ACCOUNTING ESTIMATES (Learning Objective 1)

Accounting estimate means an approximation of a monetary amount in the absence of a precise

means of measurement. This term is also used for an amount measured at fair value where there
is estimation uncertainty.

Many items in F/S have to be estimated due to uncertainties inherent in a business. Such estimates
range from simple calculations (e.g., net realizable value of inventory and depreciation of property,
plant, and equipment) to complex ones (e.g., calculating fair value of complex derivative
instruments and actuarial valuation of retirement benefits). Hence, accounting estimates
inherently present higher ROMM that could even be considered significant risks.

Responsibility for Accounting Estimates

Management is responsible for making accounting estimates that are reasonable when preparing
and presenting F/S.

Auditing Accounting Estimates

The auditor should obtain sufficient appropriate evidence about whether:

a. accounting estimates in F/S are reasonable; and
b. related disclosures in F/S are adequate.

The next exhibit summarizes auditing of accounting estimates.

Exhibit 15.1—Auditing Accounting Estimates

Risk Assessment Risk Response Conclusion and Reporting

Obtain understanding to Perform appropriate Obtain written

identify and assess responses.
ROMM.
Use work of an auditor`s
Review of actual outcome expert.
of estimates prepared in Perform additional
previous period. procedures for
significant risks relating
Evaluate degree of to accounting
estimation uncertainty estimates.
and significant risks.
Evaluate possible
management bias.
representations about
reasonableness of
estimates and
management`s intent and
ability to carry out specific
actions. Chapter6
Evaluate audit evidence and
misstatement for
reasonableness of
accounting estimates.
Documents finding and
result.
Risk Assessment

Obtain Understanding to Identify and Assess ROMM

Obtain understanding of estimation process to identify and assess ROMM, such as:

1. Requirements of AFRF.

2. Circumstances that involve accounting estimates.

3. Model/methodology (as well as changes therein), D&l of relevant controls, use of

management's expert, assumptions used, and uncertainty involved.

Review Outcomes of Estimates Prepared in Previous Periods

This is also known as retrospective review. This helps auditor to understand:

• Effectiveness (or not) of management's estimation process;
• Existence of any possible management bias (a possible fraud);
• Existence of pertinent audit evidence; and
• Extent of estimation uncertainty involved (may be a required F/S disclosure).

A difference between the outcome of an accounting estimate and the original estimate does not
necessarily represent a misstatement.

Evaluate Degree of Estimation Uncertainty and Significant Risks

Estimation uncertainty refers to the susceptibility of an accounting estimate and related

disclosures to an inherent lack of precision in its measurement. In identifying and assessing ROMM,
the auditor shall evaluate the degree of
estimation uncertainty involved.

Accounting estimates that have high estimation uncertainty may give rise to significant risks.
Examples include those highly dependent upon judgment (e.g., outcome of litigation), sensitive to
changes in assumptions, susceptible to bias, dependent on uncertain events many years in the
future, not calculated using recognized techniques or unobservable inputs, retrospective review
indicates a substantial difference, and fair value estimates of derivative instruments that are not
publicly traded.
Risk Response

Perform Appropriate Responses

Auditor's responses determine whether AFRF has been appropriately applied and methods are
appropriate and applied consistently, to wit:

1. Review subsequent events up to auditor's report.

2. Test management's estimation process.
3. Test relevant controls over accounting estimates, and perform SP.
4. Develop independent estimate and compare with management's estimate.

Use Work of an Auditor's Expert

The auditor shall consider whether specialized skills or knowledge in relation to accounting
estimates are required in order to obtain sufficient appropriate evidence. For example, in defined
benefit plans, the auditor may use the work of an actuary to test management assumptions and
process in calculating retirement
benefits.

Perform Additional Responses to Significant Risks in Accounting Estimates

The auditor shall evaluate:

a. How management addressed estimation uncertainty.
b. Whether significant assumptions are reasonable.
c. Where relevant, management's intent and ability to carry out specific actions.

Evaluate Possible Management Bias

The auditor shall:

• Identify whether there are indicators of possible management bias such as changes in estimates
calculation and pattern of optimism or pessimism. For example, where management puts the
business up for sale and the earnings goal changes from tax minimization to profit maximization.

• Consider the cumulative effect of management's bias.

Conclusion and Reporting

EvaluateAudit Evidence and Misstatement for Reasonableness of Estimates

The accounting estimates are either reasonable or misstated based on audit evidence.

Where the evidence supports a point estimate, the difference between the auditor's estimate and
management's estimate constitutes a misstatement.For example, the auditor considers P200,000
as misstatement when management's estimate for allowance for impaired loans is P1,000,000, but
the auditor estimate is P1,200,000.

Where the evidence supports a range estimate, a management point estimate that lies outside the
auditor's range would not be supported by audit evidence. The misstatement is no less than the
difference between management's point estimate and the nearest point of the auditor's range.
For example, if management's point of estimate for allowance for impaired loans is P1,000,000,
but the auditor's range of reasonable estimate is P1,300,000 to P1,500,000, misstatement is at
least P300,000.

Document Findings and Results

The auditor shall document:

• References to relevant PSAs and AFRF;
• Consultations with experts;
•Considerations of contradictory or inconsistent audit evidence; and
• Challenges that were raised and alternative positions and assumptions considered.

RELATED PARTIES (Learning Objective 2)

PAS 24, Related Parties, establishes specific disclosure requirements for related party relationships,
transactions, and balances. This enables the users of F/S to understand the nature and effects on
the F/S of related parties. Without such disclosures. Els would potentially be misleading. Therefore,
as related parties are hot independent of each other, there are often higher ROMM in related-
party
transactions.

Responsibility for Sufficient Disclosures of Related Parties

Management is responsible for appropriate accounting for and disclosure of related party
relationships and transactions.
Auditor's Objectives in Auditing Related Parties

The auditor shall obtain evidence about the sufficiency and appropriateness of related party
disclosures. The next exhibit summarizes auditing of accounting estimates.

Exhibit 15.2—Auditing Related Parties

Risk Assessment Risk Response Conclusion and Reporting

Perform RAP to Perform FAP to obtain Obtain written

identify and assess evidence about ROMM representations about
ROMM, including of related parties. completeness of
significant risks and accounting and
frud risk. Perform additional disciosures of related
procedures for parties in the F/S.
Remain alert for significant related party
indication of related transactions outside Documents result and
parties when the normal course of findings.
inspecting recods of business.
documents. Form auditor`s opinion.
Obtain evidence about
assertion that related
party transactions are
arm`s length
transactions.

Risk Assessment

Perform RAP to identify and Assess ROMM, Including Significant Risks and Fraud Risks.

The auditor shall perform RAP aimed to obtain information relevant to identhly ROMM associated
with related parties, and whether such risks are significant risks or due to fraud. Also, the auditor
shall treat identified significant related-pany transactions outside the entity's normal course of
business as significant risks.

Such procedures shall include engagement team management regarding the:

discussion and inquiry of management regarding the:
a. Identity of related parties, including changes from the prior period;
b. Nature of related party relationships; and
c. Type and purpose of related transactions.

The auditor shall inquire of management and others within the entity, and perform other RAP to
obtain an understanding of internal controls that:

a. Identify, account for, and disclose related-parties;

b. Authorize and approve transactions with related parties; and
c. Authorize and approve transactions outside the normal course of business.

Remain Alert for Indication of Related Parties When Inspecting Records or Documents

The auditor shall inspect the following for indications of related parties:
a. Bank and legal confirmations obtained as part of the auditor's procedures;
b. Minutes of meetings of shareholders and of TCWG; and
c. Such other records or documents as the auditor considers necessary in the circumstances of the
entity, such as SEC filings, conflict of interest statements, pensions, other trusts, and identify
officers thereof, etc.

Transactions that indicate the existence of related parties may include:

• Borrowing or lending at rates significantly different from market rates
• Business with major customers, suppliers, etc.
• Other unusual transactions

Risk Response

Perform FAP Obtain Evidence About ROMM of Related Parties

If the previously unidentified related parties have been identified, the auditor shall:
a. Promptly communicate the relevant information to other team members;
b. Request management to identify all transactions with the new related parties;
c. Inquire why the entity's controls failed to identify all related parties;
d. Perform SP to new identified related parties;
e. Reconsider risk of unidentified related parties, and perform additionat procedures, and
f. If non-disclosure by management appears intentional (and thereforeindicative of a ROMM due
to fraud) evaluate the implications for the audit.

Significant Related-party Transactions Outside Normal Course of Business

The auditor shall:

a. Inspect any contracts to evaluate (a) rationale of transactions which maysuggest fraud, (b) terms
of transactions are consistent with management's explanations and (c) transactions have been
appropriately accounted for and disclosed; and
b. Obtain evidence that the transactions have been appropriately authorized.

Obtain Evidence about Assertion that Related Party Transactions are Arm's Length Transactions

If F/S have an assertion that a related-party transaction was conducted in an arm's length
transaction, the auditor shall obtain evidence about the assertion.

Conclusion and Reporting

Document Results and Findings

The auditor shall document the names of identified related parties and nature of the related-party
relationships.

Form Auditor's Opinion

In forming an opinion on the F/S, the auditor shall evaluate whether the identified related-party
relationships and transactions have been appropriately accounted for and disclosed in accordance
with the AFRF. Modify the auditor's opinion if:

• Unable to obtain sufficient appropriate evidence - express a qualified opinion or a disclaimer

of opinion; or
• Management's disclosure in the F/S is not considered adequate - express a qualified opinion
or an adverse opinion.

GOING CONCERN (Learning Objective 3)

F/S are prepared on a going concern basis, unless management either intends to liquidate the
entity or to cease operations, or has no realistic alternative but to do so. When an entity is no
longer a going concern, its F/S are affected pervasively. That is, its assets and liabilities are reported
at realizable value and settlement amounts, respectively, and are usually no longer classified as
current and non-current. Hence, the auditor shall determine the appropriateness of going concern
assumption.

Responsibility for Assessment of the Entity's Ability to Continue as a Going Concern

PAS 1, Presentation of Financial Statements, requires management to assess an entity's ability to

continue as a going concern. In performing this assessment, management is required to take into
account all available information about the future, which is at least, but is not limited to, 12
months from the date of F/S.
When management concludes that there are material uncertainties that may cast significant doubt
on an entity's ability to continue as a going concern, the entity is required to disclose in the F/S
those uncertainties. A material uncertainty exists when the magnitude of its potential impact is
such that, in the auditor's judgment, clear disclosure of the nature and implications of the
uncertainty is necessary for the presentation of the F/S not to be misleading.

Examples of events or conditions that may cast significant doubt on entity's ability to continue as
a going concern are set out in Appendix 15.A.

Auditor's Objectives in Considering Going Concern Assumption

The objectives of the auditor are:

a. To obtain evidence about and conclude on the appropriateness of going concern;

b. To conclude whether a material uncertainty exists; and
c. To report on the auditor's findings.
The next exhibit summarizes auditing of going concern assumption.

Exhibit 15.3—Auditing Going Concern (GC) Assumption

Ask MGT about GC No assessment Auditor unable to Auditor`s Opinion

assessment made or not obtain sufficient
covering at least 12 cover appropriate
months after year- appropriate evidence.
end. period.
Qualified/Disclaime
Multiple material r
Assessment made uncertainties that are
that. significant to F/S.
Disclaimer

Any events conditions Represents material

that may cast uncertainty.
significant doubt on Yes
entity`s ability to
continue as a GC. Adverse
Yes
No

None
Management has
mitigating plans that
make GC still. No
GC assumption is
appropriate.
No
Yes Unmodified with
EOM

FSs prepared
Material uncertainty
under alternative
adequately disclosed. Yes
basis?
No Qualified/Adverse

Yes Unmodified with

section for material.

Unmodified
Procedures When Identified Events or Conditions Cast Significant Doubt

If such events or conditions have been identified, the auditor shall obtain sufficient appropriate
evidence to determine whether a material uncertainty exists by performing additional audit
procedures, including consideration of mitigating factors, such as:

Chapter 15-Considering Certain Specific Financial Statements Items | 351

• Analyzing and discussing cash flow, profit and other relevant forecasts or the entity's latest
available interim F/S with management.

• Reading terms of loan agreements and determining any breach.

• Reading minutes of meetings for reference to financing difficulties.

• Inquiring of entity's legal counsel regarding litigation and claims and reasonableness of
management's estimates of outcome and financial implications,

• Confirming financial support with related and third parties and assessing the financial ability
of such parties to provide additional funds.

• Evaluating the entity's plans to deal with unfilled customer orders.

• Performing procedures regarding subsequent events that either mitigate or affect the entity's
ability to continue as a going concern.

• Confirming the existence, terms and adequacy of borrowing facilities.

• Obtaining and reviewing reports of regulatory actions.

• Determining the adequacy of support for any planned disposals of assets.

Evaluate Management's Plans for Future Actions

The auditor shall evaluate management's plans relating to going concern to determine whether
the plans would improve the situation and whether the plans are feasible. For example, inquiries
of management as to its plans to liquidate assets, borrow money or restructure debt, reduce or
delay expenditures, or increase capital.

Obtain Written Representations

The auditor may consider it appropriate to obtain specific written representations in support of
audit evidence obtained regarding management's plans for future actions in relation to its going
concern assessment and the feasibility of those plans.
Conclude Whether a Material Uncertainty Exists

What constitutes a material uncertainty is a judgment involving not only (a) the nature and
materiality of the events or conditions giving rise to uncertainty, but (b) the ability of the entity to
adopt strategies that mitigate the uncertainty.

Material uncertainties may be mitigated by other favorable factors. For example being unable to
repay debts may be counterbalanced by disposal of assets, den restructuring, or obtaining
additional capital.

The auditor, in assessing the alternative strategies, considers whether they:

• are realistic;
• have a reasonable expectation of resolving any problems foreseen; and
• are likely to be implemented effectively.

If there are no alternative plans this is likely to be evidence of a material uncertainty.

Determine Adequacy of Disclosures When Events or Conditions Have Been Identified but No
Material Uncertainty Exists

Even when no material uncertainty exists, the F/S may provide adequate disclosure about such
events or conditions. Typical disclosures address about:

• Principal events or conditions;

• Management's evaluation of the significance of those events or conditions;
• Management's mitigating plans; or
• Significant judgments made by management.

Communicate with TCWG

Unless all TCWG are involved in management, the auditor shall communicate with TCWG events
or conditions identified that may cast significant doubt on the entity's ability to continue as a going
concern. Such communication shall include:

a. Whether the events or conditions constitute a material uncertainty;

b. Whether going concern basis of accounting is appropriate in the F/S preparation;
c. The adequacy of related disclosures in the F/S; and d. Where applicable, the implications for the
auditor's report.

Inquire of Reasons If Approval of F/S Significantly Delayed

If there is significant delay in F/S approval, the auditor shall inquire as to the reasons for delay. If
the auditor believes the delay relates to going concern, the auditor shall perform additional
procedures to conclude on the existence of a material uncertainty.

INVENTORY. LITIGATION AND CLAIMS, AND OPERATING SEGMENT INFORMATION (Learning

Objective 4)

Auditor's Objective and Management's Responsibility

The auditor's objective is to obtain sufficient appropriate evidence regarding the:

a. Existence and condition of inventory;

b. Completeness of litigation and claims involving the entity; and
c. Presentation and disclosure of operating segment information.

In all the three items above. management is responsible for identifying evaluating, and ensuring
their proper accounting and disclosures.

Procedures to obtain Sufficient Appropriate Audit Evidence

The next exhibit provides a summary of procedures for three items above.

Exhibit 15.4–Summary of Procedures for Inventory, Litigation and Claims, and Operating
Segment information

Existence and Condition of Material Inventory

Attended the • Evaluate management's instructions for recording/controlling count
Physica count results;
• Observe performance of management's count procedures;
• Inspect the inventory and perform test counts;
• Reconcile changes in inventory between count date and
• period end; and
• Perform alternative procedures if a physical count is
• impracticable such as inspection of supporting documents.

Confirm/ • Request confirmations of inventory held others; and Inventory Held

Inspect • Perform inspection or other appropriate audit procedures.
Inventory Held
by Others
Completeness of Litigation and Claims Involving the Entity
Make Inquiries • Inquire of management and others;
And Review • Review minutes of meetings; Relevant
Relevant • Review correspondence between entity and legal counsel; Documents
Documents • and
• Review legal expense accounts.
• These procedures should obtain evidence about:
• The existence of uncertainty arising from litigation and
• Claims.
• The period in which the cause for the uncertainty occurred
• The probability of an unfavorable outcome
• The amount or range of potential loss

Communicate Where litigation or claims are identified or suspected, the with External
with External auditor send a letter of inquiry, prepared by management. Legal Counsel
Legal Counsel requesting external legal counsel to communicate details of
claims, etc. directly with the auditor. If management refuses permission to
contact external counsel, perform alternative procedures (e.g., review all
documentation and making
additional inquiries).
Obtain Request a written representation from management and TCWG Management
Management that all known actual or possible litigation and claims have been
Representation Representation disclosed and properly accounted for in the F/S.

Presentation and Disclosure of Operating Segment Information

Understands Obtain an understanding of the methods used by management Management's
Management`s in determining segment information, and: Methods
Methods a. Evaluate if such methods result in appropriate disclosures;
and
b. Where appropriate, test the application of such methods.
Analytical Performing analytical procedures or other audit procedures.
Procedures