, and consulting services. Andersen Consulting also billed $6 million in additional non-audit fees. Annual auditor-identified adjustments were proposed to correct errors that understated expenses and overstated earnings in the company s financial statements. Management consistently refused to make the proposed adjustments. Instead, the defendants secretly entered into a 32-step agreement with Arthur Andersen to write off the accumulated errors of periods up to 10 years, and to change the underlying improper accounting practices in future periods. In essence, this formal Summary of Action Steps constituted an agreement between the external auditors and fraudsters to cover up past frauds by committing future frauds. Defendants ultimately failed to comply with the Summary of Action Steps agreement, as it would result in the company not meeting ongoing earnings targets. This led to the unraveling of the fraudulent situation. Arthur Andersen agreed to pay a $7 million penalty for its role in this fraud. The auditors knew the company was overstating profits, but caved to the will of company management. Waste Management eventually settled a class action lawsuit for $457 million related to this fraud. 19