ISA 700 requires that an auditor expresses an opinion in terms of reasonable assurance. This requires us to state an opinion that we believe a set of financial statements present a true and fair view (or are fairly presented). The assertive nature of this opinion requires a substantial amount of robust evidence to support it. It is rather too easy to drop into auditing estimates to a degree where conclusions become that management’s estimates are ‘reasonable’ or even ‘plausible’. Neither of these conclusions mirror the wording used in our actual audit report and so are insufficient to comply with the requirement of ISA 700 and ISA 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures. Obtaining certainty about the future is impossible, but obtaining evidence to support a reasonable conclusion on likely future outcomes is not. How can estimates be wrong?It is logically impossible to say that an estimate about the future is certain to be right. It’s much easier, however, to identify when an estimate is likely to be wrong. So it is perhaps easiest to start off identifying some common situations when an estimate looks likely to be materially misstated. This list isn’t exhaustive, but it includes some of the biggest potential errors and you should be sure that you’re comfortable with all of them before taking the Paper P7 exam. Misunderstanding the stated system of GAAP. In the audit report, we define true and fair, or fair presentation, by referring to full compliance with a stated system of GAAP. It is, therefore, essential to have an in-depth knowledge of the GAAP system being used to define truth and fairness before it’s possible to express an audit opinion that is built on that system. This is why you can expect a reasonable amount of accounting knowledge to be needed to pass Paper P7. Management bias. Bias is not necessarily deliberate, but is almost certain to exist in most estimates. Bias may be exacerbated during a takeover situation, when management are likely to wish to convince sellers of a business that net assets have a lower fair value than they really have, in order to obtain a lower price for the acquired business. Innate optimism and human nature may deter management from wishing to accept that less will be received from receivables than management wish. Familiarity with preparing estimates in an established way may also build in long-standing bias. Poor data, poor controls. If information systems are poor, even neutral management will produce estimates that are unreliable. For example, if a loan provider has poor data collection on overdue repayments, estimates of impairments of financial assets are likely to be unreliable. Fair values – acquisition of new subsidiariesWhen a parent company acquires a new subsidiary, it will pay the fair value of the acquired company as a whole. This is because the previous owners tend to be unwilling to sell their company for less than its fair value. In order to bring in a fair estimate of the initial value of goodwill, IFRS 3, Business Combinations requires that the individual net assets of the acquired company be valued at their fair value at the date of the acquisition. Fair value still means the amount that would be transferred between knowledgeable parties in an arm’s length transaction. Often, the acquirer will have investigated their assessment of value of material assets, liabilities and contingent liabilities of the target company as part of a pre-acquisition due diligence investigation. In these circumstances, the values ascribed to individual assets and liabilities in this due diligence will be an appropriate value to use for the initial recognition of each asset and liability. This means that fair value often becomes fair value through the eyes of the acquirer. This is not always the most appropriate valuation basis, however, since the value given by the acquirer may include some degree of the acquirer’s intentions. For example, it is common for a new acquirer to plan to restructure an acquired business shortly after the acquisition. This might include an intention to pay off any litigation in progress at the date of acquisition in order to fee management time for integration of the subsidiary into its new group. This could result in incorrect recognition of provisions that are higher than the true value of the obligation. IAS 37, Provisions, Contingent Liabilities and Contingent Assets normally prohibits recognition of contingent liabilities. This rule is overturned on the acquisition of a new subsidiary, since the existence of contingent liabilities (eg individual lawsuits against the company) will reduce the value that the acquirer is willing to pay for control of the company. To ensure a fair value of initial goodwill, contingent liabilities must be valued within the statement of financial position; with the most appropriate valuation probably being the amount that the acquirer would be willing to pay an independent third party to assume the risk on their behalf. IFRS 3 also requires recognition of any contingent consideration payable to the sellers of the new subsidiary. These are common in ‘earn out’ arrangements where the amount that the seller eventually pays is adjusted for post-acquisition profit of the business. The determination of a fair value of this contingent consideration is subject to elevated estimation uncertainty.
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