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.
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
The retrospective review is–like the tests of journal entries required in all audits–a response to potential management override of controls.
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.
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:
Other examples of conclusions are as follows:
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Charles Hall is a practicing CPA and Certified Fraud Examiner. For the last thirty years, he has primarily audited governments, nonprofits, and small businesses. He is the author of The Little Book of Local Government Fraud Prevention and Preparation of Financial Statements & Compilation Engagements. He frequently speaks at continuing education events. Charles is the quality control partner for McNair, McLemore, Middlebrooks & Co. where he provides daily audit and accounting assistance to over 65 CPAs. In addition, he consults with other CPA firms, assisting them with auditing and accounting issues.
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