SA 540 – Auditing Accounting Estimates, Including Fair Value Accounting Estimates, & Related Disclosures

Question 1

M/s. Sumati & Co. was appointed as an auditor of Mati Limited, a company operating its business
in telecom sector. As per spectrum allocation agreement with Government, Mati Limited is required
to pay certain percentage of its annual revenue as license fee. Mati Limited paid the license fee on
its core business for last two years. At the end of third year, the communication was received from
Government that it needs to pay agreed percentage on its total revenues and not only on core
business revenues. Matter was disputed and went to court of law. On prudence basis, Mati Limited
made a provision on estimated business in its books of accounts of agreed percentage on noncore
business receipts also. The amount of provision was of such huge amount that the Mali
Limited’s profit and loss account for that quarter reflected loss due to that provision. How you as
an auditor can evaluate this accounting estimate which involves significant risk and what if
Management has not addressed the effects of estimation uncertainty on provision made?

Answer 1

Evaluation of Accounting Estimates which involves significant Risks:
in the given case, S & Co, was appointed as an auditor of M Ltd, operating in Telecom Sector. M Ltd paid the license fee on its core business revenue whereas Govt required it to pay on non-core business receipts as well. Consequently, the amount of provision was of such a huge amount that M Ltd.’s P&L Acc reflected a loss due to that provision. As an Ar, evaluation would be done as under:

• As per SA 540 for accounting estimates that give rise to significant risks, in addition to other substantive procedures performed to meet the requirements of SA 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.
• If, in the auditor’s judgment, management has not adequately addressed the effects of estimation
uncertainty on the accounting estimates that give rise to significant risks, the auditor shall, if
considered necessary, develop a range with which to evaluate the reasonableness of the
accounting estimate.

Question 2

Mr. L while conducting the audit of ABC Ltd., observed that a substantial amount is recognized in respect of obsolescence of inventory and warranty obligation in the FS.

Mr. L wants to obtain written representation from the management to determine whether the assumptions and estimates used are reasonable. Guide Mr. L with reference to the relevant SA.

Answer 2

Written Representations:
As per SA 540,

–> the auditor shall obtain written representations from management and, where appropriate, TCWG

–> whether they believe significant assumptions used in making accounting estimates are reasonable.

SA 580, “Written Representations” discusses the use of written representations.

–> Depending on the nature, materiality and extent of estimation uncertainty, written representations about accounting estimates recognized or disclosed in the FS may include representations:

(i) About the appropriateness of the measurement processes, including related assumptions and models, used by management in determining accounting estimates in the context of the applicable FRF, and the consistency in application of the processes.

(ii) That the assumptions appropriately reflect management’s intent and ability to carry out specific courses of action on behalf of the entity, where relevant to the accounting estimates and disclosures.

(iii) That disclosure related to accounting estimates are complete and appropriate under the applicable FRF.

(iv) That no subsequent event requires adjustment to the accounting estimates and disclosures included in the FS.