Accounting Estimates and Accruals

1
Accounting Estimates and Accruals

• Payables/Receivables Methodology for Estimating

2
Accounting Estimates and Accruals

• An accounting estimate is an approximation of a
  financial statement element, item or account used
  because
• The measurement or valuation of some amount or
  account is uncertain, pending the outcome of
  future events, or
• Relevant data concerning events that have already
  occurred cannot be accumulated on a timely,
  cost-effective basis

3
Accounting Estimates and Accruals

• Examples of an accounting estimate include
• Property and casualty insurance loss reserves
• Taxes on real and personal property
• Revenues and costs to be incurred from
  percent-of-completion contracts
• Initial direct costs, executory costs, and
  residual values of leases
• Actuarial assumptions in pension costs and
  warranty claims

4
Accounting Estimates and Accruals

• Management is responsible for establishing a
  process for preparing accounting estimates
  consisting of
• Identifying situations requiring estimates and
  relevant factors that may affect the accounting
  estimates
• Accumulating relevant, sufficient and reliable
  data on which to base the estimates
• Developing relevant assumptions of the most
  likely circumstances and events, using judgment
  experience
• Calculating the estimated amounts based on the
  assumptions and other relevant factors
• Presenting the estimates in conformity with GAAP
  and determining that disclosures are adequate

5
Accounting Estimates and Accruals

• The risk of material misstatement of an
  accounting estimate normally varies with the
• Complexity and subjectivity associated with the
  process
• Availability and reliability of relevant data
• Number and significance of assumptions that are
  made
• Degree of uncertainty associated with the
  assumptions

6
Accounting Estimates and Accruals

• Management Controls that reduce the likelihood of
  material misstatements of estimates include
• Communication of the need for proper estimates
  and the importance of accumulating relevant,
  sufficient and reliable data for preparing the
  estimates
• Preparation of estimates by qualified personnel
• Supervision, review and approval over the process
  for developing estimates by appropriate levels of
  authority
• Comparison of prior estimates with subsequent
  results to assess reliability of the process and
  needed changes
• Consideration of the need to use specialists

7
Accounting Estimates and Accruals

• The auditors objective is to obtain sufficient
  competent evidential matter to provide reasonable
  assurance that
• All accounting estimates that could be material
  to the financial statements have been developed
• Accounting estimates are reasonable in relation
  to the circumstances
• Accounting estimates are presented in conformity
  with applicable accounting principles and are
  properly disclosed

8
Accounting Estimates and Accruals

• In evaluating reasonableness of an estimate, the
  auditor normally concentrates on key factors and
  assumptions that are
• Significant to the accounting estimate
• Sensitive to variations
• Deviations from historical patterns
• Subjective and susceptible to misstatement and
  bias

9
Accounting Estimates and Accruals

• To assess reasonableness of an estimate, the
  auditor develops an understanding and tests
  managements process by performing procedures to
  determine if
• Controls over the preparation of the estimate and
  supporting data are in place and effective
• Sources of data and factors used in forming the
  assumptions are relevant, reliable and sufficient
• No additional key factors or alternative
  assumptions exist that should have been
  considered
• Historical data is comparable and consistent with
  the current period data used in the estimate
• The calculation is accurate and well documented

10
Accounting Estimates and Accruals

• The auditor must also evaluate the reasonableness
  of accounting estimates in relation to the
  financial statements as a whole
• If the auditor believes the estimated amount is
  unreasonable, the difference between the estimate
  and the closest reasonable estimate should be
  treated as a likely misstatement and aggregated
  with other likely misstatements when forming the
  overall opinion on the financial statements