Three approaches to auditing an estimate
- Test how management made the estimate — evaluate the method, assumptions, and data used, and test the underlying calculations
- Develop an independent point estimate or range — and compare it to management's
- Review subsequent events or transactions — did events after year-end but before the report date resolve the estimate? (e.g., a receivable collected, a lawsuit settled)
Estimation uncertainty
Higher estimation uncertainty = higher inherent risk. Estimates with high uncertainty (litigation reserves, level 3 fair values, goodwill impairment) may be significant risks requiring special audit consideration and evaluation of relevant controls.
IMPORTANT — management bias: Individual estimates may each be within an acceptable range, yet all sit at the same favorable end. That pattern indicates possible management bias, which the auditor must evaluate for its effect on the financial statements as a whole and consider as a fraud risk indicator.
Retrospective review
The auditor is required to perform a retrospective review of significant prior-period accounting estimates — comparing what management estimated to what actually happened. This is not about second-guessing prior judgments with hindsight; it's about detecting a pattern of bias and improving current-year risk assessment.
Fair value measurements
| Level | Input | Audit difficulty |
|---|---|---|
| Level 1 | Quoted prices in active markets for identical assets | Lowest — verify the price |
| Level 2 | Observable inputs other than quoted prices | Moderate — test inputs and model |
| Level 3 | Unobservable inputs (management's own assumptions) | Highest — heavy judgment, often a significant risk |
EXAM TIP: When management uses a specialist (e.g., an appraiser or actuary), the auditor must evaluate the specialist's competence, capabilities, and objectivity, obtain an understanding of the work, and evaluate its appropriateness as audit evidence — the auditor cannot simply accept the specialist's conclusion, and never refers to the specialist in an unmodified opinion.