Question

Outline and explain the various uncertainties that the management should consider when making estimate for possible accounting provisions

Answer 1

Scope of this ISA
1. This International Standard on Auditing (ISA) deals with the auditor’s
responsibilities relating to accounting estimates, including fair value
accounting estimates, and related disclosures in an audit of financial
statements. Specifically, it expands on how ISA 3151
and ISA 3302
and other
relevant ISAs are to be applied in relation to accounting estimates. It also
includes requirements and guidance on misstatements of individual accounting
estimates, and indicators of possible management bias.
Nature of Accounting Estimates
2. Some financial statement items cannot be measured precisely, but can only be
estimated. For purposes of this ISA, such financial statement items are referred to
as accounting estimates. The nature and reliability of information available to
management to support the making of an accounting estimate varies widely, which
thereby affects the degree of estimation uncertainty associated with accounting
estimates. The degree of estimation uncertainty affects, in turn, the risks of material
misstatement of accounting estimates, including their susceptibility to unintentional
or intentional management bias. (Ref: Para. A1–A11)
3. The measurement objective of accounting estimates can vary depending on the
applicable financial reporting framework and the financial item being reported.
The measurement objective for some accounting estimates is to forecast the
outcome of one or more transactions, events or conditions giving rise to the
need for the accounting estimate. For other accounting estimates, including
many fair value accounting estimates, the measurement objective is different,
and is expressed in terms of the value of a current transaction or financial
statement item based on conditions prevalent at the measurement date, such as
estimated market price for a particular type of asset or liability. For example,
the applicable financial reporting framework may require fair value
measurement based on an assumed hypothetical current transaction between
knowledgeable, willing parties (sometimes referred to as “marketplace
participants” or equivalent) in an arm’s length transaction, rather than the
settlement of a transaction at some past or future date.3

4. A difference between the outcome of an accounting estimate and the amount
originally recognized or disclosed in the financial statements does not necessarily
represent a misstatement of the financial statements. This is particularly the case

1
ISA 315, “Identifying and Assessing the Risks of Material Misstatement through Understanding the
Entity and Its Environment.”
2
ISA 330, “The Auditor’s Responses to Assessed Risks.”
3
Different definitions of fair value may exist among financial reporting frameworks.
for fair value accounting estimates, as any observed outcome is invariably
affected by events or conditions subsequent to the date at which the measurement
is estimated for purposes of the financial statements.
Effective Date
5. This ISA is effective for audits of financial statements for periods beginning on
or after December 15, 2009.
Objective
6. 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 recognized or disclosed, are reasonable;
and
(b) related disclosures in the financial statements are adequate,
in the context of the applicable financial reporting framework.
Definitions
7. For purposes of the ISAs, the following terms have the meanings attributed
below:
(a) Accounting estimate – An approximation of a monetary amount in the
absence of a precise means of measurement. This term is used for an
amount measured at fair value where there is estimation uncertainty, as
well as for other amounts that require estimation. Where this ISA
addresses only accounting estimates involving measurement at fair
value, the term “fair value accounting estimates” is used.
(b) Auditor’s point estimate or auditor’s range – The amount, or range of
amounts, respectively, derived from audit evidence for use in evaluating
management’s point estimate.
(c) Estimation uncertainty – The susceptibility of an accounting estimate and
related disclosures to an inherent lack of precision in its measurement.
(d) Management bias – A lack of neutrality by management in the preparation
of information.
(e) Management’s point estimate – The amount selected by management for
recognition or disclosure in the financial statements as an accounting
estimate.
(f) Outcome of an accounting estimate – The actual monetary amount
which results from the resolution of the underlying transaction(s),
event(s) or condition(s) addressed by the accounting estimate.
Requirements
Risk Assessment Procedures and Related Activities
8. 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 315,4
the auditor shall obtain an understanding of
the following in order to provide a basis for the identification and assessment
of the risks of material misstatement for accounting estimates: (Ref: Para. A12)
(a) The requirements of the applicable financial reporting framework relevant
to accounting estimates, including related disclosures. (Ref: Para. A13–
A15)
(b) How management identifies those transactions, events and conditions
that may give rise to the need for accounting estimates to be recognized
or disclosed in the financial statements. In obtaining this understanding,
the auditor shall make inquiries of management about changes in
circumstances that may give rise to new, or the need to revise existing,
accounting estimates. (Ref: Para. A16–A21)
(c) How management makes the accounting estimates, and an understanding of
the data on which they are based, including: (Ref: Para. A22–A23)
Provision: a liability of uncertain timing or amount.
Liability:
present oblig­a­tion as a result of past events
set­tle­ment is expected to result in an outflow of resources (payment)
Con­tin­gent liability:
a possible oblig­a­tion depending on whether some uncertain future event occurs, or
a present oblig­a­tion but payment is not probable or the amount cannot be measured reliably
Con­tin­gent asset:
a possible asset that arises from past events, and
whose existence will be confirmed only by the oc­cur­rence or non-oc­cur­rence of one or more uncertain future events not wholly within the control of the entity.
Recog­ni­tion of a provision
An entity must recognise a provision if, and only if: [IAS 37.14]
a present oblig­a­tion (legal or con­struc­tive) has arisen as a result of a past event (the oblig­at­ing event),
payment is probable ('more likely than not'), and
the amount can be estimated reliably.
An oblig­at­ing event is an event that creates a legal or con­struc­tive oblig­a­tion and, therefore, results in an entity having no realistic al­ter­na­tive but to settle the oblig­a­tion. [IAS 37.10]
A con­struc­tive oblig­a­tion arises if past practice creates a valid ex­pec­ta­tion on the part of a third party, for example, a retail store that has a long-stand­ing policy of allowing customers to return mer­chan­dise within, say, a 30-day period. [IAS 37.10]
A possible oblig­a­tion (a con­tin­gent liability) is disclosed but not accrued. However, dis­clo­sure is not required if payment is remote. [IAS 37.86]
In rare cases, for example in a lawsuit, it may not be clear whether an entity has a present oblig­a­tion. In those cases, a past event is deemed to give rise to a present oblig­a­tion if, taking account of all available evidence, it is more likely than not that a present oblig­a­tion exists at the balance sheet date. A provision should be recog­nised for that present oblig­a­tion if the other recog­ni­tion criteria described above are met. If it is more likely than not that no present oblig­a­tion exists, the entity should disclose a con­tin­gent liability, unless the pos­si­bil­ity of an outflow of resources is remote. [IAS 37.15]
Mea­sure­ment of pro­vi­sions
The amount recog­nised as a provision should be the best estimate of the ex­pen­di­ture required to settle the present oblig­a­tion at the balance sheet date, that is, the amount that an entity would ra­tio­nally pay to settle the oblig­a­tion at the balance sheet date or to transfer it to a third party. [IAS 37.36] This means:
Pro­vi­sions for one-off events (re­struc­tur­ing, en­vi­ron­men­tal clean-up, set­tle­ment of a lawsuit) are measured at the most likely amount. [IAS 37.40]
Pro­vi­sions for large pop­u­la­tions of events (war­ranties, customer refunds) are measured at a prob­a­bil­ity-weighted expected value. [IAS 37.39]
Both mea­sure­ments are at dis­counted present value using a pre-tax discount rate that reflects the current market as­sess­ments of the time value of money and the risks specific to the liability. [IAS 37.45 and 37.47]
In reaching its best estimate, the entity should take into account the risks and un­cer­tain­ties that surround the un­der­ly­ing events. [IAS 37.42]
If some or all of the ex­pen­di­ture required to settle a provision is expected to be re­im­bursed by another party, the re­im­burse­ment should be recog­nised as a separate asset, and not as a reduction of the required provision, when, and only when, it is virtually certain that re­im­burse­ment will be received if the entity settles the oblig­a­tion. The amount recog­nised should not exceed the amount of the provision. [IAS 37.53]
In measuring a provision consider future events as follows:
forecast rea­son­able changes in applying existing tech­nol­ogy [IAS 37.49]
ignore possible gains on sale of assets [IAS 37.51]
consider changes in leg­is­la­tion only if virtually certain to be enacted [IAS 37.50]
Re­mea­sure­ment of pro­vi­sions [IAS 37.59]
Review and adjust pro­vi­sion
Re­struc­tur­ings
A re­struc­tur­ing is: [IAS 37.70]
sale or ter­mi­na­tion of a line of business
closure of business locations
changes in man­age­ment structure
fun­da­men­tal re­or­gan­i­sa­tions.
Re­struc­tur­ing pro­vi­sions should be recog­nised as follows: [IAS 37.72]
Sale of operation: recognise a provision only after a binding sale agreement [IAS 37.78]
Closure or re­or­gan­i­sa­tion: recognise a provision only after a detailed formal plan is adopted and has started being im­ple­mented, or announced to those affected. A board decision of itself is in­suf­fi­cient.
Future operating losses: pro­vi­sions are not recog­nised for future operating losses, even in a re­struc­tur­ing
Re­struc­tur­ing provision on ac­qui­si­tion: recognise a provision only if there is an oblig­a­tion at ac­qui­si­tion date [IFRS 3.11]
Re­struc­tur­ing pro­vi­sions should include only direct ex­pen­di­tures nec­es­sar­ily entailed by the re­struc­tur­ing, not costs that as­so­ci­ated with the ongoing ac­tiv­i­ties of the entity. [IAS 37.80]
What is the debit entry?
When a provision (liability) is recog­nised, the debit entry for a provision is not always an expense. Sometimes the provision may form part of the cost of the asset. Examples: included in the cost of in­ven­to­ries, or an oblig­a­tion for en­vi­ron­men­tal cleanup when a new mine is opened or an offshore oil rig is installed. [IAS 37.8]
Use of pro­vi­sions
Pro­vi­sions should only be used for the purpose for which they were orig­i­nally recog­nised. They should be reviewed at each balance sheet date and adjusted to reflect the current best estimate. If it is no longer probable that an outflow of resources will be required to settle the oblig­a­tion, the provision should be reversed. [IAS 37.61]
Con­tin­gent li­a­bil­i­ties
Since there is common ground as regards li­a­bil­i­ties that are uncertain, IAS 37 also deals with con­tin­gen­cies. It requires that entities should not recognise con­tin­gent li­a­bil­i­ties – but should disclose them, unless the pos­si­bil­ity of an outflow of economic resources is remote. [IAS 37.86]
Con­tin­gent assets
Con­tin­gent assets should not be recog­nised – but should be disclosed where an inflow of economic benefits is probable. When the re­al­i­sa­tion of income is virtually certain, then the related asset is not a con­tin­gent asset and its recog­ni­tion is ap­pro­pri­ate. [IAS 37.31-35]
Dis­clo­sures
Rec­on­cil­i­a­tion for each class of provision: [IAS 37.84]
opening balance
additions
used (amounts charged against the provision)
unused amounts reversed
unwinding of the discount, or changes in discount rate
closing balance
A prior year rec­on­cil­i­a­tion is not required. [IAS 37.84]
For each class of provision, a brief de­scrip­tion of: [IAS 37.85]
nature
timing
un­cer­tain­ties
as­sump­tions
re­im­burse­ment, if any.

(i) The method, including where applicable the model, used in
making the accounting estimate; (Ref: Para. A24–A26)
(ii) Relevant controls; (Ref: Para. A27–A28)
(iii) Whether management has used an expert; (Ref: Para. A29vA30)
(iv) The assumptions underlying the accounting estimates; (Ref:
Para. A31–A36)
(v) Whether there has been or ought to have been a change from the
prior period in the methods for making the accounting estimates,
and if so, why; and (Ref: Para. A37)
(vi) Whether and, if so, how management has assessed the effect of
estimation uncertainty. (Ref: Para. A38)