At a glance
The PCAOB has issued a new standard for auditing accounting estimates: AS 2501, Auditing Accounting Estimates, Including Fair Value Estimates, which creates new guidance on auditing estimates, fair value, and derivatives. The new guidance impacts the work that audit teams must perform when auditing accounting estimates. Companies should work with their auditors to understand current practices as well as the specific procedures and incremental effort the new standards will require for each audit.
Changes will be effective for audits of companies for periods ending on or after December 15, 2020 (2020 for calendar year ends).
The new PCAOB standard establishes a uniform, risk-based approach. Significant changes to the existing guidance include the following:
Consideration of the PCAOB's risk assessment standards has been integrated to focus auditors on estimates with a greater risk of material misstatement.
Auditors are prompted to devote greater attention to addressing potential management bias in accounting estimates and applying professional skepticism.
Certain requirements in the existing standard on auditing fair value measurements have been extended to apply to all accounting estimates, which expands the requirements and improves consistency.
Specific requirements have been provided for auditing the fair value of financial instruments, including the evaluation of information obtained from third-party pricing services.
The impact of the standard on individual audits may vary based on a number of factors, including the nature, complexity, subjectivity and degree of uncertainty of the accounting estimates. Management may want to discuss with their auditor the impact the new PCAOB standard may have on the audit.
The focus on risk assessment
Under the updated definition in AS 2501, an accounting estimate is a "measurement or recognition in the financial statements of (or a decision to not recognize) an account, disclosure, transaction, or event that generally involves subjective assumptions and measurement uncertainty." This encompasses fair value measurements.
The new standard applies to accounting estimates in significant accounts and disclosures (which are those accounts or disclosures that present a reasonable possibility that the account or disclosure could contain a misstatement that, individually or when aggregated with others, has a material effect on the financial statements). It considers the risks of misstatement and further integrates requirements for auditing accounting estimates with the risk assessment standards to focus auditors on accounting estimates with a greater risk of material misstatement.
Inclusion of risk factors
AS 2110, Identifying and Assessing Risks of Material Misstatement, has been amended to provide additional guidance to help auditors identify relevant risk factors related to estimates when identifying significant accounts and disclosures. These new risk factors include:
the degree of uncertainty associated with the future occurrence or outcome of events and conditions underlying the significant assumptions;
the complexity of the process for developing the accounting estimate;
the number and complexity of significant assumptions associated with the process;
the degree of subjectivity associated with significant assumptions (for example, because of significant changes in the related events and conditions or a lack of available observable inputs); and
if forecasts are important to the estimate, the length of the forecast period and degree of uncertainty regarding trends affecting the forecast
Obtaining an understanding of management's process
The existing PCAOB standards require the auditor to obtain an understanding of management's process for identifying risks relevant to financial reporting objectives, including fraud risks. For accounts that involve accounting estimates, the new standard requires this understanding of management's process to include understanding management's methods (which may include models), the data and assumptions used (including the source from which they are derived), and the extent to which management uses third parties other than specialists (for example, service organizations, pricing services, brokers or dealers, or external data providers). When management uses these types of third parties, auditors need to understand the nature of the relationship and the extent to which the third party uses company data and assumptions.
When a company uses the work of a specialist, the new PCAOB standard (AS 2110.28A) requires the auditor to address certain considerations, specifically the nature and purpose of the specialist's work; whether that work is based on data produced by the company, from external sources, or both; and the company's processes and controls for using the work of specialists.
Under the revised standard, auditors will perform a focused risk assessment of those estimates with a reasonably possible risk of material misstatement in order to develop an audit response that recognizes the differing risks of material misstatement in the components of accounting estimates. This will result in performing audit procedures that are more targeted on the sources of potential misstatement within the accounting estimate.
Companies will likely want to consider re-assessing their controls related to accounting estimates. Effective controls should address the selection process when there are multiple methods available or there is a range of potential assumptions or multiple sources of data that could be utilized when making an accounting estimate.
Identification of significant assumptions
The standard requires the auditor to identify which of the assumptions used by the company are significant to the accounting estimate (i.e., the assumptions that are important to the recognition or measurement of the accounting estimate in the financial statements). In identifying significant assumptions, the PCAOB standard requires the auditor to take into account the nature of the accounting estimate, including the related risk factors, the applicable financial reporting framework, and the auditor's understanding of the company's process for developing the accounting estimate. The standard also provides examples of assumptions that would ordinarily be considered significant assumptions, including those that are sensitive to variation, susceptible to manipulation or bias, involve unobservable data or company adjustments of observable data, and that depend on the company's intent and ability to carry out specific courses of action.
While auditors may understand management's perspective on which assumptions are significant, we believe the standard prompts auditors to independently identify the significant assumptions for the accounting estimate and focus the audit response on those assumptions that, individually or in combination with others, contribute to a risk of material misstatement.
Addressing potential management bias
By their nature, accounting estimates often involve subjective assumptions, measurement uncertainty, and complex processes and methods, and require significant management judgment. Existing standards require the evaluation of potential management bias and maintaining appropriate levels of professional skepticism in the aggregate. The new standard adds a focus on the potential for management bias at a granular level for the individual components of the estimate (method, assumptions and data) in addition to the aggregate assessment.
Methods, assumptions, and data
Given the ongoing movement to a more principles-based financial reporting framework, we believe there will be more situations when more than one method could be utilized to develop a particular estimate. The PCAOB standard includes new requirements for evaluating the methods used by the company to develop the accounting estimate. For example, if the company has changed their method, the auditor is required to determine the reasons for such change and evaluate the appropriateness of the change. When different methods result in significantly different estimates, the standard requires the auditor to obtain an understanding of the reasons for the company's choice of method and evaluate the appropriateness of the selection and if the selection could be indicative of management bias.
As part of evaluating significant assumptions, auditors are required to evaluate whether the assumptions used by the company to develop the estimate are reasonable, both individually and in combination. In addition, the auditor should evaluate whether the company has a reasonable basis for the significant assumptions used, and, when applicable, for its selection of assumptions from a range of potential assumptions. The standard has enhanced the requirements for evaluating the reasonableness of significant assumptions (which is an area of frequent inspection findings from the PCAOB) and focusing on potential management bias.
Under the new standard, auditors are required to obtain an understanding of management's analysis of critical accounting estimates and how management analyzed the sensitivity of its significant assumptions to changes resulting from other reasonably likely outcomes that would have a material effect on its financial condition or operating performance.
If auditors identify potential management bias in individually significant assumptions, or across assumptions in multiple estimates, auditors may need to reassess whether the conclusions on the identified significant assumptions remain appropriate and may conclude additional assumptions are significant.
Further, if the auditor identifies potential management bias in the components of the accounting estimate (the data, assumptions, or method), the auditor may need to reassess the risk assessment and the audit response for the accounting estimate.
As new accounting standards continue to require estimates that incorporate forward-looking information (e.g., the current expected credit loss model), we believe companies will increasingly select assumptions from a range of potential assumptions in developing accounting estimates. Management should have controls in place to prevent or detect bias in their selection of assumptions. Auditors will be focused on management's selected assumption as well as whether such selections indicate management bias and will evaluate changes in assumptions from period to period.
Different responsibilities for external vs. internally-produced data
The standard includes responsibilities for evaluating both internal and external data. It reiterates existing requirements to test the completeness and accuracy of internally-produced data (either through controls or substantive testing) and requires the auditor to evaluate the relevance and reliability of data from external sources. The standard also includes a reminder that company data supplied by management to a third party or company specialist is not data from an external source, but rather internally-produced data.
The new standard focuses the auditor on evaluating whether the data is used appropriately by the company, including whether (1) the data is relevant to the measurement objective for the accounting estimate; (2) the data is internally consistent with its use by the company in other estimates tested; and (3) the source of the company's data has changed from the prior year and, if so, whether the change is appropriate.
Evaluating audit results
In amended AS 2501, the PCAOB has emphasized the importance of "standing back" and evaluating estimates individually and in the aggregate to determine whether bias results from the cumulative effect of changes in estimates. This enhances the focus on certain assessments performed under existing auditing standards. For example, if estimates are grouped at one end of the range of "reasonable" in one year, and are grouped at the other end of the range in the next year, the auditor evaluates whether management is changing assumptions to drive swings in estimates to achieve an expected or desired outcome (e.g., an increase in earnings).
Auditing the valuation of financial instruments
The PCAOB has observed the increased use of pricing information from brokers or dealers and organizations that routinely provide uniform pricing information to users, generally on a subscription basis (pricing services). In audits, the pricing information is typically either used by (1) auditors to develop an independent expectation of the valuation of financial instruments or (2) companies to determine the valuation of financial instruments. Regardless of how it is used, the auditor is required to perform procedures to determine whether the information provided by pricing services is relevant and reliable and provides sufficient appropriate evidence to respond to the risks of material misstatement.
When assessing the relevance and reliability of pricing information from brokers or dealers, the auditor should consider whether the company has the ability to influence or control the broker or dealer, whether the broker or dealer is a market maker in the particular type of financial instrument being valued, whether the quote reflects market conditions as of the balance sheet date, whether the quote is binding on the broker dealer, and the nature of any restrictions, limitations, or disclaimers that could exist in the broker quote.
Many of the requirements to assess information provided by a third party can be performed at a group level, rather than for each financial instrument individually. In addition, less information about the particular methods and inputs used by an individual pricing service needs to be obtained when reasonably consistent pricing information is obtained from multiple pricing services.