In this video, we walk through 5 AUD practice questions teaching about recalculating significant accounting estimates. These questions are from AUD content area 3 on the AICPA CPA exam blueprints: Performing Further Procedures and Obtaining Evidence
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Recalculating Significant Accounting Estimates
Auditing significant accounting estimates requires a systematic evaluation of both the numerical accuracy and the underlying assumptions applied by management. When estimates are subject to heightened complexity or a higher risk of material misstatement—such as those involving fair value—they warrant increased auditor attention. Recalculation and reperformance procedures are two essential audit techniques used to verify the reliability of such estimates.
This article outlines the core areas auditors must address when testing high-risk estimates and illustrates how recalculation and reperformance procedures support a well-grounded audit opinion.
Identifying High-Risk Estimates
High-risk estimates are those that involve substantial judgment, subjective assumptions, or unobservable inputs. These estimates typically affect key areas of the financial statements and may arise in the following contexts:
- Fair value measurements for illiquid or complex instruments
- Impairment analyses for goodwill or long-lived assets
- Sales returns reserves based on anticipated customer behavior
- Warranty liabilities based on historical claims and product performance
Such estimates are especially susceptible to error or bias, whether intentional or unintentional. Auditors must evaluate whether the estimation method is appropriate, whether inputs are accurate, and whether the outcome presents a risk of material misstatement.
Example: An entity uses a discounted cash flow (DCF) model to estimate the fair value of a privately held equity investment. The inputs to the model include unobservable discount rates and projected cash flows over multiple years. Due to the subjective nature of these inputs, the estimate is inherently high risk and requires extensive testing.
Recalculation to Verify Input Accuracy
Recalculation involves verifying the mathematical accuracy of the estimate using management’s own methodology and assumptions. This includes testing the numerical formulas, confirming input data, and ensuring consistency with established accounting policies.
Example: A company sets its return reserve for each product line based on a fixed percentage of quarterly sales. The policy states that Basic licenses should be reserved at 3%. If quarterly sales total $1,200,000, the expected reserve is $36,000. Recalculation confirms whether the recorded reserve matches this amount. A deviation may indicate an input or formula error.
This procedure can also detect situations in which the wrong percentage or sales base was applied.
Example: If the company records only $16,000 as a reserve on $800,000 in Pro license sales—where the policy requires a 5% reserve—this suggests the company applied a 2% rate in error. The recalculated amount of $40,000 would reveal a $24,000 understatement.
Reperformance to Assess Policy Application
Reperformance involves independently reproducing the estimate to confirm the methodology has been correctly applied. This may include reconstructing calculations using original data, checking the logic of estimation steps, and testing the timing and completeness of inputs.
Example: A client applies an 8% return rate to Enterprise license sales and reports $88,000 as the reserve on $1,000,000 in Q4 sales. The expected reserve is $80,000. Reperformance may reveal that the client included an additional $100,000 in sales from Q3 or Q1 due to a cutoff error. This overstatement would suggest that the timing of inputs needs correction.
Reperformance is especially useful when estimates involve multiple components, such as tiered rates across product lines or time periods.
Evaluating Estimation Models and Complexity
Estimates involving significant complexity—such as those derived from financial models—require deeper audit scrutiny. The use of models involving Level 3 inputs (as defined by the fair value hierarchy) increases estimation uncertainty, as the inputs are not observable in the market and depend on management’s judgment.
Auditors must assess:
- Whether the model used is appropriate for the type of asset or liability
- The consistency and reliability of internal assumptions
- The mathematical accuracy of model computations
Example: In a DCF model used for fair value estimation, auditors must examine whether projected cash flows are based on reasonable and supportable assumptions. They must also verify the discount rate aligns with the risk characteristics of the asset and the market conditions as of the reporting date.
Where appropriate, the auditor may involve valuation specialists to evaluate the adequacy of the model and the reasonableness of inputs.
Analytical Procedures and Historical Trends
Estimates should be consistent with prior trends unless a clear and supportable change in circumstances justifies the deviation. Auditors perform analytical procedures to identify fluctuations in estimates that are inconsistent with expectations or industry benchmarks.
Example: If historical returns for Enterprise licenses have remained steady at 8%, but the client’s reserve suddenly reflects a 10% rate, auditors should inquire about the rationale. If no substantive change in product mix, customer base, or return patterns occurred, the excess reserve may signal a calculation or assumption error.
These procedures provide context and help the auditor determine whether further investigation or additional testing is required.
Documentation and Professional Judgment
All recalculation and reperformance procedures must be thoroughly documented. The auditor should clearly describe the methodology used, the inputs tested, and any differences identified during testing. The rationale for relying on management’s assumptions, or for challenging them, must also be supported by audit evidence.
Professional judgment plays a critical role in determining the nature, timing, and extent of procedures. For high-risk estimates, this often means applying more robust procedures and involving specialists when needed.
Conclusion
Recalculation and reperformance are fundamental techniques in auditing significant estimates with higher risk or complexity. By independently verifying the accuracy of inputs and testing the proper application of estimation methods, auditors can detect material misstatements and ensure that financial statements reflect reliable information. This is particularly important when estimates involve subjective assumptions, such as those used in fair value models, where minor inaccuracies can lead to significant reporting differences.
Thorough application of these procedures supports audit quality and fulfills professional responsibilities under relevant auditing standards.
