In assessing the risks of material misstatement relating to an accounting estimate, the auditor is required to separately assess inherent and control risk at the assertion level. These assessments then form the basis for the design and performance of further audit procedures to respond to the assessed risks of material misstatement.

Assessment of inherent risk

The assessment of inherent risk depends on the degree to which the inherent risk factors affect the likelihood or magnitude of misstatement and the auditor’s assessment of this varies on a scale referred to in the standard as the spectrum of inherent risk.

The inherent risk factors are:

• The degree of estimation uncertainty in the estimate; and
• The degree to which subjectivity, complexity or other inherent risk factors affects the selection and application of methods, data and assumptions in making the estimate or the selection of management’s point estimate and related disclosures.

Just because an estimated number is large does not mean the degree of estimation uncertainty is high or vice versa. Consider an entity for which materiality has been determined as £10,000.

The entity has an investment property, revalued each year to open market value. At the year end, the property is under offer for a price of £2m and conveyancing is progressing smoothly. While the value is significant, the degree of uncertainty is low given a firm indication of price from the offer made.

The same entity has a tax liability of £5,000, being tax on profits of £100,000 less group relief of £95,000. The allowability of group relief is disputed and the tax advisors believe it could go either way. With a 50:50 chance of success, the estimation uncertainty is £95,000, which is very high.

In relation to control risk, the auditor needs to understand the controls in place and the environment. The auditor needs to think about whether the further audit procedures planned are reliant on the operating effectiveness of controls as this will influence whether tests of controls are needed. Tests of controls are needed if the auditor plans to rely on the controls or in situations where substantive procedures alone cannot provide sufficient appropriate audit evidence.

Having considered these factors, the auditor ought to have an understanding of the risks that estimates and disclosures might be materially misstated.