Auditing standards require a retrospective review of estimates. Why? Because management can manipulate estimates to inflate earnings and assets.
Suppose a company has an established policy of reserving 90% of receivables that are 90 days or older. If in the current year, the greater-than-90-days-bucket contains $1 million, then management can increase earnings $400,000 by decreasing the reserve percentage to 50%.
Manipulating estimates is easy. Complex estimates (such as the allowance for loan losses in a bank) are even easier to change. Why? Because complex estimates are harder to understand, making it easier to explain away variations.
Retrospective Review in Financial Statement Audits
AU-C 240, Consideration of Fraud in a Financial Statement Audit, says (in paragraph .32) the auditor should do the following:
review accounting estimates for biases and evaluate whether the circumstances producing the bias, if any, represent a risk of material misstatement due to fraud. In performing this review, the auditor should
- evaluate whether the judgments and decisions made by management in making the accounting estimates included in the financial statements, even if they are individually reasonable, indicate a possible bias on the part of the entity’s management that may represent a risk of material misstatement due to fraud. If so, the auditor should reevaluate the accounting estimates taken as a whole, and
- perform a retrospective review of management judgments and assumptions related to significant accounting estimates reflected in the financial statements of the prior year. Estimates selected for review should include those that are based on highly sensitive assumptions or are otherwise significantly affected by judgments made by management.
The retrospective review is–like the tests of journal entries required in all audits–a response to potential management override of controls.
Does Bias Exist?
Financial statement fraud occurs when a business willfully manipulates numbers. Why would management intentionally alter profits? There are many potential reasons including profit-based bonuses and the need to meet debt covenant requirements. Regardless of the reason, auditors are to perform a retrospective review of judgments and assumptions used in computing the estimate. Are the judgments and assumptions the same? If they changed, why?
A retrospective review means the auditor places the current year judgments and assumptions next to those of the prior year. Why? To gain perspective. Consider doing so for at least two years. Then see if there is a trend that favors the company.
Document Your Retrospective Review
You should reference your audit program to the work paper containing the retrospective review documentation.
Consider heading up the work paper as “Retrospective Review.” Or on the work paper, use a label (Retrospective Review) to show the purpose of the trend information. Also, consider adding a purpose and conclusion statements such as:
- Purpose of work paper: To perform a retrospective review of the judgments and assumptions used in computing the estimate.
- Conclusion: While the allowance estimate is higher in the current year, the judgments and assumptions are the same. It does not appear that management bias is present.
Other examples of conclusions are as follows:
- Conclusion: Based on our review of the economic lives of assets in the depreciation schedule, no management bias was noted.
- Conclusion: We reviewed specific bad debt write-offs in the current year and compared them to the estimate for bad debts in the prior year. No management bias was noted.
Learn from the CPA Scribo newsletter!
Get my free weekly accounting and auditing digest with the latest content.