Tensions about how to audit estimated amounts on financial statements escalated dramatically during the financial crisis. Five years later, that tension remains: Regulators continue to criticize auditors over the issue, and they, in turn, increase demands on corporate finance departments.
In truth, that tension brewed for years before the crisis of 2008. As the basis for accounting shifted away from historical cost toward current market value, estimates and assumptions mushroomed in the balance sheet. “Other than cash, most items are estimated,” says Dennis Beresford, accounting professor at the University of Georgia and a former audit committee member for Fannie Mae. “A lot of readers of financial statements don't understand that.”
That presents an inherent problem for auditing, which is rooted in confirming facts. “Estimates are always wrong,” says John Keyser, national director of assurance services for McGladrey. “I don't think you ever get the right answer. We can only make a determination about whether they are reasonable, and that's always going to cause difficulty.”
The financial crisis brought the conflict to a head when the market for complex financial instruments froze. Third-party pricing services had been churning out fair-market values for illiquid securities based on their proprietary models, and management and auditors took them too readily at face value, according to inspectors for the Public Company Accounting Oversight Board. After the crisis arrived, PCAOB inspection findings tied to fair value spiked, especially when they were rooted in evidence that was difficult or impossible to see. The Securities and Exchange Commission joined the fray by reminding companies they need to understand what goes into the assertions they make on their financial statements.
That led auditors to dig deeper for evidence behind management's estimates and into controls around how estimates are reached, especially related to fair value. “Fair value has become the poster child for the difficulty in estimates,” says David Larsen, managing director for valuation firm Duff & Phelps. “It's not the quality of assets that's in question. It's the observability of the inputs. There's a good deal of judgment there.”
Marty Baumann, chief auditor for the PCAOB, says the board has seen some improvement through its inspection process, especially in its 2012 inspection cycle, for which many reports are not yet published. “There are fewer comments on fair value,” he says. “They permeated reports a couple of years before, and I won't say they've gone away, but we've seen improvement. Unfortunately, we still see adverse findings.”
Related to problems with auditing estimates, inspectors also fault auditors for failing to exercise adequate skepticism and for failing to understand the related risks of material misstatement. Baumann sees a connection. “There are some reports that have indicated auditors are not appropriately following up on contrary evidence that may have come to their attention,” he says.
“The PCAOB has done a good job of telling auditors they're not doing a good job. They've done less in telling auditors how to do a good job.”
Duff & Phelps
The PCAOB's current standard on auditing estimates, AU Section 342, tells auditors they can audit an estimate by scrutinizing management's process for arriving at the estimate, by arriving at an estimate of their own and comparing it to management's, or by looking at more recent transaction activity for comparison's sake. Doug Carmichael, a former PCAOB chief auditor and now a professor at Baruch College, says auditors should look at a variety of standards for guidance on how to audit an estimate, besides AU Section 342. Those other guidelines include standards on risk assessment, exercising skepticism, and evaluating the reliability of estimates.
Carmichael notes that the PCAOB standard has existed for many years, adopted as an interim standard when the board began under the Sarbanes-Oxley Act. The PCAOB has an item on its agenda to consider a new standard to address auditing estimates, including fair-value measurements and related disclosures, and Baumann says he hopes the board will be in a position to publish a proposal in early 2014. It is likely to emphasize the requirement for auditors to understand the inputs and assumptions underlying fair-value measurements, as well as steer auditors to search for both confirming and contradictory evidence, he says.
Below McGladrey discusses how AU-C 540 defines estimation uncertainty.
AU-C 540 defines estimation uncertainty as “the susceptibility of an accounting estimate and related
disclosures to an inherent lack of precision in its measurement.” The nature and reliability of information
available to management to support the making of an accounting estimate varies widely, which thereby
affects the degree of estimation uncertainty associated with accounting estimates. The degree of
estimation uncertainty affects, in turn, the risks of material misstatement of accounting estimates,
including their susceptibility to unintentional or intentional management bias.
The degree of estimation uncertainty varies based on the nature of the accounting estimate and may be
influenced by factors such as:
Extent to which it depends on judgment (objective vs. subjective)
Sensitivity to changes in assumptions
The existence of recognized measurement techniques
The length of the forecast period and relevance of past data
Availability of reliable data from external sources
Extent to which the estimates is based on observable vs. unobservable inputs
For example a level 1, liquid, publicly traded share of stock may have low estimation uncertainty
associated with it as there is a public market that provides readily available and reliable information on
prices at which actual transactions occur. In contrast, a level 3 investment security may have a high
degree of estimation uncertainty as there is no readily available and reliable public information available
and the fair value would change significantly as a result of a small change in one or more highly
When performing risk assessment procedures and related activities to obtain an understanding of the
entity and its environment, the auditor should obtain an understanding of how management has assessed
the effect of estimation uncertainty in its accounting estimates. Matters that the auditor may consider in
obtaining any understanding of how management has assessed the effect of estimation uncertainty
include, for example:
How management has considered alternative assumptions or outcomes
How management determines the accounting estimate when analysis indicates a number of outcome
Whether management monitors the outcome of accounting estimates made in the prior period and
whether management has appropriately responded to the outcome of that monitoring procedure
Also in identifying and assessing the risks of material misstatement, the auditor should make his or her
own assessment of the degree of estimation uncertainty associated with an accounting estimate. Matters
that the auditor considers in assessing the risks of material misstatement may include the following:
The actual or expected magnitude of an accounting estimate. It should be noted, however, that a
seemingly immaterial accounting estimate may have the potential to result in a material misstatement
due to estimation uncertainty associated with the estimation (that is, the size of the amount
recognized or disclosed in the financial statements for an accounting estimate may not be an
indicator of its estimation uncertainty).
The recorded amount of the accounting estimate (that is, management's point estimate) in relation to
the amount expected by the auditor to be recorded
Whether management has used a specialist in making the accounting estimate
The outcome of the review of prior-period accounting estimates
Finally, the auditor should determine whether, in the auditor's professional judgment, any of those
accounting estimates that have been identified as having high estimation uncertainty give rise to
Guidance is sorely needed, says Larsen, whose valuation firm sees the tension that persists over fair-value auditing. “The PCAOB has done a good job of telling auditors they're not doing a good job,” he says. “They've done less in telling auditors how to do a good job.” He sees auditors getting exasperated with repeated inspection findings, then returning to companies and demanding more work and more documentation—an experience chief accounting officers don't relish either. “It's a vicious circle.”
Larsen points out that even the Financial Accounting Standards Board has raised a concern about whether the PCAOB's approach has increased accounting and auditing complexity around fair value. In FASB's response to a post-implementation review of business combination rules, FASB said it welcomes a pending review of its fair-value measurement rule because that will give reviewers an opportunity to consider “environmental issues,” including the PCAOB's focus on the complexity that has arisen in fair-value accounting and auditing in recent years.
In response, a PCAOB spokesman said PCAOB inspections evaluate, among other things, auditors' compliance with PCAOB auditing standards. "Issues cited by PCAOB inspectors typically involve failures to execute appropriately against the relevant standards," she said. "With respect to estimates, inspectors typically do not judge the accuracy of an estimate that is audited, but instead evaluate the sufficiency of the procedures performed by the auditor to evaluate the estimate."
Despite its inspection focus, the PCAOB is still troubled to find evidence that auditors sometimes ignore information they find that contradicts management's estimates, Baumann says. That message has been heard loud and clear, says Keyser at McGladrey, where the firm has spent a great deal of time training staff on how to exercise professional judgment properly. That includes being careful not to anchor too heavily to management's number and giving fair weight to evidence that contradicts management assertions, he says.
Keyser agrees that auditors would welcome new guidance from the PCAOB on auditing estimates, especially regarding how to respond to uncertainty in estimates. The American Institute of Certified Public Accountants, through its Auditing Standards Board, recently issued guidance for non-public entities on auditing financial instruments, including dealing with estimation issues. Something similar for the public company crowd would be helpful, says Keyser. “With any accounting estimate, there's a level of uncertainty, but there are varying levels of uncertainty,” he says. Auditors could use some guidance on how to address that uncertainty to the satisfaction of regulators.
The root of the conflict, says John Hepp, a partner with Grant Thornton, is that estimates are not reliable, but the PCAOB is demanding a level of precision normally associated with reliability. The proliferation of fair-value accounting has led to an acceptance at the policy-setting level that financial statements will not necessarily be reliable because they are not as rooted in verifiable, historical fact. “The profession has not resolved that change from a reliability model to a fair-value model,” he says. “We're still trying to audit new numbers the old way.”
Hepp says he believes FASB didn't intend for fair-value measurements based on unobservable data and judgments to be precise. “I don't think the intent was to get the number as accurate as possible by doing different procedures,” he says. “The intent was you'd disclose what you'd done, and if the judgment was reasonable and you explain how you did it, that would be acceptable. The PCAOB has gone beyond that. It's added a lot of complexity into auditing.”
The intense focus also leaves auditors walking a tightrope, Carmichael says. “Not all auditors are created equal when it comes to exercising professional skepticism and objectivity,” he says. “And the tougher you are on a client, the greater the risk you're going to lose that client.”