AS 2501: Auditing Accounting Estimates, Including Fair Value Measurements

Summary Table of Contents

• .01  Introduction
• .03  Objective
• .04  Identifying and Assessing Risks of Material Misstatement
• .05  Responding to the Risks of Material Misstatement
• .09  Testing the Company's Process Used to Develop the Accounting Estimate
• .21  Developing an Independent Expectation of the Estimate
• .27  Evaluating Audit Evidence from Events or Transactions Occurring After the Measurement Date
• .30  Evaluating Audit Results
• Appendix A - Special Topics

Introduction

.01       This standard establishes requirements for auditing accounting estimates (including fair value measurements) in significant accounts and disclosures in financial statements.

.02       An accounting estimate is a measurement or recognition in the financial statements of (or a decision to not recognize) an account, disclosure, transaction, or event that generally involves subjective assumptions and measurement uncertainty. For purposes of this standard, a fair value measurement is a form of accounting estimate.

Objective

.03       The objective of the auditor is to obtain sufficient appropriate evidence to determine whether accounting estimates in significant accounts and disclosures are properly accounted for and disclosed in the financial statements.

Identifying and Assessing Risks of Material Misstatement 

.04       AS 2110, Identifying and Assessing Risks of Material Misstatement, establishes requirements regarding the process of identifying and assessing risks of material misstatement. This process includes (1) identifying accounting estimates in significant accounts and disclosures; (2) understanding the process by which accounting estimates are developed;¹ and (3) identifying and assessing the risks of material misstatement related to accounting estimates, which includes determining whether the components of estimates in significant accounts and disclosures are subject to significantly differing risks,² and which accounting estimates are associated with significant risks.

Note:  AS 2110.60 and .60A set forth risk factors relevant to the identification of significant accounts and disclosures involving accounting estimates. Paragraph .A1 in Appendix A of this standard sets forth matters that the auditor should take into account for identifying and assessing risks of material misstatement related to the fair value of financial instruments.

Responding to the Risks of Material Misstatement

.05       AS 2301, The Auditor's Responses to the Risks of Material Misstatement, requires the auditor to design and implement appropriate responses that address risks of material misstatement. This includes applying substantive procedures to accounting estimates in significant accounts and disclosures.

Note:  Responding to the risks of material misstatement involves evaluating whether the accounting estimates are in conformity with the applicable financial reporting framework³ and reasonable in the circumstances, as well as evaluating potential management bias in accounting estimates and its effect on the financial statements.⁴

Note:  If different components of an accounting estimate in a significant account or disclosure are subject to significantly differing risks of material misstatement, the auditor's responses should include procedures that are responsive to the differing risks of material misstatement.

Note:  The auditor's responses to the assessed risks of material misstatement, particularly fraud risks, should involve the application of professional skepticism in gathering and evaluating audit evidence.⁵ Audit evidence consists of both information that supports and corroborates management's assertions regarding the financial statements and information that contradicts such assertions.⁶

.06       AS 2301 provides that as the assessed risk of material misstatement increases, the evidence from substantive procedures that the auditor should obtain also increases. The evidence provided by substantive procedures depends upon the mix of the nature, timing, and extent of those procedures.⁷

.07       In performing substantive procedures⁸ to respond to the identified and assessed risks of material misstatement associated with accounting estimates, the auditor should test an accounting estimate using one or a combination of the following approaches:

1. Test the company's process used to develop the accounting estimate (see paragraphs .09–.20 of this standard);
2. Develop an independent expectation for comparison to the company's estimate (see paragraphs .21–.26 of this standard); and
3. Evaluate audit evidence from events or transactions occurring after the measurement date related to the accounting estimate for comparison to the company's estimate (see paragraphs .27–.29 of this standard).

Note:  The auditor may use any of the three approaches (individually or in combination). However, the auditor's decisions about the approach he or she takes to auditing an estimate should necessarily be informed by the auditor's understanding of the process the company used to develop the estimate and, if relevant controls are tested, the results of those tests.

Use of an Auditor's Specialist

.08       If the auditor engages a specialist to assist in obtaining or evaluating audit evidence, the auditor should also comply with the requirements of AS 1210, Using the Work of an Auditor-Engaged Specialist. If the auditor uses a specialist employed by the auditor to assist in obtaining or evaluating audit evidence, the auditor should also comply with the requirements set forth in Appendix C to AS 1201, Supervision of the Audit Engagement. ⁹

Testing the Company's Process Used to Develop the Accounting Estimate

.09       Testing the company's process involves performing procedures to test and evaluate the methods, data, and significant assumptions used in developing the estimate, in order to form a conclusion about whether the estimate is properly accounted for and disclosed in the financial statements.

Evaluating the Company's Methods

.10       The auditor should evaluate whether the methods used by the company to develop the accounting estimates are:

1. In conformity with the requirements of the applicable financial reporting framework; and
2. Appropriate for the nature of the related account or disclosure, taking into account the auditor's understanding of the company and its environment.¹⁰

Note:  Evaluating whether the methods are in conformity with the requirements of the applicable financial reporting framework includes evaluating whether the data is appropriately used and significant assumptions are appropriately applied under the applicable financial reporting framework.

.11       If the company has changed the method for determining the accounting estimate, the auditor should determine the reasons for such change and evaluate the appropriateness of the change. This includes evaluating changes in methods that represent changes in accounting principles in accordance with AS 2820, Evaluating Consistency of Financial Statements.¹¹ In circumstances where the company has determined that different methods result in significantly different estimates, the auditor should obtain an understanding of the reasons for the method selected by the company and evaluate the appropriateness of the selection. ¹²

Testing Data Used

.12       AS 1105 requires the auditor, when using information produced by the company as audit evidence, to evaluate whether the information is sufficient and appropriate for purposes of the audit by performing procedures to (1) test the accuracy and completeness of the information or test the controls over the accuracy and completeness of that information, and (2) evaluate whether the information is sufficiently precise and detailed for purposes of the audit.¹³

.13       If the company uses data from an external source, the auditor should evaluate the relevance and reliability of the data in accordance with AS 1105.¹⁴

.14       The auditor should also evaluate whether the data is appropriately used by the company in developing the accounting estimate by evaluating whether:

1. The data is relevant to the measurement objective for the accounting estimate;
2. The data is internally consistent with its use by the company in other significant accounts and disclosures; and
3. The source of the company's data has changed from the prior year and, if so, whether the change is appropriate.

Identification of Significant Assumptions

.15       The auditor should identify which of the assumptions used by the company are significant assumptions to the accounting estimate, that is, the assumptions that are important to the recognition or measurement of the accounting estimate in the financial statements. In identifying the significant assumptions, the auditor should take into account the nature of the accounting estimate, including related risk factors,¹⁵ the requirements of the applicable financial reporting framework, and the auditor's understanding of the company's process for developing the estimate. Examples of assumptions that ordinarily would be considered significant assumptions include those that:

1. Are sensitive to variation, such that minor changes in the assumption can cause significant changes in the estimate;
2. Are susceptible to manipulation or bias;
3. Involve unobservable data or company adjustments of observable data; or
4. Depend on the company's intent and ability to carry out specific courses of action.¹⁶

Evaluating the Reasonableness of Significant Assumptions

.16       The auditor should evaluate the reasonableness of the significant assumptions used by the company to develop the estimate, both individually and in combination. This includes evaluating whether:

1. The company has a reasonable basis for the significant assumptions used and, when applicable, for its selection of assumptions from a range of potential assumptions; and
2. The significant assumptions are consistent with the following, when applicable:

1. Relevant industry, regulatory, and other external factors, including economic conditions;
2. The company's objectives, strategies, and related business risks;¹⁷
3. Existing market information;
4. Historical or recent experience, taking into account changes in conditions and events affecting the company; and
5. Other significant assumptions used by the company in other estimates tested.

Note:  If the auditor evaluates the reasonableness of a significant assumption by developing an expectation of that assumption, the auditor should have a reasonable basis for that expectation.

Note:  Paragraph .A10 in Appendix A of this standard sets forth additional requirements related to evaluating the reasonableness of unobservable inputs used in the valuation of financial instruments.

.17       When a significant assumption is based on the company's intent and ability to carry out a particular course of action, the auditor should take into account the following factors in evaluating the reasonableness of the assumption:

1. The company's past history of carrying out its stated intentions;
2. The company's written plans or other relevant documentation, such as budgets or minutes;
3. The company's stated reasons for choosing a particular course of action; and
4. The company's ability to carry out a particular course of action, which includes consideration of whether:

1. The company has the financial resources and other means to carry out the action;
2. Legal, regulatory, or contractual restrictions could affect the company's ability to carry out the action; and
3. The company's plans require the action of third parties and, if so, whether those parties are committed to those actions.

.18       For critical accounting estimates,¹⁸ the auditor should obtain an understanding of how management analyzed the sensitivity of its significant assumptions to change, based on other reasonably likely outcomes that would have a material effect on its financial condition or operating performance.¹⁹ The auditor should take that understanding into account when evaluating the reasonableness of the significant assumptions and potential management bias.²⁰

Company's Use of a Specialist or Third-Party Pricing Information

.19       Using the Work of a Company's Specialist. When a specialist employed or engaged by the company assists the company in developing an accounting estimate, the auditor should look to the requirements in Appendix A of AS 1105 with respect to using the work of a company's specialist as audit evidence to support a conclusion regarding a relevant assertion of a significant account or disclosure.

.20       Using Pricing Information from a Third Party for Valuation of Financial Instruments. When the auditor is auditing the fair values of financial instruments, the company's use of pricing information from a third party affects the necessary procedures for testing the company's process. When third-party pricing information used by the company is significant to the valuation of financial instruments, the auditor should evaluate whether the company has used that information appropriately and whether it provides sufficient appropriate evidence. Paragraphs .A2–.A9 in Appendix A of this standard set forth procedures for determining whether third-party pricing information provides sufficient appropriate evidence.²¹

Developing an Independent Expectation of the Estimate

.21       Developing an independent expectation involves the auditor using some or all of his or her own methods, data, and assumptions to develop an expectation of the estimate for comparison to the company's estimate. The auditor's responsibilities with respect to developing an independent expectation depend on the source of the methods, data, and assumptions used, as discussed below.

Note:  In developing an independent expectation, the auditor should take into account the requirements of the applicable financial reporting framework and the auditor's understanding of the company's process, including the significant assumptions used by the company, so that the auditor's expectation considers the factors relevant to the estimate.

Independent Assumptions and Methods of the Auditor

.22       When the auditor independently derives assumptions or uses his or her own method in developing an independent expectation, the auditor should have a reasonable basis for the assumptions and method used.

Data and Assumptions Obtained from a Third Party

.23       If the auditor uses data or assumptions obtained from a third party in developing an independent expectation, the auditor should evaluate the relevance and reliability of the data and assumptions obtained in accordance with AS 1105.

Note:  If the auditor develops an independent expectation of the fair value of financial instruments using pricing information from a third party, the auditor should evaluate whether the pricing information provides sufficient appropriate evidence. Paragraphs .A2–.A9 in Appendix A of this standard set forth procedures for evaluating whether third-party pricing information provides sufficient appropriate evidence.

Use of Company Data, Assumptions, or Methods

.24       If the auditor uses data produced by the company, significant assumptions used by the company, or the company's methods in developing an independent expectation, the auditor should:

1. Test such data in accordance with paragraphs .12–.14 of this standard;
2. Evaluate the reasonableness of such significant assumptions in accordance with paragraphs .16–.18 of this standard; and
3. Evaluate such company methods in accordance with paragraphs .10–.11 of this standard.

Note:  If the company's data, assumptions, or methods were those of a company's specialist, the auditor should look to the requirements of Appendix A of AS 1105 with respect to using the work of the specialist as audit evidence.

Developing an Independent Expectation as a Range

.25       If the auditor's independent expectation consists of a range rather than a point estimate, the auditor should determine that the range encompasses only reasonable outcomes, in conformity with the applicable financial reporting framework, and is supported by sufficient appropriate evidence.

Comparing the Auditor's Independent Expectation to the Company's Accounting Estimate

.26       The auditor should compare the auditor's independent expectation to the company's estimate and should evaluate the differences in accordance with AS 2810.13.²²

Evaluating Audit Evidence from Events or Transactions Occurring After the Measurement Date

.27       Events and transactions that occur after the measurement date can provide relevant evidence to the extent they reflect conditions at the measurement date.²³

.28       When the auditor obtains audit evidence from events or transactions that occur after the measurement date, the auditor should evaluate whether the audit evidence is sufficient, reliable, and relevant to the company's accounting estimate and whether the evidence supports or contradicts the company's estimate.

.29       In evaluating whether an event or transaction provides evidence relevant²⁴ to the accounting estimate at the measurement date, the auditor should take into account changes in the company's circumstances and other relevant conditions between the event or transaction date and the measurement date.

Note:  As the length of time from the measurement date increases, the likelihood that events and conditions have changed during the intervening period also increases.

Evaluating Audit Results

.30       AS 2810 requires the auditor to evaluate the results of audit procedures performed on accounting estimates. This includes:

1. Evaluating identified misstatements;²⁵
2. Evaluating the qualitative aspects of the company's accounting practices, including potential bias in management's judgments about the amounts and disclosures in the financial statements;²⁶
3. Evaluating potential bias in accounting estimates;²⁷ and
4. Evaluating the presentation of the financial statements, including the disclosures and whether the financial statements contain the information essential for a fair presentation of the financial statements in conformity with the applicable financial reporting framework.²⁸

.31       Evaluating potential bias in accounting estimates includes evaluating bias in estimates individually and in aggregate. It also includes evaluating whether bias results from the cumulative effect of changes in estimates.²⁹

APPENDIX A—Special Topics

Identifying and Assessing Risks of Material Misstatement Related to the Fair Value of Financial Instruments

.A1       To identify and assess risks of material misstatement related to the fair value of financial instruments, the auditor should obtain an understanding of the nature of the financial instruments being valued. Matters that the auditor should take into account include:

1. The terms and characteristics of the financial instruments;
2. The extent to which the fair value of the type of financial instruments is based on inputs that are observable directly or indirectly; and
3. Other factors affecting the valuation of the financial instruments, such as credit or counterparty risk, market risk, and liquidity risk.

Note:  In general, fair values of financial instruments based on trades of identical financial instruments in an active market have a lower risk of material misstatement than fair values derived from observable trades of similar financial instruments or unobservable inputs.

Use of Pricing Information from Third Parties as Audit Evidence

.A2       When the auditor uses pricing information from a third party to develop an independent expectation or evaluates pricing information provided by a third party used by the company,¹ the auditor should perform procedures to determine whether the pricing information provides sufficient appropriate² evidence to respond to the risks of material misstatement.³

.A3       The following paragraphs address pricing information from:

1. Organizations that routinely provide uniform pricing information to users, generally on a subscription basis ("pricing services");⁴ and
2. Brokers or dealers.

Using Pricing Information from Pricing Services

.A4       The reliability of audit evidence depends on the nature and source of the evidence and the circumstances under which it is obtained.⁵ The following factors affect the reliability of pricing information provided by a pricing service:

1. The experience and expertise of the pricing service relative to the types of financial instruments being valued, including whether the types of financial instruments being valued are routinely priced by the pricing service;
2. Whether the methodology used by the pricing service in determining fair value of the types of financial instruments being valued is in conformity with the applicable financial reporting framework; and
3. Whether the pricing service has a relationship with the company by which company management has the ability to directly or indirectly control or significantly influence the pricing service.

Note:  The auditor should take into account the results of the procedures performed under AS 2410, Related Parties, in determining whether the pricing service has a relationship with the company by which company management has the ability to directly or indirectly control or significantly influence the pricing service.

Note:  The existence of a process by which subscribers can challenge a pricing service's pricing information does not, by itself, mean that company management has the ability to directly or indirectly control or significantly influence that pricing service.

Note:  If the auditor performs procedures to assess the reliability of pricing information provided by a pricing service at an interim date, the auditor should evaluate whether the pricing service has changed its valuation process relative to the types of financial instruments being valued, and, if so, the effect of such changes on the pricing information provided at period end.

.A5       The relevance of audit evidence refers to its relationship to the assertion or to the objective of the control being tested.⁶ The following factors affect the relevance of pricing information provided by a pricing service:

1. Whether the fair values are based on quoted prices in active markets for identical financial instruments;
2. When the fair values are based on transactions of similar financial instruments, how those transactions are identified and considered comparable to the financial instruments being valued; and
3. When no recent transactions have occurred for either the financial instrument being valued or similar financial instruments, or the price was developed using a quote from a broker or dealer, how the fair value was developed, including whether the inputs used represent the assumptions that market participants would use when pricing the financial instruments.

.A6       When the fair values are based on transactions of similar financial instruments, the auditor should perform additional audit procedures to evaluate the process used by the pricing service, including evaluating how transactions are identified, considered comparable, and used to value the types of financial instruments selected for testing.

Note:  When a pricing service uses the same process to price a group of financial instruments, the audit procedures to evaluate the process can be performed for those financial instruments as a group, rather than for each instrument individually, if the financial instruments are similar in nature (taking into account the matters in paragraph .A1).⁷

.A7       When no recent transactions have occurred for either the financial instrument being valued or similar financial instruments, the auditor should perform additional audit procedures, including evaluating the appropriateness of the valuation method and the reasonableness of observable and unobservable inputs used by the pricing service.

Using Pricing Information from Multiple Pricing Services

.A8       When pricing information is obtained from multiple pricing services, less information is needed about the particular methods and inputs used by the individual pricing services when the following conditions are met:

1. There are recent trades of the financial instrument or of financial instruments substantially similar to the financial instruments being valued;
2. The type of financial instrument being valued is routinely priced by several pricing services;
3. Prices obtained are reasonably consistent across pricing services, taking into account the nature and characteristics of the financial instruments being valued, and market conditions; and
4. The pricing information for the type of financial instrument is generally based on inputs that are observable.

Note:  When the above conditions are not met, the auditor should perform additional audit procedures, including evaluating the appropriateness of the valuation method and the reasonableness of observable and unobservable inputs for a representative price for the type of financial instrument being valued.

Using Pricing Information from a Broker or Dealer

.A9       When a fair value measurement is based on a quote from a broker or dealer ("broker quote"), the relevance and reliability of the evidence provided by the broker quote depend on whether:

1. The broker or dealer has a relationship with the company by which company management has the ability to directly or indirectly control or significantly influence the broker or dealer;
2. The broker or dealer making the quote is a market maker that transacts in the same type of financial instrument;
3. The broker quote reflects market conditions as of the financial statement date;
4. The broker quote is binding on the broker or dealer; and
5. There are any restrictions, limitations, or disclaimers in the broker quote and, if so, their nature.⁸

Note:  Broker quotes generally provide more relevant and reliable evidence when they are timely, binding quotes, without any restrictions, limitations, or disclaimers, from unaffiliated market makers transacting in the same type of financial instrument. If the broker quote does not provide sufficient appropriate evidence, the auditor should perform procedures to obtain relevant and reliable pricing information from another pricing source pursuant to the requirements of this appendix.

Note:  The auditor should take into account the results of the procedures performed under AS 2410 in determining whether the broker or dealer has a relationship with the company by which company management has the ability to directly or indirectly control or significantly influence the broker or dealer.

Unobservable Inputs

.A10       When the valuation of a financial instrument includes unobservable inputs that are significant to the valuation, the auditor should obtain an understanding of how unobservable inputs were determined and evaluate the reasonableness of the unobservable inputs by taking into account the following:

1. Whether modifications made to observable information generally reflect the assumptions that market participants would use when pricing the financial instrument, including assumptions about risk; and
2. How the company determined its fair value measurement, including whether it appropriately considered the information available.