Auditing Accounting Estimates 541 AU-C Section 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures Source: SAS No. 122; SAS No. 134; SAS No. 136. Effective for audits of financial statements for periods ending on or after December 15, 2012, unless otherwise indicated. Introduction Scope of This Section .01 This section addresses the auditor's responsibilities relating to ac- counting estimates, including fair value accounting estimates and related dis- closures, in an audit of financial statements. Specifically, it expands on how section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement; section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained;and other relevant AU-C sections are to be applied with regard to accounting esti- mates. It also includes requirements and guidance related to misstatements of individual accounting estimates and indicators of possible management bias. Nature of Accounting Estimates .02 Some financial statement items cannot be measured precisely but can only be estimated. For purposes of this section, such financial statement items are referred to as accounting estimates. The nature and reliability of informa- tion available to management to support the making of an accounting estimate varies widely, which thereby affects the degree of estimation uncertainty asso- ciated with accounting estimates. The degree of estimation uncertainty affects, in turn, the risks of material misstatement of accounting estimates, including their susceptibility to unintentional or intentional management bias. (Ref: par. .A1–.A10 and .A136) .03 The measurement objective of accounting estimates can vary, depend- ing on the applicable financial reporting framework and the financial item being reported.1 The measurement objective for some accounting estimates is to forecast the outcome of one or more transactions, events, or conditions giv- ing rise to the need for the accounting estimate. For other accounting estimates, including many fair value accounting estimates, the measurement objective is different and is expressed in terms of the value of a current transaction or financial statement item based on conditions prevalent at the measurement date, such as estimated market price for a particular type of asset or liabil- ity. For example, the applicable financial reporting framework may require fair 1 Paragraph .14 of section 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance With Generally Accepted Auditing Standards, defines financial report frame- work and the term fair presentation framework. ©2020, AICPA AU-C §540.03 542 Audit Evidence value measurement based on an assumed hypothetical current transaction be- tween knowledgeable, willing parties (sometimes referred to as market partici- pants or equivalent) in an arm's length transaction, rather than the settlement of a transaction at some past or future date.2 .04 A difference between the outcome of an accounting estimate and the amount originally recognized or disclosed in the financial statements does not necessarily represent a misstatement of the financial statements; rather, it could be an outcome of estimation uncertainty (see paragraph .02). This is par- ticularly the case for fair value accounting estimates because any observed out- come may be affected by events or conditions subsequent to the date at which the measurement is estimated for purposes of the financial statements. Effective Date .05 This section is effective for audits of financial statements for periods ending on or after December 15, 2012. Objective .06 The objective of the auditor is to obtain sufficient appropriate audit evidence about whether, in the context of the applicable financial reporting framework a. accounting estimates, including fair value accounting estimates, in the financial statements, whether recognized or disclosed, are reasonable and b. related disclosures in the financial statements are adequate. Definitions .07 For purposes of generally accepted auditing standards, the following terms have the meanings attributed as follows: Accounting estimate. An approximation of a monetary amount in the absence of a precise means of measurement. This term is used for an amount measured at fair value when there is estimation uncertainty, as well as for other amounts that require estimation. When this section addresses only accounting estimates involving measurement at fair value, the term fair value accounting esti- mates is used. Auditor's point estimate or auditor's range. The amount or range of amounts, respectively, derived from audit evidence for use in evaluating the recorded or disclosed amount(s). Estimation uncertainty. The susceptibility of an accounting esti- mate and related disclosures to an inherent lack of precision in its measurement. Management bias. A lack of neutrality by management in the preparation and fair presentation of information. Management's point estimate. The amount selected by manage- ment for recognition or disclosure in the financial statements as an accounting estimate. 2 Different definitions of fair value may exist among financial reporting frameworks. AU-C §540.04 ©2020, AICPA Auditing Accounting Estimates 543 Outcome of an accounting estimate. The actual monetary amount that results from the resolution of the underlying trans- action(s), event(s), or condition(s) addressed by the accounting estimate. Requirements Risk Assessment Procedures and Related Activities .08 When performing risk assessment procedures and related activities to obtain an understanding of the entity and its environment, including the en- tity's internal control, as required by section 315, the auditor should obtain an understanding of the following in order to provide a basis for the identi- fication and assessment of the risks of material misstatement for accounting estimates:3 (Ref: par. .A11) a. The requirements of the applicable financial reporting framework relevant to accounting estimates, including related disclosures. (Ref: par. .A12–.A14) b. How management identifies those transactions, events, and con- ditions that may give rise to the need for accounting estimates to be recognized or disclosed in the financial statements. In ob- taining this understanding, the auditor should make inquiries of management about changes in circumstances that may give rise to new, or the need to revise existing, accounting estimates. (Ref: par. .A15–.A20) c. How management makes the accounting estimates and the data on which they are based, including (Ref: par. .A21–.A22) i. the method(s), including, when applicable, the model, used in making the accounting estimate; (Ref: par. .A23–.A25) ii. relevant controls; (Ref: par. .A26–.A27) iii. whether management has used a specialist; (Ref: par. .A28–.A29) iv. the assumptions underlying the accounting estimates; (Ref: par. .A30–.A35) v. whether there has been or ought to have been a change from the prior period in the method(s) or assumption(s) for making the accounting estimates and, if so, why; and (Ref: par. .A36) vi. whether and, if so, how management has assessed the ef- fect of estimation uncertainty. (Ref: par. .A37) .09 The auditor should review the outcome of accounting estimates in- cluded in the prior period financial statements or, when applicable, their subse- quent reestimation 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 esti- mates made in the current period financial statements. However, the review is not intended to call into question the auditor's professional judgments made 3 Paragraphs .05–.06 and .12–.13 of section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement. ©2020, AICPA AU-C §540.09 544 Audit Evidence in the prior periods that were based on information available at the time. (Ref: par. .A38–.A44) Identifying and Assessing the Risks of Material Misstatement .10 In identifying and assessing the risks of material misstatement, as re- quired by section 315, the auditor should evaluate the degree of estimation uncertainty associated with an accounting estimate.4 (Ref: par. .A45–.A46) .11 The auditor should determine whether, in the auditor's professional judgment, any of those accounting estimates that have been identified as having high estimation uncertainty give rise to significant risks. (Ref: par. .A47–.A51) Responding to the Assessed Risks of Material Misstatement .12 Based on the assessed risks of material misstatement, the auditor should determine (Ref: par. .A52) a. whether management has appropriately applied the require- ments of the applicable financial reporting framework relevant to the accounting estimate and (Ref: par. .A53–.A57) b. whether the methods for making the accounting estimates are appropriate and have been applied consistently and whether changes from the prior period, if any, in accounting estimates or the method for making them are appropriate in the circum- stances. (Ref: par. .A58–.A59) .13 In responding to the assessed risks of material misstatement, as re- quired by section 330, the auditor should undertake one or more of the fol- lowing, taking into account the nature of the accounting estimate:5 (Ref: