Auditing Optimistic Accounting Estimates Under SA 540

Can an Auditor Accept Management’s Optimistic Accounting Estimates and Assumptions? An Analysis under SA 540

Question

Delta Limited is a listed manufacturing company engaged in the production of industrial equipment. During the financial year ended 31^st March 2026, the company experienced a noticeable decline in demand due to adverse economic conditions and increased competition from imported products. As a result, sales declined by approximately 18% compared to the previous year, and several customers began delaying payments.

One of the most significant balances in the financial statements is the Expected Credit Loss (ECL) allowance recognised on trade receivables in accordance with Ind AS 109. Management has estimated the ECL allowance at ₹18 crore based on its internally developed impairment model.

The auditor, while understanding the estimation process, observes the following:

  a) Management has assumed that the slowdown in collections is only temporary and expects recoveries to improve substantially within the next six months.

  b) Historical default rates have been adjusted downward on the basis that management expects a significant improvement in economic conditions during the next financial year.

  c) The macroeconomic forecasts incorporated into the ECL model are considerably more optimistic than forecasts published by the Reserve Bank of India and other independent economic agencies.

  d) Approximately 40% of the receivables are more than 180 days overdue, yet management believes that long-standing customer relationships justify a lower expected default rate.

  e) Similar optimistic assumptions were used in the previous year; however, actual recoveries during the current year were significantly below management’s earlier estimates.

  f) The audit team identifies no mathematical errors in the ECL model, and the methodology adopted is broadly consistent with that used in prior years.

Management argues that accounting estimates inherently involve judgment and that different assumptions can legitimately produce different outcomes. Since its assumptions are supported by internal business plans approved by the Board of Directors, management contends that the auditor should not substitute its own expectations for management’s judgment.

The engagement partner is now in a dilemma: can the auditor accept management’s accounting estimate merely because the estimation model is technically sound and the assumptions appear plausible, or does SA 540 require the auditor to critically evaluate and challenge management’s assumptions, particularly where indicators of possible management bias exist?

Relevant Provisions

SA 540

Para 9 of SA 540

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. The nature and extent of the auditor’s review takes account of the nature of the accounting estimates, and whether the information obtained from the review would be relevant to identifying and assessing risks of material misstatement of accounting estimates made in the current period financial statements.

Para 11 of SA 540

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.

Para 15 of 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.

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