Objective The objective of the auditor is to obtain sufficient appropriate audit evidence about whether: (a) accounting estimates, including fair value accounting estimates, in the financial statements, whether recognised or disclosed, are reasonable; and (b) related disclosures in the financial statements are adequate, in the context of the applicable financial reporting framework. (paragraph 6) |
When performing risk assessment procedures and related activities to obtain an understanding of the entity and its environment, including the entity's internal control, as required by ISA (UK and Ireland) 315, the auditor shall obtain an understanding of ...: (b) How management identifies those transactions, events and conditions that may give rise to the need for accounting estimates to be recognised or disclosed in the financial statements. (c) How management makes the accounting estimates, and an understanding of the data on which they are based ... (paragraph 8) The auditor shall review the outcome of accounting estimates included in the prior period financial statements, or, where applicable, their subsequent re-estimation for the purpose of the current period. ... (paragraph 9) In identifying and assessing the risks of material misstatement, as required by ISA (UK and Ireland) 315, the auditor shall evaluate the degree of estimation uncertainty associated with an accounting estimate. (paragraph 10) The auditor shall determine whether, in the auditor's judgment, any of those accounting estimates that have been identified as having high estimation uncertainty give rise to significant risks. (paragraph 11) Based on the assessed risks of material misstatement, the auditor shall determine: (a) Whether management has appropriately applied the requirements of the applicable financial reporting framework relevant to the accounting estimate; and (b) Whether the methods for making the accounting estimates are appropriate and have been applied consistently, and whether changes, if any, in accounting estimates or in the method for making them from the prior period are appropriate in the circumstances. (paragraph 12) In responding to the assessed risks of material misstatement, as required by ISA (UK and Ireland) 330, the auditor shall undertake one or more of the following, taking account of the nature of the accounting estimate: (a) Determine whether events occurring up to the date of the auditor's report provide audit evidence regarding the accounting estimate. (b) Test how management made the accounting estimate and the data on which it is based. In doing so, the auditor shall evaluate whether: (i) The method of measurement used is appropriate in the circumstances; and (ii) The assumptions used by management are reasonable in light of the measurement objectives of the applicable financial reporting framework. (c) Test the operating effectiveness of the controls over how management made the accounting estimate, together with appropriate substantive procedures. (d) Develop a point estimate or a range to evaluate management's point estimate. For this purpose: (i) If the auditor uses assumptions or methods that differ from management's, the auditor shall obtain an understanding of management's assumptions or methods sufficient to establish that the auditor's point estimate or range takes into account relevant variables and to evaluate any significant differences from management's point estimate. (ii) If the auditor concludes that it is appropriate to use a range, the auditor shall narrow the range, based on audit evidence available, until all outcomes within the range are considered reasonable. (paragraph 13) For accounting estimates that give rise to significant risks, in addition to other substantive procedures performed to meet the requirements of ISA (UK and Ireland) 330, the auditor shall evaluate the following: (a) How management has considered alternative assumptions or outcomes, and why it has rejected them, or how management has otherwise addressed estimation uncertainty in making the accounting estimate. (b) Whether the significant assumptions used by management are reasonable. (c) Where relevant to the reasonableness of the significant assumptions used by management or the appropriate application of the applicable financial reporting framework, management's intent to carry out specific courses of action and its ability to do so. (paragraph 15) The auditor shall evaluate, based on the audit evidence, whether the accounting estimates in the financial statements are either reasonable in the context of the applicable financial reporting framework, or are misstated. (paragraph 18) |
| 162. | Accounting estimates are used for valuation purposes in a number of areas: the most common examples are impairment calculations, and the fair value measurement of financial instruments where quoted market prices are not available for those instruments, both of which may represent significant risks. Estimates of allowances for impairment or provisions for compensation payable to customers may also represent significant risks. |
| 163. | In reviewing the effective interest rate calculations prepared by management the auditor carefully audits the inputs used in the models to determine the estimated cash flows which are then subject to the effective interest rate ('EIR') calculation. The auditor considers the information provided in IAS 39 (and its UK GAAP equivalent FRS 26) Application Guidance as to the reliability of such information being used. When estimating the cash flows management considers all contractual terms of the instrument and includes all reliable estimates of those cash flows. Factors that would be considered include all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs, premiums or discounts, the expectation of timing and amount of the interest cash flows and whether the instrument is a floating or fixed instrument. Generally these will be amortised over the expected life of the instrument, however a shorter period is used if this is the period to which they relate and the auditor would assess the conclusion reached by the entity for reasonableness. |
| 164. | IAS 39 (FRS 26) requires all financial assets, with the exception of those measured at fair value through profit and loss to be reviewed for impairment. An impairment loss is only recognised when it is incurred, and it is only incurred if there is objective evidence of impairment as a result of one or more events that occurred after initial recognition and that event has an impact on the estimated future cash flows of the asset or group of assets, that can be reliably measured. The auditor evaluates the policy adopted by the entity to assess for impairment on all financial assets (excluding those measured at fair value through profit and loss) including reviewing what is constituted as a loss event and what events will result in an impairment loss being recognised, as one discrete event may not necessarily imply an impairment loss. Similarly the auditor challenges the entity on those events which have occurred which have not been recognised as a loss event by the entity. |
| 165. | IAS 39 (FRS 26) gives guidance on the types of evidence to be considered in identifying whether an event has taken place (a 'loss event') which leads to an impairment calculation. Such factors include observable data about the following loss events: |
| significant financial difficulties of the issuer or obligor; |
| breach of contract; |
| a concession (such as a forbearance arrangement) being granted by the lender for economic or legal reasons relating to the borrower's financial difficulty which the lender would not otherwise consider; |
| probability that the borrower will enter bankruptcy or financial reorganisation; |
| disappearance of an active market due to financial difficulties; and |
| observable data indicating that there is a measurable decrease in the estimated future cash flows from a group of financial assets since the initial recognition of those assets, although the decrease cannot be observed within individual assets including: |
| adverse changes in the payment status of the borrowers in the group; or |
| national or local economic conditions that correlate with defaults on other assets within the group. |
| Further factors will apply when considering the impairment of equity investments such as significant changes with an adverse effect that have taken place in the technological, market, economic or legal environment in which the issuer operates or a significant or prolonged decline in the fair value of the equity instrument. |
| 166. | If, following the auditor's consideration of the factors outlined in paragraph 165, it is determined that a loss event has taken place, the auditor evaluates the assumptions made by management in arriving at their estimate of likely cash flows to be received from the impaired loans (including, where relevant, assumptions about the values of assets provided by way of security). The auditor assesses whether these assumptions have been made after due consideration and whether they are supported by relevant evidence, including evidence derived from backtesting. In making these assessments, the auditor considers whether an appropriate degree of caution has been exercised by management in judging anticipated future cash flows. In the case of individual loan impairment calculations such evidence will be specific to the borrower but where impairment is estimated for a portfolio of similar loans the auditor considers observable data across the group of assets as a whole such as arrears statistics or national or local economic conditions. |
| 167. | Loan impairments are often calculated using extensive and sometimes complex spreadsheet models and the auditor assesses the control over the inputs to the models and the controls that ensure the consistency and integrity of the model. In doing so, the auditor applies the assessments around management assumptions described in paragraph 166 to model inputs. The auditor evaluates models for consistency and accuracy and looks for evidence to support the assumptions being made in the models. These assumptions would include some or all of the following factors: financial guarantees and collateral, the expectation of timing and amount of the cash flows, probabilities of default, loss given default, emergence periods, whether the instrument is a floating or fixed instrument, prepayment speeds and recovery rates. |
| 168. | IAS 39 (FRS 26) does permit an entity to assess for impairment on a group of financial assets but only where an entity first considers whether there is objective evidence of an impairment for financial assets that are 'individually significant'. The auditor evaluates the judgment applied by the entity in assessing what is considered as 'individually significant'. Where this collective impairment assessment is performed by the entity the auditor evaluates the evidence used in determining the cash flows for reasonableness and grouping of assets with similar risk characteristics. This will involve reviewing historical loss experience for similar assets, peer group experience if none available for specific entity losses and reviewing the methodology and assumptions made by the entity. |
| 169. | The auditor considers the mechanics of the models particularly where portfolio calculations are performed in respect of tracking impairment charges and reversals of impairments in order to ensure that the correct accounting has been applied depending on the security involved. |
| 170. | Additional complexity has been added to impairment models and effective interest rate models as a result of IAS 39 Reclassification of financial assets, specifically from the Fair Value through Profit and Loss category to the Loans and Receivables category at distressed market prices. The auditor may wish to consult with an expert to assist in the audit of these balances as the calculation of EIR and the need to either record an adjustment to Profit and Loss or revise the EIR can be technical in nature. |
| 171. | Based on the audit evidence obtained, the auditor may conclude that the evidence points to an estimate that differs from management's estimate, and that the difference between the auditor's estimate or range and management's estimate constitutes a financial statement misstatement. In such cases, where the auditor has developed a range, a misstatement exists when management's estimate lies outside the auditor's range. The misstatement is measured as the difference between management's estimate and the nearest point of the auditor's range. |
| 172. | The valuation of derivative and other financial instruments which are not quoted in an active market and so for which valuation techniques are required is an activity that can give rise to significant audit risk. Such financial instruments are priced using valuation techniques such as discounted cash flow models, options pricing models or by reference to another instrument that is substantially the same as the financial instrument subject to valuation. The auditor reviews the controls, procedures and testing of the valuation techniques used by the entity. Controls and substantive testing could include focusing on: |
| valuation technique approval and testing procedures used by the entity; |
| the independence of review, sourcing and reasonableness of observable market data and other parameters used in the valuation techniques; |
| calibration procedures used by the entity to test the validity of valuation techniques applied by comparing outputs to observable market transactions; |
| completeness and appropriate inclusion of all relevant observable market data; |
| the observability in practice of data classified by the entity as observable market data; |
| the appropriateness and validity of classification of instruments designated as being traded in a non active and in an active market in light of best market practice; |
| the appropriateness and validity of the particular valuation technique applied to particular financial instruments; |
| the appropriateness and reasonableness of the assumptions used by the entity particularly where these are not supported by observable parameters; |
| the appropriateness and validity of the parameters used by the entity to designate an instrument as substantially the same as the financial instrument being valued; |
| mathematical integrity of the valuation model; and |
| access controls over valuation models. |
| The auditor performs these procedures in light of their knowledge and experience and of the information readily available to the auditor. |
| 173. | In the more subjective areas of valuation the auditor obtains an understanding of the assumptions used and undertakes a review of the estimates involved for reasonableness, consistency and conformity with generally accepted practices. In some cases, the auditor may use his own valuation techniques to assess the entity's valuations. See paragraphs 135 to 147 above concerning disclosure of market risk information. Given the complexities involved and the subjective nature of the judgments inherent the auditor may involve an expert in elements of this work (see the ISA (UK and Ireland) 620 section of this Practice Note and ISA (UK and Ireland) 220). |
| 174. | In addition, the auditor considers whether the valuations overall appear reasonable based on the auditor's industry knowledge, market trends and the auditor's understanding of other entities' valuations (having regard to client confidentiality) and other relevant price indicators. If the valuations appear to be consistently overly aggressive or conservative, this may be evidence of management bias (see paragraphs 182–186). The auditor takes this into consideration when evaluating the audit evidence obtained. |
| 175. | Additional guidance is also provided in the IASB Expert Advisory Panel Report issued in October 2008 which deals with measuring and disclosing the fair value of financial instruments in markets that are no longer active. |
| 176. | Additional guidance is provided for auditors in Practice Note 23 (Revised), 'Auditing Complex Financial Instruments – Interim Guidance', specifically paragraphs 75–80 and 110–142 dealing with the valuation of complex financial instruments. This guidance has not been duplicated in this Practice Note. |
| 177. | The auditor may also wish to consider benchmarking the valuation methodologies and assumptions used by management to other comparable companies holding comparable financial instruments to ensure that there is consistency in the market place for such valuation techniques. However, the availability and comparability of data will need to be considered for each case. |
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