Exposure Draft - ISA 540 (Revised and Redrafted), Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures

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1 Tel +44 (0) Dorset Rise Fax +44 (0) London EC4Y 8EN United Kingdom Executive Director, Professional Standards International Auditing and Assurance Standards Board International Federation of Accountants 545 Fifth Avenue, 14th Floor New York, New York USA Our ref Contact Sylvia Smith +44 (0) Dear Sirs Exposure Draft - ISA 540 (Revised and Redrafted), Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures We are pleased to have the opportunity to comment on the above Exposure Draft issued by the International Auditing and Assurance Standards Board (IAASB). Generally we support the exposure draft. Our comments on the proposals are set out below. Responses to questions in the Explanatory Memorandum 1 Is the objective to be achieved by the auditor, stated in the proposed revised and redrafted ISA, appropriate? We agree that the proposed objective is appropriate. 2 Have the criteria identified by the IAASB for determining whether a requirement should be specified been applied appropriately and consistently, such that the resulting requirements promote consistency in performance and the use of professional judgment by auditors? Generally, we believe that the criteria identified by the IAASB for determining requirements have been applied appropriately and consistently. Further, in developing our response to this Exposure Draft we asked colleagues involved with audits of complex estimates measured at fair values to specifically comment on the appropriateness of the requirements and application material. They concluded that the proposed ISA strikes an appropriate balance between setting out different procedures for the auditor to perform and allowing the auditor scope to determine the nature, timing and extent of those procedures after considering factors such as the nature of the estimate and the risk of material, a UK company limited by guarantee, is a member of KPMG International, a Swiss cooperative Registered in England No Registered office: 100 Temple Street, Bristol BS1 6AG

2 misstatement. However, we do identify below a few areas where the intent of the requirements can be more clearly explained. Combination of ISAs 540 (Revised) and 545# We generally support the combination of ISAs 540 and 545. However, we believe that the combination may have affected the usefulness/understandability of the guidance in the following areas: Use of an expert proposed paragraphs 12 and A51 do not capture all the relevant guidance included in paragraph 17 of an extant ISA 540 and paragraphs 29 through 32 of extant ISA 545. We recognise that general guidance on use of an expert will be included in ISA 620 (Revised) but we believe that there are specific considerations applicable to the use of a valuation expert in developing a fair value estimate that need to be emphasized in this ISA. For example, we recommend that the proposed standard incorporate the reference in ISA to the need for the auditor to consider that the definition of fair value and the method that the expert will use to determine fair value are consistent with the definition and methods used by management and with the requirements of the applicable financial reporting framework. Definition of expert used by the auditor proposed paragraph 7(b) includes a reference to a third party expert engaged by the auditor, whereas paragraphs 12 and A51 refer to the auditor s expert, and paragraph A80 refers to the auditor employing or engaging an expert. We recommend that consistent terminology be used throughout the ISA. We also recommend that the terminology be consistent with the definition of engagement team in ISA 220. Measurement basis proposed paragraph 16(b) is being inappropriately restricted to estimates accounted for at fair value. This may be because the ISA 545 requirements have been combined with those of 540. We recommend the following change to paragraph 16: For accounting estimates that give rise to significant risks, the auditor shall obtain sufficient appropriate audit evidence about whether management s decision to: (a) management s decision to recognize, or to not recognize, the accounting estimates in the financial statements, or and (b) use fair value as the measurement basis for the accounting estimates, is in accordance with the requirements of the applicable financial reporting framework. Retrospective review 2

3 Paragraphs 9 and A31 to A33 make reference to a review of the outcome, or re-estimation, of accounting estimates made in prior period financial statements. We believe this is similar to the retrospective review procedure the auditor is required to carry out in paragraph 32 of ISA 240 (Redrafted). We therefore recommend that the procedure be described as a retrospective review and that it be cross referenced to ISA 240 to help readers make the link. In addition, the last sentence of paragraph A32 states that the retrospective review to be carried out by the auditor is not intended to call into question the judgements made in the prior year that were based on information available at the time. We believe that this comment is essential to understanding the nature of a retrospective review. We therefore recommend including it in the requirements as essential explanatory material. We also recommend changing prior year to prior period. Responses to the Assessed Risks of Material Misstatement We note an inconsistency between paragraph 13 and A52. Paragraph 13 requires the auditor to respond to the assessed risks of material misstatement by taking account of the nature of the accounting estimate. However, the considerations listed in paragraph A52 are broader than just the nature of accounting estimates referred to in paragraph 13. Accordingly, we recommend deleting the phrase taking account of the nature of the accounting estimate in paragraph 13. Evaluating the Reasonableness of the Accounting Estimates and Related Disclosures, and Determining Misstatements Proposed paragraph 18 requires the auditor to evaluate whether the accounting estimates and related disclosures are either reasonable in the context of the applicable financial reporting framework, or are misstated. We find this requirement unclear since it appears to suggest that consideration of the reasonableness of an accounting estimate and whether it is misstated are two separate considerations. We believe that a conclusion on reasonableness encompasses a conclusion that an estimate is not materially misstated. This is supported by the objective of the auditor in paragraph 6. We therefore recommend changing the requirement in paragraph 18 to the following: The auditor shall evaluate, based on the audit evidence, whether the accounting estimates and related disclosures in the financial statements are either reasonable in the context of the applicable financial framework, or are misstated. We also recommend deleting reference to determining misstatements from the sub-heading preceding paragraph 18. 3

4 Audit Documentation We do not support the inclusion of a specific documentation requirement in this standard. We find the purpose of the requirement in paragraph 21(b) to document indicators unclear in the absence of any specific actions with respect to the indicators. Having said this, we question the need for any specific documentation requirements in this ISA. We agree with the view that the proposed requirements in this ISA are encompassed by the general requirements of ISA 230. Including a requirement on one aspect of a standard tends to detract from the other matters that would need to be documented in order to comply with ISA 230. Accordingly, we recommend deleting paragraph 21 in its entirety. Small entities We generally support the guidance provided with respect to smaller entities. However, we have the following minor comments: Paragraph A20 we recommend replacing straightforward with less complex. Paragraph A90 we recommend deleting the last sentence of this paragraph as it is not relevant to an auditing standard. Other comments Paragraph A10 This paragraph refers to specialized assets for which there are no readily available and reliable sources of information for purposes of measurement fair value for which measurement may be difficult or not possible at all. To help auditors understand this point, we recommend that the paragraph provide an example of the type of assets being referred to. Paragraph A18 We believe that the 3 rd bullet is inappropriate since auditors should have knowledge of changes to requirements in the applicable financial reporting framework, based on their own knowledge of accounting standards. Auditors should not have to rely on inquiries of management to obtain this type of information. Accordingly, we recommend changing this bullet to make reference to inquiries of management as to whether accounting policies relating to accounting estimates have changed. Paragraph A22 We recommend clarifying the third bullet as follows: Whether the accounting estimates were made based on data available at an interim date and if so, whether and how management has taken into account the effect of 4

5 Paragraph A 51 We recommend including the word to after refer in the second line of this paragraph. Paragraph A84 The first sentence of this paragraph makes reference to the amount lower than materiality determined for purposes of assessing risks and designing further audit procedures referred to in ISA 320. We recommend amending this phrase as follows so that it is consistent with the wording used in ISA 320: the amount lower than the materiality level for the financial statements as a whole determined for purposes of assessing risks of material misstatement and designing further audit procedures The second sentence of this paragraph states that in certain industries it may not be possible to narrow a range used to evaluate the reasonableness of management s point estimate below materiality determined for purposes of assessing risks and designing further audit procedures. To help auditors understand this point, we recommend that the paragraph provide guidance as to why this may be the case, including examples of the industries being referred to. Paragraph A91 We recommend deleting the first sentence of this paragraph as it describes an inherent characteristic of significant assumptions and is therefore not necessary. Paragraph 104 We recommend changing financial statement to financial statements at the end of the first sentence. Paragraph A106 We recommend deleting this paragraph. The importance of notes as an integral part of the financial statements and the need for them to be audited is emphasised in ISA 700. It is therefore not necessary to make reference to this matter here. Paragraph A109 This paragraph makes reference to the nature, materiality and extent of estimation uncertainty as factors that may influence representations relating to the reasonableness of significant assumptions to be obtained by the auditor. We question whether it is necessary/appropriate to refer to materiality in this context as it is encompassed by the nature and extent of estimation uncertainty. More importantly, we recommend that the guidance in this paragraph be more 5

6 closely aligned with the guidance relating to specific representations in proposed ISA 580 (Revised and Redrafted). Appendix We question the usefulness and appropriateness of providing generic accounting-type guidance in an auditing standard. We recommend deleting the appendix. * * * Please contact Sylvia Smith at +44 (0) if you wish to discuss any of the issues raised in this letter. Yours faithfully 6