 Hello and welcome to the session in which we'll discuss the objective of the auditor when it comes to accounting estimates. What is accounting estimates and who makes accounting estimates? First, we have to understand that management is responsible for accounting estimates. What is an estimate? Well, it's an approximation. Think of it as a guess. Obviously, it has to be an educated guess, a guess based on data, based on the industry, based on prior knowledge. But it's an approximation of a monetary amount without precise means of measurement because we don't have a precise measurement. Therefore, we estimate. If we know the exact amount, we don't have to estimate. Now, every time we estimate, this is a subjective matter, subject to professional judgment, subject to judgment. What does that mean? It means you are telling us your best estimate. And here's what happened. You might be subject to biases, either intentional, you might be overstating certain numbers, understating certain numbers, whether intentionally or unintentionally. You are doing so intentionally with a purpose or just you don't know any better and you are making those estimates. Now, let's take a look at some sample estimates to put this into perspectives. We can look at a pending lawsuit, warranties, but that expense, depreciation. And yes, depreciation is a form of estimate, estimate, fair value estimates, and many other estimates. Now, this is management part. What is the auditor responsible for? Well, the auditor is responsible for gathering enough relevant evidence to determine if the estimates are reasonable. And remember, you have the amount as well as the disclosure meets the requirement of the financial reporting framework, whatever that framework is, whether it's US GAAP or the IFRS. So this is the auditor's objective. So basically to evaluate what management did gather evidence and basically evaluate what they did. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. No obligation, no credit card required. We are going to differentiate between two types of estimates. Now, there's not really two types of estimates. The reason we do this, to help you understand that not all estimates are of equal risks. Certain estimates will have a low risk and low uncertainty estimate. They're not difficult. They're not complex. They're easily verified estimate, which is part of our normal routine business operation. Other estimates, they're going to be high risk. So let's just kind of make sure we understand what's a low risk versus high risk to put things into perspective. A low risk estimate will be something like depreciation. All companies book depreciation. Depreciation rules are well known. Although I said that, although I said depreciation is a low risk estimate, don't get me wrong. Some companies book depreciation. In other words, fudge the numbers with depreciation to fudge the books and influence their stock price. A case in point, a company called Waste Management, if you are interested. But generally speaking, when I say low risk, depreciation is supposed to be low risk because the information is readily available. You know how much you pay for the asset? You can estimate a life. It should be reasonable. You would estimate a salvage value. The knowledge is there, but you can be creative as Waste Management and do something else, right? But that expense also a routine business expense, a routine business expense, warranties, but again, although I'm saying routine low risk, those could be subject, could be high risk, depending on the context. The market value of readily available prices. If you're looking for a market value of something and the prices are readily available. If you want to do a fair estimate for an asset based on a known, well accepted model, that's also low risk. Now, we have a high risk estimate. Well, pending lawsuit is considered, generally speaking, a high risk. Why? Because you don't know the outcome, whether you're going to win or you're going to loss and you don't know the dollar amount involved in that outcome. So that's why a pending lawsuit. Now, pending lawsuit could also be a low risk. If the amount is small, it doesn't really matter. So I'm just trying to tell you that just give you examples. What could be high, low, those could be interchangeable. Just so you understand the big picture. If you're estimating fair value based on limited data or unavailable, comparable data versus market value of readily available prices. If you are using some sort of a specialized knowledge, formula, model, for example, you're trying to estimate the derivatives. Or the degree of completion for a project or software development and you need specialized knowledge. Well, now we're dealing with a high risk uncertainty. Why do we have to differentiate from an auditor's perspective between high risk and low risk is because more work is done, more evidence is collected, more substantive testing for high risk areas. For example, you need to review the outcome. You need to test management estimate method. You need to test any relevant controls. We're going to talk about the auditor's response in a moment and develop a point estimate or range to evaluate management estimate. What does that mean? That means you do your own estimate and compare it. You'll have a range and compare your numbers to their numbers. See if you came up to the same or close numbers. Now, the way we evaluate accounting estimate is a risk based, risk based audit approach. What does that mean? It means first the auditor will have to learn about the company. The auditor should understand the financial reporting framework. What are they using? If they're using GAP, you have to have an understanding of GAP. If they're using IFRS, you have to have an understanding of IFRS. You have to understand how did the management arrives to this accounting estimate, looking at the data that they use and any estimation and certainty assessment that they assess at high risk, low risk, so on and so forth, that they use any specialized skills or knowledge for the estimate. You may need, if they have a specialized skill or specialized knowledge, like they use an actuary, and you really want to be sure you would hire your own actuary and perform the same study if the situation is of a really high risk and there's a high uncertainty to the financial numbers. How management assess this uncertainty? As I said, how did they assess it with a low risk or high risk? Is the assessment consistent and appropriate? Are they randomly using different assessment and they're not appropriate or are they consistent? We have to look at this. Okay. So the auditor simply put should evaluate the level of estimation and certainty and determine if any of the estimate will pause any significant misstatement risk. In other words, significant means it's going to affect the financial statement overall. If that's the case, if there's an estimate like this, you may want to go further and evaluate the relevant controls, test the relevant control, test the effectiveness of the applicable controls and perform more substantive testing about that, whatever that uncertainty is. So how do we respond to the assess risk? How do we respond to it? Again, we evaluate the accounting estimate using up-to-date material, up-to-date data. So for example, if the estimate was made in November, we want to take a look at that same estimate in January or February before we issued the financial statement to see if that estimate's the relevant because we made the estimate and the numbers were booked. Let's do it again. Review models or method used, prepare sensitivity analysis and or monitor prior accounting estimate. Now in prior years, they made estimate. See if those estimates were actually realized. For example, they're back their expense. That's easy to see how much they estimated last year, a million dollar. And this year, they only wrote off 200,000. It means they overestimated or they estimated a million. And the actual write off was 3 million. They underestimated. So you could always look at prior year to just check their appropriateness and reasonableness. Review the reasonableness of their assumptions because when you make estimate, you always make assumptions and they have to tell you what those assumptions are. You have to ask them. You have to ask them to put it in writing. You can take a look at these assumptions and determine whether they are reasonable or not. Again, compare them to the prior year and see what they said in the prior year and see if those assumptions were materialized. Test the operating effectiveness of the control. We talked about this, especially if there's a significant risk. Also, use audit evidence to create your own estimate. You also want to do your own work. Say, this is what I came up to. This is what they came up to. What is the gap in between? And also evaluate the disclosure. Always you have to look at the disclosure as well, because the disclosure is an important part of the financial statement. It's basically part of the basic financial statement. Also, you have to consider biases. Here you are looking at the management objective. You want to see what is the management objective? Do they want to report more revenues or less expenses? What is their objective? Depending on what their objective is, and you have to determine this. OK, for example, if it's if it's a publicly traded company and they like their stock price to go up, well, most likely they're going to try to record more revenues. And how do you look at some at those biases or those indications or red flags? Well, they change their estimates on regular basis. They keep changing their estimate. They're not consistent. The assumptions that they make are inconsistent and or inappropriate. And they have a bias toward either optimism or pessimism. When they have a bias, it means you have a bias. OK, you are trying to cook the books. You are trying to get the numbers that you want. Well, if that's the case, we have to be on the lookout knowing that you have that bias toward either optimism or pessimism. OK, when there is a significant uncertainty, what can I do? I can just add that that estimate as an emphasis of a matter in the audit report, just to make sure it's an accounting estimate. This is how they come up to it. This one, you know, because it's significant. Here's the information. Also, we have to document the auditor should document the basis for their conclusion about the reasonableness of the accounting estimate, especially the one with significant risk. And how did they come up with the disclosure as well? Is it adequate disclosure? Indication of any possible management biases. If we think we have those management biases there, we have to document this. OK, and the auditor should, the best way to protect yourself, obtain written representation from management about the reasonableness and assumptions. Because remember, when management makes a claim like an accounting estimate, they're making this claim, they're making this estimate. They use certain information assumptions. You want them to tell you in writing that they did this in good faith based on X, Y, Z. And you have this in writing. This is basically your protection that you relied on what they are saying. Now, you're going to have to do your work, but at least they told you all the information that's needed to come up with that estimate. You want that in writing to protect yourself. What should you do now? Go to Farhat Lectures and look at additional MCQs. That's going to help you understand this important topic for the CPA exam or whatever professional certification or your audit course. 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