Just as companies prepare to adopt new rules steeped in estimates, auditors have been handed new rules telling them to put more muscle into their scrutiny of estimates and the specialists who produce them.
The Securities and Exchange Commission approved two new auditing standards adopted by the Public Company Accounting Oversight Board giving auditors marching orders to get more skeptical when auditing estimates and the work of specialists. The standards take effect in 2020.
That’s the same year public companies will implement CECL, a standard adopted by the Financial Accounting Standards Board telling them to estimate future credit losses using a “current expected credit losses” approach. Especially in the financial services sector, companies are deep into implementation activity, preparing or finalizing models that rely on a mix of historic data and future projections to estimate future losses.
As economists warn markets to brace for another downturn, the new standards could create a kind of perfect storm in financial reporting. “In the banking industry, loan losses have always been a focus, with or without new rules,” says Mike Santay, an audit partner at Grant Thornton. “Certainly with economic cycles there are going to be downturns, where estimates get stress tested. These standards are going to be helpful in those areas.”
The PCAOB began digging into auditors’ scrutiny of estimates as part of the board’s routine inspections. Criticism started to rise, especially following the financial crisis, where inspectors routinely called out auditors when they too easily accepted management estimates or the work of their third-party specialists to arrive at valuations and other key figures that are important to financial statements.
That prompted the PCAOB to revisit its standards to assure they said more clearly what auditors are expected to do. Given the number of inspection cycles firms have endured while the board developed and finalized the new guidance, auditors have already adapted to much of what the new rules require, says Christine McAlarney, shareholder at audit firm Mayer Hoffman McCann. Where changes may happen, it will occur largely in how and to what degree auditors document their work, she says.
“Audit methodologies have developed and evolved over time. Many of the changes the PCAOB made in the final standards are relatively consistent with current practices at many firms. This is more evolution than revolution.”
Brian Croteau, Partner, PwC
In auditing estimates, for example, auditors now have clearer requirements to document their reasoning when they perform their own independent analyses of management estimates, says McAlarney. They also have more explicit guidance on auditing data arising within the organization that forms the basis for an estimate, a point the PCAOB has hammered on in inspections.
“They’re now emphasizing more so to make sure you are testing information produced by the entity,” says McAlarney. “We needed to have that change written into the standards.”
With respect to the work of specialists, that new standard gives auditors more clear direction on exercising skepticism over information from specialists not employed by the audit firm, especially third-party services hired by management, says McAlarney. It tells auditors, for example, they can’t assume the objectivity of third-party information because the providers are engaged by management, which has a bias in arriving at estimates.
“This change as it relates to specialists was much needed,” says McAlarney. “It was an area of confusion for engagement teams.”
The intersection of new auditing standards with CECL, which will hinge to varying degrees on estimates and data provided by third-party services, suggests an even more intense focus on how companies arrived at their reserves and disclosures under the new accounting.
“It’s going to be very relevant for CECL considerations,” says Santay. “It’s going to be a key area for the auditor.”
Beyond CECL, there are plenty of areas in financial statements where estimation and use of outside specialists is already commonplace. Fair-value measurements, especially financial instruments that are thinly traded, are heavily based on estimates and assumptions, along with goodwill impairment testing, intangible asset impairment testing, and business combinations.
“Derivatives, or any sort of financing or equity offering that has derivative instruments—those are all estimates,” says McAlarney. Any kind of allowance for doubtful accounts would be based on estimates, she says, as are valuation allowances tied to deferred tax assets and inventory.
The extent of change in the audit experience for any given company will depend on a number of factors, says Brian Croteau, a partner at PwC, including the nature of a given company’s accounting estimates; the specialists it uses; and the historic approach the audit firm has taken with respect to estimates, among others.
“Audit methodologies have developed and evolved over time,” says Croteau. “Many of the changes the PCAOB made in the final standards are relatively consistent with current practices at many firms. This is more evolution than revolution.”
With respect to CECL, auditors will focus as expected on understanding the nature and suitability of CECL models, understanding the basis for assumptions that are used in the accounting, and testing the reliability of the underlying data, says Croteau. “Those concepts are not new,” he says.
Audit committees can expect potentially more questions around what management considered in arriving at estimates, says McAlarney. “There will be maybe more questioning around what they didn’t consider in their estimates as opposed to just corroborating what they did consider,” she says. “This is really pushing audit teams to challenge management on contradictory evidence that management didn’t consider.”