When 1 + 1 = 3…Testing Estimates and Assumptions

4 Steps to Testing Estimates and Assumptions in your Integrated Auditing Approach

Contrary to belief, accounting is not a field that is black and white in application.  Organizations are allowed to “estimate” certain items or mark others to fair market value or depreciate some in a manner of their choosing until the book value reaches zero.  Each of these has some sort of effect on income statements and balances sheets.  In theory, devious organizations can manipulate these items to their benefit.  As part of integrated internal audit engagements (i.e. financial, operational, information technology & compliance), it is beneficial for internal auditors to evaluate the appropriateness of significant estimates and assumptions produced by areas under review.

Typical estimates and assumptions include things like bad debt expense, goodwill, and loan loss reserves.  I have personally experienced the effects of bad assumptions.  One instance in particular was simply management’s failure to come to terms with the fact that an asset had lost so much value that it needed to be written down significantly.  In another instance, an Excel worksheet used to calculate loan loss reserves was critically flawed causing substantial write downs.

In 4 simple steps, you can evaluate estimates and assumptions.

1.  DETERMINE THE PURPOSE
There must be a reason for each accounting estimate.  Determining the intended purpose will assist in the assessment.  Obtain an understanding of (a) why the estimate is important (b) what laws/rules/regs discuss the estimate and (c) who is considered the internal subject matter expert.

2.  DO SOME RESEARCH
Research the laws, rules and/or regulations that govern the estimate or assumption.

3.  UNDERSTAND CURRENT PRACTICE
Gain an understanding of who prepares the estimate, when it is prepared, what are the assumptions used in calculations, and the data sources/calculations/output.

4.  TEST FOR REASONABLENESS
Once you have an understanding of the intent, completed sufficient research, and now understand what your organization is doing, it is time to test the estimate or assumption for reasonableness.

What do you think?  Are you actively reviewing significant estimates and assumptions during your audit engagements?

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