INTERNATIONAL STANDARD ON AUDITING 540

AUDIT OF ACCOUNTING ESTIMATES

(Effective for audits of financial statements for periods
beginning on or after December 15, 2004)∗

CONTENTS
Paragraph
Introduction ................................................................................................... 1-4
The Nature of Accounting Estimates ............................................................. 5-7
Audit Procedures Responsive to the Risk of Material Misstatement
of the Entity’s Accounting Estimates ..................................................... 8-10
Reviewing and Testing the Process Used by Management ............................ 11-21
Use of an Independent Estimate .................................................................... 22
Review of Subsequent Events ........................................................................ 23
Evaluation of Results of Audit Procedures .................................................... 24-27

International Standard on Auditing (ISA) 540, “Audit of Accounting Estimates”

should be read in the context of the “Preface to the International Standards on Quality
Control, Auditing, Review, Other Assurance and Related Services,” which sets out
the application and authority of ISAs.

AUDITING
∗ ISA 315, “Understanding the Entity and Its Environment and Assessing the Risks of Material
Misstatement,” ISA 330, “The Auditor’s Procedures in Response to Assessed Risks,” and ISA 500,
“Audit Evidence” gave rise to conforming amendments to ISA 540. The conforming amendments are
effective for audits of financial statements for periods beginning on or after December 15, 2004 and have
been incorporated in the text of ISA 540.
ISA 540 has been revised. In addition, matters of continuing relevance in ISA 545, “Auditing Fair Value
Measurements and Disclosures” have been revised and incorporated in the revised ISA 540 to form one
combined ISA dealing with the audit of accounting estimates, including fair value accounting estimates.
The IAASB’s clarity drafting conventions have been applied to the combined ISA. ISA 540 (Revised
and Redrafted), “Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and
Related Disclosures” can be found in Part II of the Handbook of International Auditing, Assurance, and
Ethics Pronouncements. It is effective for audits of financial statements for periods beginning on or after
December 15, 2009.

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Introduction
1. The purpose of this International Standard on Auditing (ISA) is to establish
standards and provide guidance on the audit of accounting estimates contained
in financial statements. This ISA is not intended to be applicable to the
examination of prospective financial information, though many of the audit
procedures outlined herein may be suitable for that purpose.
2. The auditor should obtain sufficient appropriate audit evidence regarding
accounting estimates.
3. “Accounting estimate” means an approximation of the amount of an item in
the absence of a precise means of measurement. Examples are:
• Allowances to reduce inventory and accounts receivable to their estimated
realizable value.
• Provisions to allocate the cost of fixed assets over their estimated useful
lives.
• Accrued revenue.
• Deferred tax.
• Provision for a loss from a lawsuit.
• Losses on construction contracts in progress.
• Provision to meet warranty claims.
4. Management is responsible for making accounting estimates included in
financial statements. These estimates are often made in conditions of
uncertainty regarding the outcome of events that have occurred or are likely to
occur and involve the use of judgment. As a result, the risk of material
misstatement is greater when accounting estimates are involved and in some
cases the auditor may determine that the risk of material misstatement related
to an accounting estimate is a significant risk that requires special audit
consideration. See paragraphs 108-114 of ISA 315, “Understanding the Entity
and Its Environment and Assessing the Risks of Material Misstatement.”

The Nature of Accounting Estimates

5. The determination of an accounting estimate may be simple or complex
depending upon the nature of the item. For example, accruing a charge for rent
may be a simple calculation, whereas estimating a provision for slow-moving
or surplus inventory may involve considerable analyses of current data and a
forecast of future sales. In complex estimates, there may be a high degree of
special knowledge and judgment required.
6. Accounting estimates may be determined as part of the routine information
system relevant to financial reporting operating on a continuing basis, or may

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be nonroutine, operating only at period end. In many cases, accounting

estimates are made by using a formula based on experience, such as the use of
standard rates for depreciating each category of fixed assets or a standard
percentage of sales revenue for computing a warranty provision. In such cases,
the formula needs to be reviewed regularly by management, for example, by
reassessing the remaining useful lives of assets or by comparing actual results
with the estimate and adjusting the formula when necessary.
7. The uncertainty associated with an item, or the lack of objective data may
make it incapable of reasonable estimation, in which case the auditor needs to
consider whether the auditor’s report needs modification to comply with ISA
701, “Modifications to the Independent Auditor’s Report.”

Audit Procedures Responsive to the Risk of Material Misstatement

of the Entity’s Accounting Estimates
8. The auditor should design and perform further audit procedures to obtain
sufficient appropriate audit evidence as to whether the entity’s accounting
estimates are reasonable in the circumstances and, when required,
appropriately disclosed. The audit evidence available to detect a material
misstatement in an accounting estimate will often be more difficult to obtain
and less persuasive than audit evidence available to detect a material
misstatement in other items in the financial statements. The auditor’s
understanding of the entity and its environment, including its internal control,
assists the auditor in identifying and assessing the risks of material
misstatement of the entity’s accounting estimates.
9. An understanding of the procedures and methods, including relevant control
activities, used by management in making the accounting estimates is
important for the auditor to identify and assess risks of material misstatement
in order to design the nature, timing and extent of the further audit procedures.

AUDITING
10. The auditor should adopt one or a combination of the following
approaches in the audit of an accounting estimate:
(a) Review and test the process used by management to develop the
estimate;
(b) Use an independent estimate for comparison with that prepared by
management; or
(c) Review of subsequent events which provide audit evidence of the
reasonableness of the estimate made.

Reviewing and Testing the Process Used by Management

11. The steps ordinarily involved in reviewing and testing of the process used by
management are:

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(a) Evaluation of the data and consideration of assumptions on which the

estimate is based;
(b) Testing of the calculations involved in the estimate;
(c) Comparison, when possible, of estimates made for prior periods with
actual results of those periods; and
(d) Consideration of management’s approval procedures.

Evaluation of Data and Consideration of Assumptions

12. The auditor would evaluate whether the data on which the estimate is based is
accurate, complete and relevant. When information produced by the entity is
used, it will need to be consistent with the data processed through the
information system relevant to financial reporting. For example, in
substantiating a warranty provision, the auditor would obtain audit evidence
that the data relating to products still within the warranty period at period end
agree with the sales information within the information system relevant to
financial reporting. ISA 500, “Audit Evidence” paragraph 11 provides
additional guidance on the requirement to obtain audit evidence about the
accuracy and completeness of information produced by the entity when it is
used in performing audit procedures.
13. The auditor may also seek audit evidence from sources outside the entity. For
example, when examining a provision for inventory obsolescence calculated
by reference to anticipated future sales, the auditor may, in addition to
examining internal data such as past levels of sales, orders on hand and
marketing trends, seek audit evidence from industry-produced sales projections
and market analyses. Similarly, when examining management’s estimates of
the financial implications of litigation and claims, the auditor would seek direct
communication with the entity’s lawyers.
14. The auditor would evaluate whether the data collected is appropriately
analyzed and projected to form a reasonable basis for determining the
accounting estimate. Examples are the analysis of the age of accounts
receivable and the projection of the number of months of supply on hand of an
item of inventory based on past and forecast usage.
15. The auditor would evaluate whether the entity has an appropriate base for the
principal assumptions used in the accounting estimate. In some cases, the
assumptions will be based on industry or government statistics, such as future
inflation rates, interest rates, employment rates and anticipated market growth.
In other cases, the assumptions will be specific to the entity and will be based
on internally generated data.
16. In evaluating the assumptions on which the estimate is based, the auditor
would consider, among other things, whether they are:

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• Reasonable in light of actual results in prior periods;

• Consistent with those used for other accounting estimates; and
• Consistent with management’s plans which appear appropriate.
The auditor would need to pay particular attention to assumptions which are
sensitive to variation, subjective or susceptible to material misstatement.
17. In the case of complex estimating processes involving specialized techniques,
it may be necessary for the auditor to use the work of an expert, for example,
engineers for estimating quantities in stock piles of mineral ores. Guidance on
how to use the work of an expert is provided in ISA 620, “Using the Work of
an Expert.”
18. The auditor would review the continuing appropriateness of formulae used by
management in the preparation of accounting estimates. Such a review would
reflect the auditor’s knowledge of the financial results of the entity in prior
periods, practices used by other entities in the industry and the future plans of
management as disclosed to the auditor.

Testing of Calculations
19. The auditor would perform audit procedures on the calculation procedures
used by management. The nature, timing and extent of the auditor’s procedures
will depend on the assessed risk of material misstatement, which is impacted
by such factors as the complexity involved in calculating the accounting
estimate, the auditor’s understanding and evaluation of the procedures and
methods, including relevant control activities used by the entity in producing
the estimate and the materiality of the estimate in the context of the financial
statements.

Comparison of Previous Estimates with Actual Results

AUDITING
20. When possible, the auditor would compare accounting estimates made for
prior periods with actual results of those periods to assist in:
(a) Obtaining audit evidence about the general reliability of the entity’s
estimating procedures and methods, including relevant control
activities;
(b) Considering whether adjustments to estimating formulae may be
required; and
(c) Evaluating whether differences between actual results and previous
estimates have been quantified and that, where necessary, appropriate
adjustments or disclosures have been made.

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Consideration of Management’s Approval Procedures

21. Material accounting estimates are ordinarily reviewed and approved by
management. The auditor would consider whether such review and approval is
performed by the appropriate level of management and that it is evidenced in
the documentation supporting the determination of the accounting estimate.

Use of an Independent Estimate

22. The auditor may make or obtain an independent estimate and compare it with
the accounting estimate prepared by management. When using an independent
estimate the auditor would ordinarily evaluate the data, consider the
assumptions and perform audit procedures on the calculation procedures used
in its development. It may also be appropriate to compare accounting estimates
made for prior periods with actual results of those periods.

Review of Subsequent Events

23. Transactions and events which occur after period end, but prior to completion
of the audit, may provide audit evidence regarding an accounting estimate
made by management. The auditor’s review of such transactions and events
may reduce, or even remove, the need for the auditor to review and perform
audit procedures on the process used by management to develop the
accounting estimate or to use an independent estimate in assessing the
reasonableness of the accounting estimate.

Evaluation of Results of Audit Procedures

24. The auditor should make a final assessment of the reasonableness of the
entity’s accounting estimates based on the auditor’s understanding of the
entity and its environment and whether the estimates are consistent with
other audit evidence obtained during the audit.
25. The auditor would consider whether there are any significant subsequent
transactions or events which affect the data and the assumptions used in
determining the accounting estimates.
26. Because of the uncertainties inherent in accounting estimates, evaluating
differences can be more difficult than in other areas of the audit. When there is
a difference between the auditor’s estimate of the amount best supported by the
available audit evidence and the estimated amount included in the financial
statements, the auditor would determine whether such a difference requires
adjustment. If the difference is reasonable, for example, because the amount in
the financial statements falls within a range of acceptable results, it may not
require adjustment. However, if the auditor believes the difference is
unreasonable, management would be requested to revise the estimate. If
management refuses to revise the estimate, the difference would be considered

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a misstatement and would be considered with all other misstatements in

assessing whether the effect on the financial statements is material.
27. The auditor would also consider whether individual differences which have
been accepted as reasonable are biased in one direction, so that, on a
cumulative basis, they may have a material effect on the financial statements.
In such circumstances, the auditor would evaluate the accounting estimates
taken as a whole.

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