Accounting Estimates - ISA 540

The IAASB noted in it's Work Plan for 2015-2016 that the IAASB intends to invest significant effort to supporting global financial stability, including in relation to financial institutions. To this end, a Working Group was formed in January 2015 to consider issues with respect to the audit of financial institutions.

Since commencing its work, the Working Group has undertaken significant outreach activities to identify issues involving audits of financial institutions to inform the development of a project proposal. The leadership of the Working Group and Staff has met with, amongst others, representatives of the Financial Stability Board, the United States Public Company Accounting Oversight Board, the International Association of Insurance Supervisors (IAIS) and the Basel Committee on Banking Supervision’s (Basel Committee) Accounting Expert Group, and has also met several times with the Global Public Policy Committee’s  Banking IAASB Liaison Subgroup. The IAASB has received further input via letters from the IAIS  and the Basel Committee,  and has also discussed the International Forum of Independent Audit Regulators’ (IFIAR) annual survey of inspection findings with the IFIAR Standards Coordination Working Group.

These outreach activities and the input received formed the basis of the Working Group’s presentations at the March and June 2015 IAASB meetings. One of the key themes arising from the outreach activities was that regulators and auditors of financial institutions were of the view that the IAASB should focus on the issues for audits of financial institutions arising from the impending adoption of IFRS 9,  (i.e., ahead of its effective date for financial statements for annual periods beginning on or after January 1, 2018) and a similar project conducted by the United States Financial Accounting Standards Board that is due for completion soon. These standards adopt an expected credit loss model for loan loss provisions, which fundamentally changes the way that banks and other entities will account for their loan assets. Many stakeholders are therefore of the view that these changes will bring new and urgent challenges for management and the audit profession. To further inform the IAASB’s considerations, the Working Group prepared a “gap analysis”, the purpose of which was to determine whether extant ISA 540 was viewed as effective in addressing the audit issues arising from IFRS 9.

This analysis was discussed by the IAASB and the IAASB Consultative Advisory Group at their respective September 2015 meetings. The discussions in these meetings highlighted that most, if not all, of the issues identified would be equally relevant when auditing complex accounting estimates more generally and in particular for audits of all entities that will have to apply IFRS 9, rather than only financial institutions. Accordingly, it was concluded that a holistic revision of ISA 540 should be undertaken as a matter of priority, recognizing the importance of taking action to respond to the issues identified and, in particular, the importance of being responsive to concerns raised in relation to audits of financial institutions and other entities applying IFRS 9.

The IAASB approved a project proposal to revise ISA 540. Consistent with the Board’s discussions at its September 2015 meeting, the project will deal holistically with a number of issues relevant to auditing accounting estimates, including auditing issues arising from the adoption of Expected Credit Loss models and issues related to audits of financial institutions. While ISA 540 is already a robust standard, the IAASB believes that it is worth examining whether changes to it are needed in light of evolving accounting standards, audit practice, and audit inspection findings.

The Board also agreed that supplemental activities may be necessary in the future to address specific considerations in the audit of financial institutions, beyond those that will be addressed in the revision of ISA 540. This may include IAPNs, Staff publications, project updates or other materials addressing specific audit considerations related to financial institutions, the relationship between a financial institution’s regulatory supervisor and its external auditor, or other specific guidance in relation to audits of financial institutions (such as IFRS 9, the International Accounting Standards Board’s’(IASB) proposed standard on insurance contracts (or similar standards under other financial reporting frameworks) or other specific topics).

In its March 2017 meeting, the IAASB approved the release of proposed ISA 540 (Revised) for public exposure, including related conforming amendments to other International Standards. The Exposure Draft was issued on April 20, for comment by August 1st. 

The exposure draft (ED) of proposed International Standard on Auditing (ISA) 540 (Revised) (ED-540) is the result of a significant effort over the last two years. In early 2015, the International Auditing and Assurance Standards Board (IAASB) commenced a project to address issues relevant to the audits of financial institutions, as well as ISA 540 more broadly. Outreach activities with regulators and other key stakeholders, along with the impending adoption of IFRS 9, pointed to the need for the IAASB to focus attention in the near term on revisions to ISA 540.

The objective of ED-540 is for the auditor to obtain sufficient appropriate audit evidence to evaluate whether accounting estimates and related disclosures are reasonable in the context of the applicable financial reporting framework, or are misstated. ED-540 includes enhanced requirements for risk assessment procedures and the auditor’s work effort in responding to the assessed risks of material misstatement to support this evaluation.

ED-540 highlights that the auditor’s identification and assessment of the risks of material misstatement for accounting estimates, and the auditor’s responses to those assessed risks, are affected by complexity, the need for the use of judgment by management, and estimation uncertainty. Accordingly, these three factors are incorporated throughout ED-540. ED-540 also emphasizes the important considerations regarding complex models, forward-looking information, and internal controls in auditing accounting estimates.

Professional skepticism plays a central role in the audit of accounting estimates. ED-540 contains several key provisions that are designed to enhance the auditor’s application of professional skepticism and consideration of the potential for management bias, including enhanced risk assessment requirements, more granular requirements with respect to obtaining audit evidence, and requirements to “stand back” and evaluate the audit evidence obtained.

The IAASB also sought to make ED-540 scalable, recognizing that the standard applies to all accounting estimates. The ED-540 requires the auditor, when dealing with accounting estimates with low inherent risk, to determine whether one or more specific further audit procedures that may provide sufficient appropriate audit evidence in the circumstances. For inherent risk that is not low, the auditor is required to design further audit procedures to obtain audit evidence about matters relating to complexity, judgment or estimation uncertainty, to the extent these factors are the reasons for the assessed risks of material misstatement.

The ED also includes conforming amendments to ISA 260 (Revised), ISA 500, and ISA 580. Of particular note are the conforming amendments to ISA 500, which deal with the audit evidence implications of external information sources.