CPA Exam — AUDAssessing Risk and Developing a Planned ResponseHard
A client, a regional bank, has a significant number of loan accounts. The auditor determines that the allowance for loan losses is a significant accounting estimate. Which of the following audit procedures would be most effective in addressing the risk of material misstatement related to the valuation of the allowance for loan losses?
- AConfirming a sample of loan balances directly with borrowers.
- BEvaluating the reasonableness of management's assumptions and methodology used to develop the estimate.
- CComparing the current year's allowance to prior years' allowances and investigating significant fluctuations.
- DPerforming analytical procedures on the overall loan portfolio to identify unusual trends.
Show answer & explanationAnswer & explanation
Correct answer: B. Evaluating the reasonableness of management's assumptions and methodology used to develop the estimate.
The allowance for loan losses is a complex accounting estimate based on significant judgment and assumptions. The most effective way to audit such an estimate is to evaluate the underlying assumptions and methodology management used to arrive at the estimate, as this directly addresses the valuation assertion.
Why the other options are wrong
- A. Confirming loan balances addresses existence and rights/obligations, not directly the valuation of the allowance for loan losses.
- C. Comparing to prior years and investigating fluctuations is an analytical procedure, which can identify potential issues but is generally less effective than evaluating underlying assumptions for a complex estimate.
- D. Analytical procedures are useful for identifying areas of potential risk but are typically not sufficient on their own to provide assurance over complex estimates like the allowance for loan losses.
Auditing Accounting Estimates
Procedures performed by an auditor to obtain sufficient appropriate audit evidence about whether accounting estimates and related disclosures are reasonable in the context of the applicable financial reporting framework.
- Focus on management's judgment and assumptions.
- Requires understanding the process used to develop the estimate.
- Often involves specialized knowledge or external experts.
Memory trick: Estimates need 'Assumptions, Data, Review' to be right.