Auditing Accounting Estimates
Accounting estimates are approximations of financial statement amounts when precise measurement is not possible. Examples include the allowance for doubtful accounts, warranty reserves, depreciation, fair value measurements, and contingent liabilities. Because estimates involve significant management judgment, they carry inherent risk of material misstatement and potential management bias.
How the Auditor Evaluates Estimates
The auditor uses one or a combination of the following three approaches to evaluate accounting estimates:
1. Review Management's Process
The auditor evaluates the method, assumptions, and data used by management to develop the estimate:
- Method: Is the estimation method appropriate and consistently applied?
- Assumptions: Are the significant assumptions reasonable and supported by evidence?
- Data: Is the underlying data complete, accurate, and relevant?
2. Develop an Independent Estimate
The auditor develops a separate, independent estimate (a point estimate or range) to compare with management's recorded amount. If the auditor's estimate differs materially from management's, further investigation is warranted.
3. Review Subsequent Events
The auditor examines events or transactions occurring after the balance sheet date but before the audit report date that may provide evidence about the reasonableness of the estimate.
The auditor may use one, two, or all three approaches. The choice depends on the nature of the estimate and the assessed risk of material misstatement. For high-risk estimates, the auditor may use multiple approaches to obtain more persuasive evidence.
Example: Evaluating an Estimate at Gies Co.
Gies Co. records a warranty reserve of $500,000. The auditor:
- Reviews management's process – Examines the historical warranty claim rate, the assumptions about future claims, and the data used (sales volume, defect rates)
- Develops an independent estimate – Using Gies Co.'s historical claim data and industry benchmarks, the auditor independently calculates an expected warranty reserve of $480,000–$530,000
- Reviews subsequent events – Examines warranty claims received in January and February to see if the pattern is consistent with management's estimate
Since management's $500,000 falls within the auditor's reasonable range, the estimate is considered acceptable.
Sources of Estimation Uncertainty
Accounting estimates are inherently uncertain. Key sources of uncertainty include:
| Source | Description |
|---|---|
| Complexity of the estimate | Multi-variable models (e.g., pension obligations, fair value of derivatives) are more uncertain |
| Subjectivity of assumptions | Assumptions about future events (e.g., discount rates, growth rates) involve significant judgment |
| Length of the forecast period | Estimates requiring projections far into the future carry more uncertainty |
| Availability of reliable data | Limited historical data or data from volatile markets increases uncertainty |
| Sensitivity to changes | Small changes in key assumptions that produce large changes in the estimate indicate high sensitivity |
| Management bias | Management may have incentives to bias estimates in a particular direction |
The auditor must evaluate whether management's assumptions and methods suggest intentional bias. A pattern of optimistic or pessimistic estimates across multiple accounts may indicate management is manipulating results. Indicators include consistently selecting assumptions at one end of a reasonable range.
Audit Procedures for Contingencies and Litigation
Contingent liabilities arise from lawsuits, regulatory actions, tax disputes, and other uncertain situations. Auditing contingencies requires specialized procedures because management may not voluntarily disclose unfavorable legal matters.
Letter of Inquiry to the Client's Attorney
The attorney letter (also called a letter of audit inquiry or legal letter) is a primary procedure for identifying and evaluating litigation, claims, and assessments.
Process
- Management prepares a letter describing all pending or threatened litigation, claims, and assessments
- The letter is sent to the client's outside legal counsel (attorneys), requesting them to confirm or comment on:
- The existence of the matters described
- The likelihood of an unfavorable outcome (probable, reasonably possible, or remote)
- An estimate of the potential loss or a statement that an estimate cannot be made
- The attorney responds directly to the auditor
The letter is prepared by management (not the auditor) because it is management who has the attorney-client relationship. However, the response is sent to the auditor to ensure the information is not filtered through management.
Other Procedures for Contingencies
| Procedure | Description |
|---|---|
| Inquiry of management | Ask management about known or potential claims, litigation, and regulatory actions |
| Review board minutes | Board meeting minutes may reference legal matters, settlements, or claims |
| Review contracts and correspondence | Examine contracts for penalty clauses, guarantees, or indemnification agreements |
| Review tax returns and assessments | Identify potential tax-related contingencies |
| Obtain a representation letter | Management's written representations should specifically address litigation and contingencies |
Example: Contingency Audit at BIF Partners
BIF Partners is involved in a breach-of-contract lawsuit filed by Illini Security. The auditor:
- Reviews management's description of the lawsuit in the attorney letter
- Sends the letter to BIF Partners' outside counsel, who confirms the lawsuit exists and assesses the likelihood of an unfavorable outcome as "reasonably possible" with a potential range of $200,000–$400,000
- Reviews the board minutes from the September meeting, which reference the lawsuit and discuss settlement options
- Reviews the engagement letter between BIF Partners and its attorney for scope of legal representation
- Verifies that BIF Partners disclosed the contingency in the notes to the financial statements
Effect on the Audit Opinion
Client Refuses to Send the Attorney Letter
If the client refuses to allow the auditor to send a letter of inquiry to its attorney, this constitutes a scope limitation imposed by the client. The auditor should consider:
- Qualified opinion – If the potential misstatement could be material but not pervasive
- Disclaimer of opinion – If the potential misstatement could be both material and pervasive
- Withdrawal from the engagement – In some circumstances, particularly if the refusal suggests a broader integrity concern
Attorney Refuses to Respond
If the client's attorney refuses to furnish information requested in the letter of inquiry, this also creates a scope limitation. The auditor's response depends on the significance of the matter:
| Scenario | Potential Impact on Opinion |
|---|---|
| Attorney refuses to respond to specific items that are potentially material | Qualified opinion or disclaimer |
| Attorney refuses to respond entirely | Disclaimer of opinion is likely warranted |
| Attorney limits response due to inherent uncertainty (cannot estimate outcome) | Not necessarily a scope limitation—the auditor evaluates disclosure adequacy |
Example: Attorney Non-Response at MAS Inc.
MAS Inc.'s attorney refuses to respond to the auditor's inquiry regarding a pending regulatory action by the SEC. The auditor is unable to obtain sufficient appropriate evidence about the potential liability. Because the matter could be material and pervasive to the financial statements, the auditor issues a disclaimer of opinion, citing the inability to obtain sufficient evidence about the litigation contingency.
Summary
| Procedure/Concept | Key Point |
|---|---|
| Evaluating estimates | Three approaches: review management's process, develop independent estimate, review subsequent events |
| Estimation uncertainty | Driven by complexity, subjectivity, forecast horizon, data availability, sensitivity, and potential bias |
| Attorney letter | Prepared by management, sent to attorney, response goes directly to auditor |
| Client refuses attorney inquiry | Scope limitation → qualified opinion or disclaimer |
| Attorney refuses to respond | Scope limitation → qualified opinion or disclaimer |