sample essay of AFX5120 (1)

few days ago, Julia announced new cabinet. Rudd got a position.:) the boss of DIAC is changed, now- Chris Bowen~ anyway~~

here is the third assessment of AFX5120, the first one is a test, and the second one is an essay. i will post the third one later
BTW, 7 out of 10 of this one.


Introduction


Due to the inherent uncertainties involved in business activities, certain items appearing in the financial statements cannot be measured accurately. They can only be estimated. (e.g. Bad debts.). The use of reasonable estimates which involve judgments based on the latest information available is essential for preparation of financial statements. It is called accounting estimates. It is very subjective, so in the auditing process, evaluating differences can be more difficult than in other areas of the audit. This essay will describe the auditor’s responsibility for examining management generated accounting estimates and describe the techniques commonly used by auditors to assess the reasonableness of those estimates. After that, it will show Waste Management Inc’s case to make these questions vividly.

ASA 540 Audit of Accounting Estimates

ASA 540 establishes mandatory requirements and provides explanatory guidance on the audit of accounting estimates contained in a financial report. In ASA 540, it states that the auditor shall obtain sufficient appropriate audit evidence regarding accounting estimates. Also, the auditor shall design and perform further audit procedures to obtain sufficient appropriate audit evidence as to whether the entity’s accounting estimates are reasonable in the circumstances and, when required, appropriately disclosed. The auditor shall make a final assessment of the reasonableness of the entity’s accounting estimates based on the auditor’s understanding of the entity and its environment and whether the estimates are consistent with other audit evidence obtained during the audit.

Auditors, in complying with ASA 540, should consider the possibility of management bias in developing estimates by considering whether the differences between the estimates best supported by the audit evidence and the estimates included in the financial statements indicate a possible management bias. For example, if each individual accounting estimate included in the financial statements was reasonable and, at the same time, the effect of the difference between each management estimate and the estimate best supported by the audit evidence was to increase income, the auditor should reconsider the estimates taken as a whole. Moreover, auditors should perform a retrospective review of significant accounting estimates reflected in the prior year's financial statements to determine whether management's judgments and assumptions relating to estimates indicate a possible bias on the part of management. If the auditor identifies a possible bias, he or she should evaluate whether the circumstances producing such a bias represent a risk of material misstatement due to fraud.

To sum up, the auditor has responsibility for examining management generated accounting estimates, the auditor needs to have an understanding of the procedures and methods to identify and assess risks of material misstatement in order to design the nature, timing and extent of the further audit procedures.

In ASA 540, there are some means to help auditors to assess the accounting estimates. The auditor shall endeavour to obtain written representations from management regarding the reasonableness of significant assumptions used by them in making accounting estimates. Management representation letter is used to let the client's management declare in writing that the financial statements and other presentations to the auditor are sufficient and appropriate and without omission of material facts to the financial statements, to the best of the management's knowledge.

In Para 14, it states that the auditor shall adopt one or a combination of the following approaches in the audit of an accounting estimate:

(a) Review and test the process used by management to develop the estimates;

(b) Use an independent estimate for comparison with that prepared by management; or

(c) Review of subsequent events which provide audit evidence of the reasonableness of the estimate made.

For reviewing and testing the process used by management, the auditor can evaluation of data and consideration of assumptions, testing of calculations, comparison of previous estimates with actual results or consideration of management’s approval procedures. Using of an independent estimate is a very useful way to examine accounting estimates, the auditor may make or obtain an independent estimate and compare it with the accounting estimate prepared by management. When using an independent estimate the auditor ordinarily evaluates the data, considers the assumptions and performs audit procedures on the calculation procedures used in its development. It may also be appropriate to compare accounting estimates made for prior periods with actual results of those periods. In some cases, subsequent events may provide audit evidence regarding an accounting estimate made by management. The auditor’s review of such event may reduce, or even remove, the need for the auditor to review and perform audit procedures on the process used by management to develop the accounting estimate or to use an independent estimate in assessing the reasonableness of the accounting estimate.

Nowadays, computer-assisted audit techniques may be required to identify entries that exist only electronically.

To sum up, auditors can choose one or some methods provided in ASA 540 to examine accounting estimate.
Waste Management, Inc

Arthur Andersen, LLP, was Waste Management’s auditor since before the Waste Management became a public company in 1971. And in 1990s, Arthur Andersen failed to reveal fraud which primarily centered on inappropriate estimates of salvage values and useful lives for property and equipment. But according to ASA 540, there are some techniques Andersen auditors could have used to assess the reasonableness of those estimates used to create Waste Management’s financial statements.

Firstly, Andersen should review and test the process used by management to develop the estimate. Generally, the auditor would evaluate whether the data on which the estimate is based is accurate. In Waste Management Inc’s case, the company changed the salvage values and useful lives for property and equipment in 1996, and disclosed it in the financial statement. At that time, Andersen should assess whether the change was reasonable. Also, the auditor can evaluates whether the entity has an appropriate base for the principal assumptions used in accounting estimate. Andersen could check whether Waste Management’s accounting policy was logical based on industry or government statistics.

Secondly, auditor can use an independent estimate for comparison with that prepared by management. When Waste Management changed their accounting policy, Andersen should evaluate it by itself. But in fact, it did not.

To sum up, Andersen had the chance and method to find Waste Management’s fraud, but it failed to do that.
Conclusion

In ASA 540, it states quite clear that the auditor has responsibility for examining management generated accounting estimates. And it also lists some methods which auditor can use to detect the mistakes or fraud in accounting estimates. In Waste Management case, Andersen had the chance and methods to find Waste Management’s fraud, but in fact, it did not do that.
Bibliography

ASA 540 Audit of Accounting Estimates

Apostolou, N. and Crumbley, D., (2009), Auditors’ Responsibilities with Respect to Fraud: A Possible Shift?, http://www.nysscpa.org/cpajournal/2008/208/essentials/p32.htm

Conceptsinfo, (2009), Teminology, http://conceptsinfo.com/teminology.asp