(a) ED-540 Auditing Accounting Estimates and Related Disclosures
In April 2017, the IAASB issued Proposed International Standard on Auditing 540 (Revised) Auditing Accounting Estimates and Related Disclosures (ED-540).The IAASB has sought to make ED-540 scalable, recognising that the standard applies to all accounting estimates from the simplest depreciation calculation through to the most complex of derivative financial instruments and expected credit losses. While the simpler accounting estimates will not generally give rise to high audit risk, many measurements based on estimates, including fair value measurements and impairments in relation to financial instruments, are imprecise and subjective in nature and will give rise to high inherent risk. Such fair value and impairment assessments are likely to involve significant, complex judgements, for example, regarding market conditions, the timing of cash flows and the future intentions of the entity. The valuations will often involve complex models built on significant assumptions such as the predicted timing of cash flows, the most appropriate discount factor to use and judgements about probability weighted averages. Management may not always have sufficient knowledge and experience in making these judgements. Moreover, there may even be a deliberate attempt by management to manipulate the value of an estimate in order to window dress the financial statements. Professional scepticism is key to the audit of accounting estimates and ED-540 contains provisions which are designed to enhance the auditor’s application of professional scepticism and a consideration of the potential for management bias.
Outreach activities with regulators and other key stakeholders pointed to the need for the IAASB to focus attention on revisions to ISA 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures. Feedback from the IAASB’s outreach projects revealed a perceived lack of consistency in the extent to which auditors obtained an understanding of accounting estimates together with evidence of insufficient and inappropriate work effort by auditors in this area. The consultation process also identified a lack of professional scepticism being exercised by auditors and a need for more specific risk assessment requirements and more granular requirements regarding obtaining audit evidence. It also identified a need to enhance communication between auditors and those charged with governance about accounting estimates and in particular the auditor’s views about significant qualitative aspects of the entity’s accounting practices.
The objective of ISA 540 is for the auditor to obtain sufficient appropriate evidence to evaluate whether accounting estimates and related disclosures are reasonable in the context of the relevant financial reporting framework or are misstated. Consequently, ED-540 aims to include enhanced risk assessment requirements and the draft standard emphasises that the risk of material misstatement in relation to the audit of accounting estimates is impacted by three key factors: complexity, the application of management judgement and estimation uncertainty. The increased emphasis on the use of fair value measurement in IFRS Standards and the associated development of IFRS 13 Fair Value Measurement reflect the increasing complexity of the business environment. Furthermore, given the increased emphasis on the use of external sources in IFRS 13 and in making accounting estimates such as fair values, ED-540 aims to improve and clarify the requirements on the use of such information as it is in the public interest to do so. These factors, together with the implementation of IFRS 9 Financial Instruments and in particular its complex and highly subjective expected loss approach to the measurement of impairments and extensive disclosure requirements, highlighted a need to modernise ISA 540 for evolving financial reporting frameworks.
The risk that an entity’s internal systems and controls fail to prevent and detect valuation errors needs to be assessed as part of the overall assessment of audit risk. In relation to complex fair value and impairment estimates, a particular problem is that the measurement is likely to be performed infrequently for external reporting purposes and outside the normal accounting and management systems. This is especially true where the valuation is performed by an external specialist. As a non-routine event,therefore, the assessment of fair value is likely not to have the same level of monitoring or controls as a day-to-day business transaction and may give rise to high control risk.
The auditor should always seek to manage detection risk at an acceptable level through effective planning and execution of audit procedures. However, the audit team may lack knowledge and experience in dealing with the estimation technique in question and therefore may be unlikely to detect errors in the valuation and modelling techniques applied by the client. Any resulting over-reliance on an external specialist could also lead to errors not being identified.
(b) Difficulties in auditing accounting estimates and procedures
(i) Cash-settled share-based payment scheme
The expense recognised this year of $825,000 in respect of the cash-settled share-based payment scheme represents 11·1% of profit before tax and is therefore material to Awdry Co’s statement of profit or loss for the year. The related liability of $825,000 which would be recognised on the statement of financial position is on the borderline of materiality to assets at 1·4%.
IFRS 2 Share-Based Payment requires that for cash-settled share-based payment transactions, the entity should measure the services acquired and the liability incurred at the fair value of the liability. Moreover, it states that until the liability is settled, the entity should remeasure the fair value of the liability at the end of each reporting period and at the date of settlement, with any changes in fair value recognised in profit or loss for the period. In the case of Awdry Co, the expense and the associated liability has been calculated based on the fair value of the rights as at the reporting date and the treatment therefore complies with the requirements of IFRS 2 ($4·50 x 550,000 x 1/3 = $825,000).
IFRS 2 also requires that the amount recognised as an expense for cash-settled share-based payments should be based on the best available estimate of the number of awards which are expected to vest. The entity must therefore estimate the number of awards which are expected to vest. In this case, management’s estimate that all 55 staff will qualify for the rights appears to be based on a perception of good historic staff relations which may be inaccurate and the expectation that none of the eligible staff will leave over the three-year vesting period may prove to be unrealistic. The predictive nature of management’s estimate in this regard represents a challenge to the auditor as it is difficult to obtain reliable evidence.
The fair value estimate of $4·50 is based on an options pricing models which is an example of a complex valuation model which, according to ED-540, is built on significant estimates and assumptions and is therefore challenging to audit. The initial choice of which option-pricing model to use is also a matter of judgement and whichever model is selected, it will incorporate judgemental inputs such as the current risk-free interest rate and measures of share price volatility.
Procedures:​​​​​​​
– Obtain a copy of the contractual documentation for the share-based payment scheme and supporting file notes detailing principal terms and confirm:
o grant date and vesting date
o number of executives and senior employees awarded share appreciation rights
o number of share appreciation rights awarded to each individual member of staff
o conditions attaching to the share appreciation rights.
– Perform an assessment of the appropriateness of the model used to value the share appreciation rights and confirm that it is in line with the requirements of IFRS 2.
– Obtain details of the external expert used and assess the appropriateness of their appointment by considering their professional certification, experience, reputation and objectivity.
– Perform a review of the expert’s valuation including an assessment of the assumptions used in order to determine the fair value of the share appreciation rights.
– Obtain details of historic staff turnover rates obtained from the human resources department including actual data for the first year of the vesting period and consider this in conjunction with the assumptions made by management.
– Perform a review of the forecast staffing levels through to the end of the vesting period including an assessment of the reasonableness of the assumptions used and their consistency with other budgets and forecasts.
– Discuss the basis of staff retention assumptions with management and challenge their appropriateness.
– Perform sensitivity analyses on both the valuation model and the staffing forecasts.
(ii) Regulatory penalties​​​​​​​
The expense recognised in this year’s statement of profit or loss for the year of $1·3 million is material to both profit (17·6%) and assets (2·2%). According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, the fine should be measured at its present value at the reporting date. IAS 37 states that where the effect of the time value of money is material, the amount of a provision should be the present value of the expenditures expected to be required to settle the obligation and that the discount rate used in the calculation should be a pre-tax rate which reflects current market assessments of the time value of money and the risks specific to the liability. The cash flows for the repayment of the fine over the ten years should therefore be discounted at an appropriate rate to present value as at 28 February 20X9.
The audit of the provision represents a challenge for the auditor in a number of respects. First, it is difficult to estimate the amount payable as it has not yet been finalised and the amount currently recognised is an estimate based on management’s judgement. These difficulties are compounded by IAS 37 requirements to measure the provision at present value. The measurement process therefore also requires management to predict the payment dates and to identify an appropriate pre-tax rate to be applied as the discount factor. Both of these will require a significant level of management judgement which will be a challenge for the auditor to obtain sufficient relevant and reliable evidence on. Moreover, there is also the possibility of other provisions being needed in relation to the costs of remedying the safety issues which the regulator has identified and in relation to other potentially unidentified safety problems. Here, addressing the completeness assertion will represent a key challenge to the auditor as it is inherently difficult to predict all of the costs to be incurred in the future especially when they have not yet been determined.
Procedures:​​​​​​​
– Obtain a copy of the regulator’s notice detailing the date of the issue and any indication of the amount of the penalty to be paid by Awdry Co.
– Obtain a copy of any draft instalment agreement detailing the timing and amount of each repayment.
– Review Awdry Co’s correspondence with the regulator for evidence of the amount payable and details of the repayment schedule.
– Confirm to post year-end cash book and bank statements if any amounts have been paid after the year end.
– Inspect Awdry Co’s correspondence with its lawyers in order to ascertain current status of negotiations and the views of its legal advisers.
– Review Awdry Co’s cash flow statements and forecasts in order to assess the company’s ability to pay the instalments.
– Enquire of management in relation to the current status of the negotiations; the need to measure the provision at present value and their non-compliance with IAS 37 (i.e. their failure to measure the provision at present value).
– Review the board minutes for evidence of management’s discussion of the penalty, any planned remedial action to address safety issues and any other possible safety issues.
– Discuss with management the need for the company to perform a calculation of the present value of the provision (including identification of an appropriate discount rate).
(iii) Property development​​​​​​​
The proposed valuation of the property at $4·9 million represents 8·4% of assets and is material to Awdry Co’s statement of financial position as at 28 February 20X9. According to IFRS 13 Fair Value Measurement, the fair value measurement of a non-financial asset should take into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant who would use the asset in its highest and best use.
The audit of the property development will be challenging for the auditor first because judgement will be required in order to identify the property’s highest and best use per IFRS 13. The auditor must ensure, for example, that the valuation is compared to the property’s fair value in its existing use as well as in any other potential uses. Indeed, there may be other potential uses which have not been considered.
IFRS 13 also states that the highest and best use of a non-financial asset such as a property must be:
– physically possible: this will therefore require independent expert confirmation that the conversion can be successfully undertaken;
– legally permissible: this will require obtaining confirmation of formal permission from the local planning authority; and
– financially feasible: this will require a detailed assessment of whether Awdry Co will have sufficient cash flows in order to fund the development through to completion to complete development.
Overall therefore, the auditor will need extensive audit evidence, much of it from third parties, in order to confirm management’s judgement that conversion into residential apartments represents the highest and best use of its former maintenance depot.
According to IFRS 13, when considering alternative uses for non-financial assets, the valuation should include all costs associated with the alternative uses. Hence, if the proposed development does represent the highest and best use of the property, the valuation should be adjusted for all of its associated costs. The proposed valuation at $4·9 million is not therefore in compliance with IFRS 13 and on the basis of the information available, the valuation should be $3,527,000 (i.e. $4·9 million – $1·2 million – $173,000). If the additional costs are fairly stated therefore, the property is currently overstated by $1·373 million ($4·9 million – $3,527,000). The auditor will, however, need external confirmation of the $173,000 in fees from the local building regulator and will also need to obtain sufficient appropriate audit evidence that the conversion costs of $1·2 million are fairly stated. The conversion costs will present a particular challenge to the auditor as they will be based on the estimation of industry experts and the amounts will be inherently uncertain. There may be unforeseen additional costs payable to complete the conversion which will be difficult for the auditor to identify and quantify.
Procedures:
– Physically inspect the building to assess its condition and to perform an initial assessment of whether it might be suitable for conversion into residential apartments.
– Agree the carrying amount of the property to Awdry Co’s non-current asset register.
– Obtain a valuation of the completed development by an independent external expert and agree the basis of valuation is in line with the requirements of IFRS 13.
– Obtain details of the external expert and assess their expertise and objectivity through assessment of their professional certification, experience, reputation and connections with Awdry Co.
– Inspect the quotation or contract with the building contractor to confirm the expected cost of $1·2 million.
– Inspect the planning permission documentation from the local authority in order to ensure that the proposed alternative use of property has been approved.
– Inspect correspondence with the local building regulator confirming the fees of $173,000.
– Discuss with management alternative uses of the property, explaining IFRS 13’s valuation principles and confirming that no additional fees or costs will be payable.
– Review board minutes for evidence of management’s discussion of the development.
– Review Awdry Co’s cash flow statements and forecasts to ensure the project is financially feasible.
– Obtain written representations from management confirming all details and costs concerning development have been disclosed to the auditor.