Statement on Auditing Standards No. 143: Auditing Accounting Estimates and Related Disclosures is effective for 2023 year-end audits. The standard provides auditors updated guidelines on the nature of estimates and how to audit these items. Depending on the nature and number of estimates in your financial statements, you will see differences in how we audit these estimates. In turn, your financial statements may include enhanced disclosures on estimates.
Just how many estimates are in your financial statements? If you offer a product warranty, your accrual is an estimate. If you're in litigation, the accrual for your estimated liability is also an estimate.
Odds are that your financial statements have many more estimates. These are some of the estimates we regularly see in financial statements:
- 1. Allowance for credit losses on accounts receivable. (A zero allowance is also an estimate.)
- 2. Estimated salvage value and estimated useful life of depreciable property and equipment.
- 3. Self-insured liabilities for claims incurred but not reported.
- 4. Variable consideration in contracts with customers.
When auditing estimates, we need to consider if the methods and data used were selected appropriately, including when alternative methods for making the accounting estimate and alternative sources of data were available. For example, management in setting its allowance for credit losses may:
- 1. Estimate it as a percentage of revenue.
- 2. Specifically identify potentially uncollectible accounts receivable.
- 3. Make a "seat of the pants" estimate.
We are more likely to feel comfortable with the first two approaches than the last. Regardless of management's estimate, we initially test the estimate in one of three ways:
- 1. Test activity after the date of the financial statements to see if the allowance is reasonable.
- 2. Examine management's method and documentation supporting the allowance and determine if it is reasonable.
- 3. Come up with our own estimate based on a different methodology the auditor considers likely to provide a better estimate.
We will place greater scrutiny on the selection and application of the methods, significant assumptions, and data used by management in making accounting estimates. We will also look at how management selected the point estimate and developed related disclosures about estimation uncertainty. Some estimates will require increased testing, primarily those where there are a wide range of possible outcomes.
While the standard disclosure about estimates in the summary of significant accounting policies continues, SAS 143 requires us to evaluate the disclosures pertaining to estimation uncertainty in the financial statements. It is possible that disclosures used in previous years may still comply with generally accepted accounting principles, but we may deem them inadequate considering the circumstances and facts that are involved. Our emphasis on the adequacy of disclosures increases as the range of possible outcomes for management's accounting estimate increases in relationship to their materiality to the financial statements.
We encourage financial statement preparers to review their policies and procedures for developing their estimates and, if necessary, strengthen them. Doing so may aid in the timely completion of the audit.
Questions? Please reach out to Joel Ungar, CPA at (248) 444-4691 or jungar@peasebell.com to discuss this change further.
