Imagine your client, Rajesh & Co. Pvt. Ltd., tells you their bad debt provision is ₹12 lakhs. How do you, as an auditor, know whether that number is reasonable or just made up? That's exactly what SA 540 — Auditing Accounting Estimates is about. It guides the auditor on how to examine figures that are not exact — they're judgments, not facts.
Accounting estimates are approximations of a monetary amount where no precise measurement exists. Common examples: provision for doubtful debts, depreciation on WDV, warranty provisions, employee gratuity liability, and fair value of unlisted investments. Because these figures depend on management's judgment, they carry a higher risk of misstatement — intentional or otherwise. SA 540 requires the auditor to treat this risk seriously.
The auditor follows three broad steps. First, during risk assessment, the auditor identifies which estimates are material and whether any have high estimation uncertainty (like fair value of illiquid assets). Second, the auditor responds to those risks using one or more of three approaches: (a) review subsequent events — e.g., did a debtor actually pay after year-end, confirming or denying the provision? (b) test management's estimation process — check the assumptions, data inputs, and calculations management used; (c) develop an independent estimate — the auditor independently calculates what the figure should be and compares it to management's figure. Third, the auditor evaluates whether the disclosures in financial statements about estimates are adequate.
A critical concept here is management bias — this is when estimates are consistently skewed in one direction (always optimistic or always conservative) to manipulate profit. Auditors must be alert to indicators of bias even when individual estimates seem technically defensible. SA 540 also requires the auditor to document their own point estimate or range to compare against management. This is asked frequently as a 5-mark theory or scenario question in Paper 5, especially around the three approaches and management bias.