Management Bias in Accounting Estimates Under SA 540

1. Facts

A company engaged in diversified operations is required to make several accounting estimates at the end of the reporting period, including impairment assessments, provisions, and Expected Credit Loss (ECL) calculations. On review, the following patterns are observed:

(a) Impairment testing across multiple cash-generating units does not result in any impairment loss. This is primarily supported by optimistic assumptions such as high future growth rates, stable margins, and favourable discount rates.

(b) Provisions relating to areas such as litigation, warranties, and other obligations are consistently recognised at the lower end of the possible range of outcomes. These estimates are based on interpretations of available information that favour minimal outflows.

(c) Expected Credit Loss (ECL) calculations reflect improving credit quality and low default expectations, even though external economic conditions and industry trends indicate some level of uncertainty or stress.

(d) A comparison with prior periods shows that actual outcomes have often been less favourable than earlier estimates, indicating a tendency of estimates to be optimistic in hindsight.

(e) Management has provided explanations and supporting data for each estimate, and when assessed individually, the assumptions appear reasonable and within an acceptable range.

However, when all these estimates are considered together, a clear pattern emerges – each estimate leans towards a favourable outcome, resulting in an overall optimistic presentation in the financial statements.

In this context, the question arises whether such a consistent pattern indicates the presence of management bias, even though no single estimate appears unreasonable on a standalone basis, and what the appropriate audit approach should be in line with SA 540.

2. Relevant Provisions under SA 540

SA 540, Auditing Accounting Estimates

Para 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 SA 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 recognised 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)

(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. A29-A30)

(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)

Para 9 – 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. However, the review is not intended to call into question the judgments made in the prior periods that were based on information available at that time. (Ref – Para. A39-A44)

Para A40 – The review of prior period accounting estimates may also assist the auditor, in the current period, in identifying circumstances or conditions that increase the susceptibility of accounting estimates to, or indicate the presence of, possible management bias. The auditor’s professional skepticism assists in identifying such circumstances or conditions and in determining the nature, timing and extent of further audit procedures.

Para 21 – The auditor shall review the judgments and decisions made by management in the making of accounting estimates to identify whether there are indicators of possible management bias. Indicators of possible management bias do not themselves constitute misstatements for the purposes of drawing conclusions on the reasonableness of individual accounting estimates. (Ref – Para. A124-A125)

Para A125 – Examples of indicators of possible management bias with respect to accounting estimates include:

• Changes in an accounting estimate, or the method for making it, where management has made a subjective assessment that there has been a change in circumstances.
• Use of an entity’s own assumptions for fair value accounting estimates when they are inconsistent with observable marketplace assumptions.
• Selection or construction of significant assumptions that yield a point estimate favourable for management objectives.
• Selection of a point estimate that may indicate a pattern of optimism or pessimism.

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