The Australian Auditing and Assurance Standards Board (AUASB) have recently released a revised auditing standard (ASA 540) on accounting estimates and related disclosures. This revision has important implications not just for auditors but for those responsible for financial statement preparation and the determination of accounting estimates.

ASA 540 (Revised) Auditing Accounting Estimates and Related Disclosures has recently been implemented and became effective for financial reporting periods beginning on or after 15 December 2019. Despite being an auditing standard, there are some important implications from a Company perspective that will change the way audits are conducted and the information that management need to prepare accordingly. The revised standard will impact the 30 June 2021 financial reporting period for the first time and will likely require improvements in documentation and enhanced communication between auditors, management and those charged with governance (TCWG) as part of the year end close process.

Why was the Standard revised?

The previous version of ASA 540 was written well before several significant changes in Australian Accounting Standards were introduced, several of which now involve a greater degree of estimation uncertainty than previously observed. Such recent changes include the calculation of expected credit losses (AASB 9), updates to the revenue recognition framework (AASB 15) and accounting for leases (AASB 16). The calculations inherent in these transactions and balances include a degree of management estimation that can be complex and involve significant judgement. Material estimates must therefore be disclosed appropriately and challenged by management and auditors accordingly. As a result, there is now a greater focus on critical estimates and judgements in the financial report and their perceived importance to users.

The revised standard is intended to foster a more independent, challenging and sceptical mindset by auditors and management, and address the recurring themes from regulatory audit quality inspections over recent years.

What to expect and how to prepare?

Auditors are now required to place greater emphasis on exercising professional scepticism when it comes to auditing accounting estimates, which is particularly important given the increased levels of uncertainly many entities are experiencing due to COVID-19 in recent times. Material estimates may include areas such as conducting impairment reviews, determining fair values of assets, calculating expected credit losses and accounting for complex revenue contracts.

Management and TCWG may therefore be subject to a heightened degree of questioning regarding how they have derived the accounting estimates and their processes and controls in place. Auditors are required to obtain formal documented policies and procedures to understand the nature and extent of the estimation process as well as communicating to TCWG where process gaps have been identified. Management should therefore factor in additional time requirements for documenting the key judgements and decision making processes in preparation for upcoming audit periods.

The professional scepticism requirements also extend beyond management to any inhouse or externally appointed experts who are involved in the calculation of accounting estimates. Such experts may include valuation specialists and external advisors as well as the directors and audit committees recommending the approval of the financial statements. As such, documentation regarding how these experts are used and the process management have in place to review key valuation methods, assumptions and data will be required.

Best practice documentation requirements

It is important that the internal processes used and observed by management to identify, determine and calculate these estimates are documented and observed. Equally important is the expectation that TCWG have oversight of the internal processes used as well as the output prepared by management as part of the financial reporting process.

In light of the increased focus on transparent documentation, management and preparers of the financial statements should ensure internal policies and procedures address the following core principles when considering accounting estimates:

  1. Management should clearly document the selection and application of methods, assumptions and data used in arriving at material accounting estimates;
  2. Estimation uncertainty should be identified and addressed by selecting an appropriate point estimate, eliminating the risk of potential management bias, and making appropriate financial statement disclosures in respect of estimation uncertainty;
  3. The methodology, assumptions and data used to prepare material estimates, along with the proposed financial statement disclosure, should be reported to, and accepted by, TCWG; and
  4. The documentation of material estimates as well as associated policies and procedures should be reviewed and formally approved by TCWG at least annually to evidence an appropriate degree of oversight.

It is important to note that the accounting estimates included in the scope of this revised standard include those that are often considered routine and thus may not have been thoroughly considered and/or documented by management in the past. Some examples include determining the useful life of property, plant and equipment and calculating employee benefit provisions such as long service leave. Such matters still involve a degree of estimation and thus should be documented and disclosed accordingly.

Final considerations

Overall, having observed the revised ASA 540 auditing standard in practice, it is clear that those responsible for financial statement preparation will be subject to greater level of enquiry and scrutiny from auditors in respect of accounting estimates. In order to minimise disruption, preparers are encouraged to clearly document the methods, assumptions and data underlying the determination of material estimates and to disclose the associated estimation uncertainty in the financial statements.