In its complaint, the SEC indicated that Xerox inappropriately used accounting reserves to inflate earnings. ... What responsibility do auditors have regarding accounting reserves established by company management? How should auditors test the reasonableness of accounting reserves established by company management?

Question

What will be an ideal response?

Answer 1

Accounting reserves are established for expenses expected to be incurred in the future as a result of past
business activities. Accounting reserves are an example of an accounting estimate and thus the auditor is
responsible for evaluating the reasonableness of accounting estimates made by management in the context
of the financial statements taken as a whole (see AU Section 342). The auditor needs to obtain reasonable
assurance that the accounting reserve amount is reasonable and that its presentation and disclose is
appropriate. The reasonableness of the accounting reserve amount can be evaluated by one or a combination
of the following approaches:
Review and test the process used by management to develop the accounting reserve amount,
Develop an independent expectation of the accounting reserve amount to corroborate the reasonableness
of management’s estimate,
Review subsequent events or transactions occurring prior to completion of fieldwork.
Note that AU Section 316 requires auditors to perform a retrospective review of actual expenses incurred
related to reserve accounts to evaluate whether management judgments and assumptions are reasonable.