SA 540 explained: this guide covers what it means, who it applies to, the step-by-step process, documents required, fees, due dates and penalties in India — so you can stay compliant with confidence and avoid costly mistakes.
SA 540 deals with items in the accounts that cannot be measured exactly and can only be estimated, such as provisions, useful lives and fair values. This first part covers what an auditor must understand about how management makes estimates, how estimation uncertainty is assessed, and the four approaches available to respond.
SA 540, as effective for audits of financial statements for periods beginning on or after 1 April 2009, applies to all estimates in the accounts, and this part covers paragraphs 1-14. ICAI may revise standards, so check icai.org for the current text. Finance teams that document provisions and valuations, for instance with virtual CFO services, find this audit area easier. Part 2 covers significant risks, bias, disclosures and representations: SA 540 part 2.
The objective is to obtain sufficient appropriate evidence that estimates and fair value estimates are reasonable and the related disclosures are adequate (paragraph 6). The auditor first understands the framework's requirements and how management identifies and makes estimates, reviews the outcome of prior-period estimates, and evaluates estimation uncertainty. The response is one or more of four approaches: events up to the report date, testing how management made the estimate, testing controls, or developing the auditor's own point estimate or range.
What SA 540 covers (paragraphs 1-7)
The standard expands how SA 315 and SA 330 apply to accounting estimates, and also covers misstatement of individual estimates and indicators of management bias (paragraph 1). Some items "can only be estimated", and the reliability of information behind them varies widely, which drives the degree of estimation uncertainty and with it the risk of misstatement, including unintentional or intentional bias (paragraph 2).
The measurement objective differs. Some estimates forecast the outcome of transactions or events; others, including many fair value estimates, express the value of a current transaction or item as at the measurement date (paragraph 3). A difference between the actual outcome and the amount originally recognised is not necessarily a misstatement, particularly for fair value estimates (paragraph 4). The auditor is not responsible for predicting future conditions that, if known at the time of the audit, might have significantly affected management's assumptions (A8).
| Term (paragraph 7) | Plain meaning |
|---|---|
| Accounting estimate | An approximation of a monetary amount where there is no precise way to measure it, including fair value amounts that carry estimation uncertainty |
| Estimation uncertainty | How far an estimate and its disclosures are open to inherent lack of precision |
| Management's point estimate | The amount management chooses to recognise or disclose |
| Auditor's point estimate or range | The amount or range the auditor derives from evidence to evaluate management's figure |
| Outcome | The actual amount when the underlying matter is finally resolved |
| Management bias | Lack of neutrality in preparing and presenting information |
The application material lists examples: low-uncertainty estimates such as those from routine transactions or readily available published data (A2), and high-uncertainty ones such as litigation outcomes or unlisted derivatives (A3). Other estimates include allowance for doubtful accounts, inventory obsolescence, warranty obligations, depreciation method or useful life, provisions against investments, and the outcome of long-term contracts (A6). Fair value examples include share-based payments, goodwill and intangibles acquired in a business combination, and assets held for disposal (A7).
Risk assessment: what the auditor must understand (paragraph 8)
Under SA 315, the auditor gains an understanding of the following to identify and assess risks of material misstatement (see SA 315 part 2).
| What to understand | Paragraph |
|---|---|
| The requirements of the financial reporting framework on estimates and disclosures | 8(a) |
| How management identifies transactions and events needing estimates, including enquiry about changes in circumstances | 8(b) |
| How management makes the estimates and the data they rest on | 8(c) |
Inside 8(c) there are six items: the method or model; relevant controls; whether management used an expert; the assumptions; whether the method changed or should have changed from the prior period, and why; and whether and how management assessed the effect of estimation uncertainty. For the expert point compare the evidence principles in SA 500 and the auditor's own expert in SA 620.
Looking back at last year's estimates (paragraph 9)
The auditor reviews the outcome of estimates in the prior-period statements, or their re-estimation for this period. The aim is to learn how well management estimated, not to question judgments that were reasonable on the information then available. The review can show how effective management's process was, supply evidence for the current re-estimation, and indicate matters of estimation uncertainty that need disclosure (A39). It can also point to susceptibility to management bias (A40) and may be done together with the retrospective review that SA 240 requires (A41). A more detailed review suits estimates that were highly uncertain or have changed significantly (A42). A difference between outcome and the earlier amount is not automatically a misstatement of the prior period, but may be one if the difference arose from information that was available, or could reasonably have been obtained, when the earlier statements were finalised (A44). For accounting treatment of changes in estimates and errors, see our guide on Ind AS 8.
Identifying and assessing risk (paragraphs 10-11)
The auditor evaluates the degree of estimation uncertainty (paragraph 10). Factors named in A45 include reliance on judgment, sensitivity to changes in assumptions, the availability of recognised measurement techniques, the length of the forecast period, the availability of reliable external data and whether inputs are observable. A46 adds the magnitude of the estimate, how management's figure compares with the auditor's expectation, use of an expert and the result of the prior-period review. The auditor then decides whether any estimates with high uncertainty give rise to significant risks (paragraph 11); these attract the additional work in part 2.
Responding to the assessed risks (paragraphs 12-14)
First, based on the assessed risks, the auditor determines whether management has applied the framework's requirements appropriately and whether methods are appropriate and consistently applied, with any changes justified (paragraph 12).
Then, following SA 330, the auditor undertakes one or more of four approaches, chosen with the nature of the estimate in mind (paragraph 13):
| Approach | What it involves | Paragraph |
|---|---|---|
| (a) Events up to the report date | Decide whether later events give evidence about the estimate | 13(a) |
| (b) Test how management made it | Evaluate whether the method is appropriate and the assumptions reasonable in light of the framework's measurement objective, and test the data | 13(b) |
| (c) Test controls | Test operating effectiveness of controls over the estimation, together with suitable substantive procedures | 13(c) |
| (d) Develop a point estimate or range | If the auditor's method differs, understand management's enough to take account of relevant variables; if using a range, narrow it until all outcomes within it are considered reasonable | 13(d) |
Finally the auditor considers whether specialised skills are needed, and may involve an auditor's expert (paragraph 14).
Illustrative example
Meridian Pumps Pvt Ltd is an invented company; all figures are illustrative. Its warranty provision is Rs 85 lakh, calculated from claim history and expected failure rates. The auditor reads the framework requirement for provisions, asks how management identified new product lines with claims, and compares last year's provision of Rs 70 lakh with actual claims settled. The claims came to Rs 74 lakh, which gives some comfort about management's process. The auditor tests the claim data to service records, checks that the failure-rate assumption matches the engineering data, and reviews claims paid after the year-end (approach (a)). The provision is not highly uncertain, so no significant risk is identified.
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Key takeaways
- Estimates are approximations; the audit asks whether they are reasonable and the disclosures adequate.
- The auditor must understand the framework, management's process, data, method, assumptions and controls.
- Last year's estimates are compared with outcomes to judge management's process, not to second-guess it.
- Higher estimation uncertainty leads to higher risk and the possibility of significant risk.
- Four approaches are available, alone or in combination.
Read next
- SA 540 part 2: significant risks and management bias
- SA 315 part 2: significant risks
- SA 620: using an auditor's expert
- SA 330: responses to assessed risks
Disclaimer: Based on the Standards on Auditing and quality standards issued by the Institute of Chartered Accountants of India, in the versions named in the article, and ICAI's announcement of 31 March 2026 on SQM 1 and SQM 2, as consulted on 3 October 2026. ICAI revises standards from time to time; check the current text and effective dates on icai.org. This article is general information, not legal advice; check the official text before acting.