Advanced Audit and Assurance (International) · Audit procedures and obtaining evidence

Auditing Estimates, Fair Values and Related Parties (ISA 540, 550)

Updated 11 October 2026 · Fact-checked

ISA 540 (Revised) requires you to assess the risk of material misstatement in accounting estimates, including fair values, and respond with tests of method, data and assumptions. ISA 550 requires you to identify related parties and transactions, assess risk, and obtain evidence that they are properly accounted for and disclosed.

Understand Auditing Estimates, Fair Values and Related Parties (ISA 540, 550)

An accounting estimate is a monetary amount that cannot be observed directly, so management has to measure it with judgement. Examples are expected credit losses, provisions, inventory write-downs, depreciation, pension obligations and impairment. A fair value measurement is an estimate too, usually for assets that have no easily seen price.

The risk is estimation uncertainty. The more uncertain the amount, the wider the range of reasonable outcomes. Added to that are complexity and subjectivity. ISA 540 (Revised) asks you to assess inherent risk by considering estimation uncertainty, complexity and subjectivity. Susceptibility to management bias is a related inherent risk factor, because management may steer results to a target. You assess control risk separately. You do not treat inherent and control risk as one combined assessment.

Your response has three possible approaches. You can test how management made the estimate, which covers method, assumptions and data. You can use an auditor's point estimate or range and compare it with management's figure. Or you can obtain evidence from events up to the date of the auditor's report, such as cash received after the year end. You may combine them. At the end, you evaluate whether the estimates and disclosures are reasonable, and whether there are indicators of management bias.

Fair value work follows the same logic, but you also consider the IFRS 13 hierarchy. Level 1 inputs are quoted prices in active markets. Level 2 uses observable inputs other than those quoted prices. Level 3 uses unobservable inputs and carries the most risk. Higher levels of judgement call for more evidence and often for an auditor's expert under ISA 620.

Related parties are a different risk. ISA 550 is concerned that related party transactions may be on non-arm's-length terms, may be hidden, or may be used for fraud or to move value. IAS 24 sets the disclosure requirements. As the auditor, you must stay alert throughout the audit for related parties that management has not identified. You then obtain evidence that the transactions are properly authorised, accounted for and disclosed. If management's financial statements include an assertion that a related party transaction was conducted on terms equivalent to arm's-length, ISA 550 requires the auditor to obtain sufficient appropriate audit evidence about the assertion.

Key rules to remember

ISA 540 risk factors: Estimation uncertainty + complexity + subjectivity (and bias) → inherent risk; Assess inherent risk and control risk separately. Higher inherent risk calls for more persuasive evidence.
Three response approaches: Test management's process | Develop auditor's point estimate or range | Use events up to the auditor's report date; You can combine them. Choose based on risk, available data and timing.
What to test in management's process: Method + significant assumptions + data; Check suitability and consistency of the method, reasonableness of assumptions, and relevance and reliability of data.
IFRS 13 hierarchy: Level 1: quoted prices | Level 2: observable inputs | Level 3: unobservable inputs; Level 3 has the greatest estimation uncertainty and needs the strongest evidence.
Related party audit cycle: Identify → assess risk → obtain evidence → evaluate disclosure → obtain representations; Remain alert for undisclosed related parties throughout the audit.
Bias evaluation: Indicators of management bias in estimates = possible misstatement; consider the effect on the financial statements as a whole; Bias is not always a misstatement in itself, but you must evaluate it, including its effect on audit risk.

How to solve Auditing Estimates, Fair Values and Related Parties (ISA 540, 550) questions

Use this approach for any question on estimates, fair values or related parties. It keeps you tied to the scenario and to the requirement.

1Read the requirement. Decide whether you need risks, procedures, evaluation of evidence or reporting.
2Identify the item in the scenario. Say whether it is an estimate, a fair value or a related party transaction.
3State why it is risky, using scenario facts: uncertainty, subjectivity, complexity, unobservable inputs, management incentives, or terms that look off-market.
4Give specific procedures linked to each risk. For estimates, cover method, assumptions, data and subsequent events. For related parties, cover identification, terms and disclosure.
5Consider whether you need an expert, third-party evidence or a point estimate or range.
6Say what you would do with the results: evaluate misstatements, bias and disclosure, and request management representations.
7Conclude with the effect on the audit opinion or communication with those charged with governance if the evidence is insufficient or management refuses to adjust.

Quickest way: Risk, procedure, conclusion

When to use it: Use this when you have around two minutes per mark and a long scenario with several items.

For each item, write the risk in one line using a scenario fact.
Write two or three procedures, each starting with an action verb such as inspect, recalculate, compare or enquire.
For estimates, check the headings method, assumptions, data and subsequent events. For related parties, check identify, terms and disclose.
Add one line on expert use or representations if relevant.
Finish with the audit consequence: adjustment, disclosure or modified opinion.

Common mistakes in Auditing Estimates, Fair Values and Related Parties (ISA 540, 550)

Listing generic audit procedures that could apply to any balance.
Students memorise a standard list and do not link it to the scenario.
Fix: Anchor each procedure to a specific risk from the scenario, such as an unobservable input or a director's loan on unusual terms.
Only reperforming management's calculation for an estimate.
Recalculation is easy to describe and feels like evidence.
Fix: Recalculation checks arithmetic only. Also challenge the assumptions and test the data, and compare with actual outcomes and subsequent events.
Ignoring management bias.
Students focus on error and forget incentives such as bonuses or covenants.
Fix: Look for incentives in the scenario. Compare prior-year estimates with actual outcomes and look for a consistent direction.
Treating related parties as a disclosure check only.
IAS 24 is thought of as a pure disclosure standard.
Fix: State that you must also identify related parties, assess fraud risk, and test authorisation and terms of transactions.
Relying on a valuer's report without evaluating the valuer.
A professional report appears to be sufficient on its face.
Fix: Evaluate competence, capabilities and objectivity, understand the work, and assess whether the findings support the assertions, as ISA 500 and ISA 620 require when using an expert.
Accepting management's assertion that a related party transaction was at arm's length without evidence.
Students accept management's assertion without evidence.
Fix: ISA 550 requires you to obtain sufficient appropriate audit evidence about the assertion. If it cannot be substantiated, the disclosure is a misstatement.

Worked examples

Example 1

A client holds an unquoted equity investment valued at $4.2 million using a discounted cash flow model prepared by management. The growth rate assumption is 9%, while the sector average is 4%. The finance director's bonus depends on profit. Explain the risks and the audit procedures you would perform.

Show the solution

Risk: the investment is valued using unobservable inputs, so it falls into Level 3 of the IFRS 13 hierarchy. Estimation uncertainty and subjectivity are high.
Risk: the growth rate of 9% is well above the 4% sector average, and the bonus creates an incentive to overstate value. This indicates possible management bias.
Procedure: understand management's process and test the suitability and consistency of the DCF method with the prior year and IFRS 13.
Procedure: challenge the 9% growth rate. Compare with budgets, board minutes, historical performance and industry data, and ask for support.
Procedure: test the data used, such as cash flows, by agreeing to approved forecasts and checking whether past forecasts were accurate.
Procedure: perform sensitivity analysis on growth and discount rate, and consider whether to develop an auditor's range, perhaps using an expert under ISA 620.
Procedure: review subsequent events, such as the investee's results after the year end, and check disclosures of the valuation techniques and key assumptions.
Conclusion: if the value lies outside a reasonable range, ask management to adjust. If they refuse, consider the effect on the opinion.

Answer: The investment is a high-risk Level 3 fair value with an apparent bias indicator. Test method, assumptions and data, challenge the 9% growth rate, use sensitivity analysis or an expert, review subsequent events and disclosures, and modify the opinion if a material misstatement is not corrected.

Example 2

During the audit of Hale Co, you notice that a sale of $800,000 was made in the last week of the year to a company owned by a director's spouse, and was not mentioned in the related party list provided by management. Explain the audit implications and what you would do.

Show the solution

Implication: the transaction suggests an undisclosed related party relationship, so management's list may be incomplete. This raises the risk of fraud and weakens reliance on management's representations.
Action: enquire of management and those charged with governance about the relationship, and the business rationale for the sale.
Action: inspect contracts, board approvals and correspondence to see whether the transaction was authorised and on arm's-length terms. Compare the price with other sales.
Action: check whether revenue should be recognised, such as delivery, transfer of control and subsequent cash receipt.
Action: extend procedures to look for other undisclosed related parties, such as through registers of interests, bank and legal confirmations, and unusual transactions.
Reporting: communicate the finding to those charged with governance and ask for the related party disclosure to be corrected in line with IAS 24.
Opinion: first confirm whether the omitted disclosure is material, by comparing the $800,000 sale and the nature of the relationship with materiality. If management refuses to correct it and the omission is material but not pervasive, issue a qualified ('except for') opinion. Issue an adverse opinion only if the misstatement is both material and pervasive. If practicable, and if sufficient appropriate evidence about the omitted disclosures has been obtained, describe the nature of the omitted information in the basis for opinion section.

Answer: Treat it as an undisclosed related party and a fraud risk. Enquire, inspect authorisation, terms and revenue recognition, search for other related parties, and report to those charged with governance. Confirm materiality. If the disclosure is not corrected and the omission is material but not pervasive, qualify the opinion. Use an adverse opinion only if it is also pervasive.

Exam tips

Link every procedure to a scenario fact. Generic lists earn few marks.
Use the headings method, assumptions, data and subsequent events for estimates. They give you a structure and prompt the points examiners expect.
Look for incentives such as bonuses, covenants or targets. They are usually planted in the scenario to signal management bias.
For related parties, cover identification, authorisation and terms, and disclosure. Add the fraud and communication angles.
Show professional skills: scepticism in challenging assumptions, and commercial awareness about why management might want a particular number.

Practice questions from Audit procedures and obtaining evidence

Auditing Estimates, Fair Values and Related Parties (ISA 540, 550) in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CA FinalSA 540: Auditing Accounting Estimates and Related Disclosures

Auditing Estimates, Fair Values and Related Parties (ISA 540, 550): frequently asked questions

What did ISA 540 (Revised) change?

It focuses on assessing inherent risk using estimation uncertainty, complexity and subjectivity. It also requires separate assessment of inherent and control risk, and a stronger approach to professional scepticism and management bias.

How is auditing fair value different from other estimates?

Fair value is an estimate, so ISA 540 applies. You also consider the IFRS 13 hierarchy, market data availability and the need for an expert. Level 3 measurements need the most evidence.

Do I have to find all related parties?

No audit can guarantee that. You must perform procedures to identify related parties and remain alert throughout the audit for information that indicates undisclosed relationships.

What can I do if management will not adjust a biased estimate?

Evaluate the effect on the financial statements, communicate with those charged with governance, and consider the audit opinion. A material uncorrected misstatement leads to a modified opinion.