[Federal Register Volume 84, Number 65 (Thursday, April 4, 2019)]
[Notices]
[Pages 13396-13439]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-06426]
[[Page 13395]]
Vol. 84
Thursday,
No. 65
April 4, 2019
Part II
Securities and Exchange Commission
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Public Company Accounting Oversight Board; Notice of Filing of
Proposed Rules on Auditing Accounting Estimates, Including Fair Value
Measurements, and Amendments to PCAOB Auditing Standards; Notice
Federal Register / Vol. 84 , No. 65 / Thursday, April 4, 2019 /
Notices
[[Page 13396]]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-85434; File No. PCAOB-2019-02]
Public Company Accounting Oversight Board; Notice of Filing of
Proposed Rules on Auditing Accounting Estimates, Including Fair Value
Measurements, and Amendments to PCAOB Auditing Standards
March 28, 2019.
Pursuant to Section 107(b) of the Sarbanes-Oxley Act of 2002 (the
``Act'' or ``Sarbanes-Oxley Act''), notice is hereby given that on
March 20, 2019, the Public Company Accounting Oversight Board (the
``Board'' or ``PCAOB'') filed with the Securities and Exchange
Commission (the ``Commission'' or ``SEC'') the proposed rules described
in Items I and II below, which items have been prepared by the Board.
The Commission is publishing this notice to solicit comments on the
proposed rules from interested persons.
I. Board's Statement of the Terms of Substance of the Proposed Rules
On December 20, 2018, the Board adopted a new rule and amendments
to auditing standards (collectively, the ``proposed rules''), under
which the three existing standards related to auditing estimates,
including fair value measurements, will be replaced with a single,
updated standard. The text of the proposed rules appears in Exhibit A
to the SEC Filing Form 19b-4 and is available on the Board's website at
https://pcaobus.org/Rulemaking/Pages/docket-043-auditing-accounting-estimates-fair-value-measurements.aspx and at the Commission's Public
Reference Room.
II. Board's Statement of the Purpose of, and Statutory Basis for, the
Proposed Rules
In its filing with the Commission, the Board included statements
concerning the purpose of, and basis for, the proposed rules and
discussed any comments it received on the proposed rules. The text of
these statements may be examined at the places specified in Item IV
below. The Board has prepared summaries, set forth in sections A, B,
and C below, of the most significant aspects of such statements. In
addition, the Board is requesting that, pursuant to Section
103(a)(3)(C) of the Sarbanes-Oxley Act, the Commission approve the
proposed rules for application to audits of emerging growth companies
(``EGCs'').\1\ The Board's request is set forth in section D.
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\1\ The term ``emerging growth company'' is defined in Section
3(a)(80) of the Securities Exchange Act of 1934 (the ``Exchange
Act'') (15 U.S.C. 78c(a)(80)). See also Inflation Adjustments and
Other Technical Amendments Under Titles I and III of the JOBS Act,
Release No. 33-10332 (Mar. 31, 2017), 82 FR 17545 (Apr. 12, 2017).
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A. Board's Statement of the Purpose of, and Statutory Basis for, the
Proposed Rules
(a) Purpose
Summary
The Board has adopted amendments to its standards for auditing
accounting estimates and fair value measurements, under which three
existing standards will be replaced with a single, updated standard
(``AS 2501 (Revised)'' or the ``new standard''). As discussed in more
detail below, in the Board's view, the new standard and related
amendments will further investor protection by strengthening audit
requirements, applying a more uniform, risk-based approach to an area
of the audit that is of increasing prevalence and significance, and
updating the standards in light of recent developments.
The financial statements of most companies reflect amounts in
accounts and disclosures that require estimation, which may include
fair value measurements or other types of estimates. These estimates
appear in items like revenues from contracts with customers, valuations
of certain financial and non-financial assets, impairments of long-
lived assets, allowances for credit losses, and contingent liabilities.
As financial reporting frameworks evolve toward greater use of
estimates, accounting estimates are becoming more prevalent and more
significant, often having a significant impact on a company's reported
financial position and results of operations.
By their nature, accounting estimates, including fair value
measurements, generally involve subjective assumptions and measurement
uncertainty, making them susceptible to management bias. Some estimates
involve complex processes and methods. As a result, accounting
estimates are often some of the areas of greatest risk in an audit,
requiring additional audit attention and appropriate application of
professional skepticism. The challenges of auditing estimates may be
compounded by cognitive bias, which could lead auditors to anchor on
management's estimates and inappropriately weight confirmatory over
contradictory evidence.
The Board's oversight activities, which have revealed a recurring
pattern of deficiencies in this area, also raise concerns about
auditors' application of professional skepticism, including addressing
potential management bias, in this area of the audit. Over the years,
PCAOB staff has provided guidance for auditors related to auditing
accounting estimates, but this area remains challenging and practices
among firms vary.
Currently, three PCAOB auditing standards primarily relate to
accounting estimates, including fair value measurements. These three
standards, which were originally adopted between 1988 and 2003, include
common approaches for substantive testing but vary in the level of
detail in describing the auditor's responsibilities with respect to
those approaches. In addition, because the three standards predate the
Board's risk assessment standards, they do not fully integrate risk
assessment requirements that relate to identifying, assessing, and
responding to the risks of material misstatement in accounting
estimates.
The new standard builds on the common approaches in the three
existing standards and will strengthen PCAOB auditing standards in the
following respects:
Providing direction to prompt auditors to devote greater
attention to addressing potential management bias in accounting
estimates, as part of applying professional skepticism.
Extending certain key requirements in the existing
standard on auditing fair value measurements, the newest and most
comprehensive of the three existing standards, to other accounting
estimates in significant accounts and disclosures, reflecting a more
uniform approach to substantive testing for estimates.
More explicitly integrating requirements with the Board's
risk assessment standards to focus auditors on estimates with greater
risk of material misstatement.
Making other updates to the requirements for auditing
accounting estimates to provide additional clarity and specificity.
Providing a special topics appendix to address certain
aspects unique to auditing fair values of financial instruments,
including the use of pricing information from third parties such as
pricing services and brokers or dealers.
The Board has adopted the new standard and related amendments after
substantial outreach, including two
[[Page 13397]]
rounds of public comment. Commenters generally supported the Board's
objective of improving the quality of audits involving accounting
estimates, and suggested areas where the proposed requirements could be
modified or clarified. The Board has taken all of these comments, as
well as observations from PCAOB oversight activities and the relevant
academic literature, into account.
In a separate PCAOB release, the Board also adopted amendments to
its standards for using the work of specialists, which are often
involved in developing, or assisting in the evaluation of, accounting
estimates.\2\ Certain provisions of the new standard include references
to AS 1210, Using the Work of an Auditor-Engaged Specialist; AS 1201,
Supervision of the Audit Engagement; and AS 1105, Audit Evidence, as
amended.
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\2\ See Amendments to Auditing Standards for Auditor's Use of
the Work of Specialists, PCAOB Release No. 2018-006 (Dec. 20, 2018)
(``Specialists Release'').
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In its consideration of the new standard and related amendments,
the Board is mindful of the significant advances in technology that
have occurred in recent years, including increased use of data analysis
tools and emerging technologies. An increased use of technology-based
tools, together with future developments in the use of data and
technology, could have a fundamental impact on the audit process. The
Board is actively exploring these potential impacts through ongoing
staff research and outreach.
In the context of this rulemaking, the Board considered how changes
in technology could affect the processes companies use to develop
accounting estimates, including fair value measurements, and the tools
and techniques auditors apply to audit them. The Board believes that
the new standard and related amendments are sufficiently principles-
based and flexible to accommodate continued advances in the use of data
and technology by both companies and auditors. The Board will continue
to monitor advances in this area and any effect they may have on the
application of the new standard.
The new standard and related amendments apply to all audits
conducted under PCAOB standards. Subject to approval by the Commission,
the new standard and related amendments will take effect for audits for
fiscal years ending on or after December 15, 2020.
(b) Statutory Basis
The statutory basis for the proposed rules is Title I of the Act.
B. Board's Statement on Burden on Competition
Not applicable. The Board's consideration of the economic impacts
of the proposed rules is discussed in section D below.
C. Board's Statement on Comments on the Proposed Rules Received From
Members, Participants or Others
The Board released the proposed rules for public comment in
Proposed Auditing Standard--Auditing Accounting Estimates, Including
Fair Value Measurements, and Proposed Amendments to PCAOB Auditing
Standards, PCAOB Release No. 2017-002 (June 1, 2017) (``proposal'' or
``Estimates Proposing Release''). The PCAOB also issued for public
comment a Staff Consultation Paper, Auditing Accounting Estimates and
Fair Value Measurements (Aug. 19, 2014) (``SCP''). Copies of Release
No. 2017-002, the SCP, and the comment letters received in response to
the PCAOB's requests for comment are available on the PCAOB's website
at https:/pcaobus.org/Rulemaking/Pages/docket-043-auditing-accounting-
estimates-fair-value-measurements.aspx. The PCAOB received 81 written
comment letters. The Board's response to the comments received and the
changes made to the rules in response to the comments received are
discussed below.
Background
Accounting estimates are an essential part of financial statements.
Most companies' financial statements reflect accounts or amounts in
disclosures that require estimation. Accounting estimates are pervasive
to financial statements, often substantially affecting a company's
financial position and results of operations. Examples of accounting
estimates include certain revenues from contracts with customers,
valuations of financial and non-financial assets, impairments of long-
lived assets, allowances for credit losses, and contingent liabilities.
The evolution of financial reporting frameworks toward greater use
of estimates includes expanded use of fair value measurements that need
to be estimated. For purposes of this rulemaking, a fair value
measurement is considered a form of accounting estimate because it
generally shares many of the same characteristics with other estimates,
including subjective assumptions and measurement uncertainty.
Rulemaking History
The PCAOB has engaged in extensive outreach to explore the views of
market participants and others on the potential for improvement of the
auditing standards related to accounting estimates. This includes
discussions with the Board's Standing Advisory Group (``SAG'') and the
Pricing Sources Task Force. In addition, in August 2014, the PCAOB
issued the SCP, to solicit comments on various issues, including the
potential need for standard setting and key aspects of a potential new
standard and related requirements.
In June 2017, the Board proposed to replace three auditing
standards that primarily relate to accounting estimates, including fair
value measurements, with a single standard. The proposal included a
special topics appendix addressing certain matters relevant to auditing
the fair value of financial instruments and amendments to several PCAOB
standards to align them with the single standard. A number of
commenters across many affiliations supported the Board's efforts to
strengthen auditing practices and update its standards in this area.
In addition to this outreach, the Board's approach has been
informed by, among other things, observations from PCAOB oversight
activities and SEC enforcement actions and consideration of academic
research, the standard on auditing accounting estimates recently
adopted by the International Auditing and Assurance Standards Board
(``IAASB''), and the extant standard on auditing accounting estimates
of the Auditing Standards Board (``ASB'') of the American Institute of
Certified Public Accountants.
Overview of Existing Requirements
The primary PCAOB standards that apply specifically to auditing
accounting estimates, including fair value measurements are:
AS 2501, Auditing Accounting Estimates (originally issued
in April 1988) (``accounting estimates standard'')--applies to auditing
accounting estimates in general.
AS 2502, Auditing Fair Value Measurements and Disclosures
(originally issued in January 2003) (``fair value standard'')--applies
to auditing the measurement and disclosure of assets, liabilities, and
specific components of equity presented or disclosed at fair value in
financial statements.
AS 2503, Auditing Derivative Instruments, Hedging
Activities, and Investments in Securities (originally issued in
September 2000) (``derivatives
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standard'')--applies to auditing financial statement assertions for
derivative instruments, hedging activities, and investments in
securities. Its scope includes requirements for auditing the valuation
of derivative instruments and securities, including those measured at
fair value.
The accounting estimates standard, fair value standard, and
derivatives standard are referred to collectively as the ``estimates
standards.''
In addition, the Board's risk assessment standards,\3\ which set
forth requirements for the auditor's assessment of and response to risk
in an audit, include requirements that relate to accounting estimates.
These requirements involve procedures regarding identifying and
assessing risks of material misstatement in accounting estimates,\4\
identifying and evaluating misstatements in accounting estimates,\5\
and evaluating potential management bias associated with accounting
estimates.\6\ PCAOB standards also set forth requirements for the
auditor to plan and perform his or her work with due professional care,
which includes the application of professional skepticism.\7\
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\3\ The Board's ``risk assessment standards'' include AS 1101,
Audit Risk; AS 1105; AS 1201; AS 2101, Audit Planning; AS 2105,
Consideration of Materiality in Planning and Performing an Audit; AS
2110, Identifying and Assessing Risks of Material Misstatement; AS
2301, The Auditor's Responses to the Risks of Material Misstatement;
and AS 2810, Evaluating Audit Results.
\4\ See generally AS 2110.13.
\5\ See AS 2810.13.
\6\ See AS 2810.27.
\7\ See generally paragraph .07 of AS 1015, Due Professional
Care in the Performance of Work.
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Both the accounting estimates standard and the fair value standard
provide that the auditor may apply one or a combination of three
approaches to substantively test an accounting estimate:
Testing management's process. This generally involves:
Evaluating the reasonableness of assumptions used by
management that are significant to the estimate, and testing and
evaluating the completeness, accuracy, and relevance of data used; \8\
and
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\8\ See generally AS 2501 and AS 2502.26-.39.
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Evaluating the consistency of management's assumptions
with other information.\9\
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\9\ Id.
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Developing an independent estimate. This generally
involves using management's assumptions, or alternative assumptions, to
develop an independent estimate or an expectation of an estimate.\10\
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\10\ See generally AS 2501.12 and AS 2502.40.
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Reviewing subsequent events or transactions. This
generally involves using events or transactions occurring subsequent to
the balance sheet date, but prior to the date of the auditor's report,
to provide evidence about the reasonableness of the estimate.\11\
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\11\ See generally AS 2501.13 and AS 2502.41-.42.
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In general, the fair value standard, which is the most recent of
the estimates standards, sets forth more detailed procedures for the
common approaches described above. The level of detail within the fair
value standard, however, varies.\12\ For example, the fair value
standard sets forth a number of different requirements for testing
management's process but only a few general requirements for developing
an independent estimate.\13\
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\12\ See generally AS 2502.26-.40.
\13\ See generally AS 2502.40.
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The derivatives standard primarily addresses auditing derivatives.
This standard also includes requirements for auditing the valuation of
derivatives and investment securities, including valuations based on an
investee's financial results, and testing assertions about securities
based on management's intent and ability.\14\
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\14\ See generally AS 2503.28-.34 and .56-.57.
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Existing Practice
The PCAOB's understanding of audit practice at both larger and
smaller audit firms under existing PCAOB standards has been informed
by, among other things, the collective experience of PCAOB staff,
observations from oversight activities of the Board, enforcement
actions of the SEC, comments received on the SCP and proposal, and
discussions with the SAG and audit firms.
Overview of Existing Practice
The PCAOB has observed through its oversight activities that some
audit firms' policies, procedures, and guidance (``methodologies'') use
approaches that apply certain of the basic procedures for auditing fair
value measurements to other accounting estimates (e.g., evaluating the
method used by management to develop estimates).\15\ The PCAOB has also
observed that when testing management's process, some auditors have
developed expectations of certain significant assumptions as an
additional consideration in evaluating the reasonableness of those
assumptions.
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\15\ Notably, most of those firms base their methodologies
largely on the standards of the IAASB or the ASB, both of which have
adopted one standard for auditing both fair value measurements and
other accounting estimates.
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Over the past few years, some audit firms have updated their
methodologies, often in response to identified inspection deficiencies.
For example, in the area of auditing the fair value of financial
instruments, some firms have directed resources to implement more
rigorous procedures to evaluate the process used by third-party pricing
sources to determine the fair value of financial instruments.
The PCAOB has observed diversity in how audit firms use information
obtained from third-party sources in auditing fair value measurements.
Such third-party sources include pricing services and brokers or
dealers, which provide pricing information related to the fair value of
financial instruments.\16\
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\16\ Another type of third-party source--specialists who develop
independent estimates or assist in evaluating a company's estimate
or the work of a company's specialist--is addressed separately in
the Specialists Release. See supra note 2.
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Some larger audit firms have implemented centralized approaches to
developing independent estimates of the fair value of financial
instruments. These firms may use centralized, national-level pricing
desks or groups to assist in performing procedures relating to testing
the fair value of financial instruments. The level of information
provided by these centralized groups to engagement teams varies. In
some cases, the national-level pricing desk obtains pricing information
from pricing services at the request of the engagement team.
Additionally, national-level pricing desks may periodically provide
information about a pricing service's controls and methodologies, and
provide information on current market conditions for different types of
securities to inform an engagement team's risk assessment. In other
cases, the national-level pricing desk itself may develop estimates of
fair value for certain types of securities, assist audit teams with
evaluating the specific methods and assumptions related to a particular
instrument, or evaluate differences between a company's price and price
from a pricing source. Smaller audit firms that do not have a national
pricing group may engage valuation specialists to perform some or all
of these functions. Some smaller firms use a combination of external
valuation specialists and internal pricing groups.
Commenters generally did not disagree with the description of
current practice in the proposal. A few commenters pointed to
additional areas where company and firm size and available resources
can result in diverse audit approaches (e.g., impairment testing,
estimates of environmental
[[Page 13399]]
liabilities, and obtaining evidence related to complex transactions).
Observations From Audit Inspections
Through its oversight activities, the PCAOB has historically
observed numerous deficiencies in auditing accounting estimates. Audit
deficiencies have been observed in both larger and smaller audit
firms.\17\
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\17\ See, e.g., Annual Report on the Interim Inspection Program
Related to Audits of Brokers and Dealers, PCAOB Release No. 2018-003
(Aug. 20, 2018); PCAOB Staff Inspection Brief, Preview of
Observations from 2016 Inspections of Auditors of Issuers (Nov.
2017); and Annual Report on the Interim Inspection Program Related
to Audits of Brokers and Dealers, PCAOB Release No. 2017-004 (Aug.
18, 2017). See also Estimates Proposing Release at 12, footnote 39.
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PCAOB inspections staff has observed audit deficiencies in issuer
audits related to a variety of accounting estimates, including revenue-
related estimates and reserves, the allowance for loan losses, the fair
value of financial instruments, the valuation of assets and liabilities
acquired in a business combination, goodwill and long-lived asset
impairments, inventory valuation allowances, and equity-related
transactions. Examples of such deficiencies include failures to (1)
sufficiently test the accuracy and completeness of company data used in
fair value measurements or other estimates, (2) evaluate the
reasonableness of significant assumptions used by management, and (3)
understand information provided by third-party pricing sources. In
audits of brokers or dealers, deficiencies include failures to (1)
obtain an understanding of the methods and assumptions internally
developed or obtained by third parties that were used by the broker or
dealer to determine fair value of securities, and (2) perform
sufficient procedures to test valuation of securities. The observed
deficiencies are frequently associated with, among other things, a
failure to appropriately apply professional skepticism in auditing the
estimates.\18\
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\18\ Audit deficiencies have also been observed by other
regulators internationally. For example, an International Forum of
Independent Audit Regulators (``IFIAR'') survey released in 2018
reported that accounting estimates was one of the audit areas with
the highest rate and greatest number of findings. The most commonly
observed deficiencies related to failures to assess the
reasonableness of assumptions, including consideration of contrary
or inconsistent evidence where applicable; sufficiently test the
accuracy of data used; perform sufficient risk assessment
procedures; take relevant variables into account; evaluate how
management considered alternative assumptions; and adequately
consider indicators of bias. See IFIAR, Report on 2017 Survey of
Inspection Findings (Mar. 9, 2018), at 10 and B-6.
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More recently, there are some indications in PCAOB inspections of
issuer audits that observed deficiencies in this area are decreasing,
as compared to earlier years. Some audit firms have updated their audit
practices in light of deficiencies identified through inspections. Not
all firms have improved their practices in this area, however, and
PCAOB inspections staff has continued to observe deficiencies similar
to those described above. Inspection observations continue to raise
concerns about auditors' application of professional skepticism,
including addressing potential management bias, in auditing accounting
estimates.
Observations From Enforcement Cases
Over the years, there have been a number of enforcement actions by
the PCAOB and SEC for violations of PCAOB standards in auditing
accounting estimates, demonstrating the importance of this aspect of
the audit. Enforcement actions have been brought against larger and
smaller firms, with domestic and international practices.
PCAOB enforcement cases related to auditing estimates have
generally involved one or more of the following violations (1) failure
to perform any procedures to determine the reasonableness of
significant assumptions; (2) failure to test the relevance,
sufficiency, and reliability of the data supporting the accounting
estimates; (3) failure to perform a retrospective review of a
significant accounting estimate to determine whether management's
judgments and assumptions relating to the estimate indicated a possible
bias; and (4) failure to adequately consider contradictory evidence or
perform procedures to obtain corroboration for management
representations regarding accounting estimates.\19\
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\19\ See, e.g., Deloitte & Touche LLP, PCAOB Release No. 105-
2018-008 (May 23, 2018); Tarvaran Askelson & Company, LLP, Eric
Askelson, and Patrick Tarvaran, PCAOB Release No. 105-2018-001 (Feb.
27, 2018); David M. Burns, CPA, PCAOB Release No. 105-2017-055 (Dec.
19, 2017); Grant Thornton LLP, PCAOB Release No. 105-2017-054 (Dec.
19, 2017); Anthony Kam & Associates Limited, and Anthony KAM Hau
Choi, CPA, PCAOB Release No. 105-2017-043 (Corrected Copy) (Nov. 28,
2017); BDO Auditores, S.L.P., Santiago Sa[ntilde][eacute] Figueras,
and Jos[eacute] Ignacio Alg[aacute]s Fern[aacute]ndez, PCAOB Release
No. 105-2017-039 (Sept. 26, 2017); Kyle L. Tingle, CPA, LLC and Kyle
L. Tingle, CPA, PCAOB Release No. 105-2017-027 (May 24, 2017);
Wander Rodrigues Teles, PCAOB Release No. 105-2017-007 (Mar. 20,
2017); KAP Purwantono, Sungkoro & Surja, Roy Iman Wirahardja, and
James Randall Leali, PCAOB Release No. 105-2017-002 (Feb. 9, 2017);
HJ & Associates, LLC, S. Jeffrey Jones, CPA, Robert M. Jensen, CPA,
and Charles D. Roe, CPA, PCAOB Release No. 105-2017-001 (Jan. 24,
2017); Arshak Davtyan, Inc. and Arshak Davtyan, CPA, PCAOB Release
No. 105-2016-053 (Dec. 20, 2016); David C. Lee, CPA, PCAOB Release
No. 105-2016-052 (Dec. 20, 2016); Arturo Vargas Arellano, CPC, PCAOB
Release No. 105-2016-045 (Dec. 5, 2016); and Goldman Kurland and
Mohidin, LLP and Ahmed Mohidin, CPA, PCAOB Release No. 105-2016-027
(Sept. 13, 2016). See also Estimates Proposing Release at 13,
footnote 41.
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Similarly, the SEC has brought Rule 102(e) proceedings against
auditors for substantive failures in auditing accounting estimates,
including failures to obtain sufficient appropriate audit evidence for
significant accounting estimates in an entity's financial statements
and failures to exercise due professional care, including professional
skepticism, throughout the audit.\20\ In some cases, the auditor (1)
obtained little, if any, reliable or persuasive evidence with respect
to management's adjustments to stale appraised values; (2) failed to
identify and address bias in management's estimates; or (3) failed to
evaluate the results of audit procedures performed, including whether
the evidence obtained supported or contradicted estimates in the
financial statements.\21\
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\20\ See, e.g., Paritz & Company, P.A., Lester S. Albert, CPA,
and Brian A. Serotta, CPA, SEC Accounting and Auditing Enforcement
Release (``AAER'') No. 3899 (Sept. 21, 2017); KPMG LLP and John
Riordan, CPA, SEC AAER No. 3888 (Aug. 15, 2017); William Joseph
Kouser Jr., CPA, and Ryan James Dougherty, CPA, AAER No. 3864 (Apr.
4, 2017); Grassi & Co., CPAs, P.C., SEC AAER No. 3826 (Nov. 21,
2016). See also Estimates Proposing Release at 14, footnote 42.
\21\ See, e.g., Miller Energy Resources, Inc., Paul W. Boyd,
CPA, David M. Hall, and Carlton W. Vogt, III, CPA, SEC AAER Nos.
3780 (June 7, 2016) and 3673 (Aug. 6, 2015); Grant Thornton, LLP,
SEC AAER No. 3718 (Dec. 2, 2015).
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Reasons To Improve Auditing Standards
The Board believes that its standards for auditing accounting
estimates, including fair value measurements, can be improved to
provide better direction to auditors with respect to both the
application of professional skepticism, including addressing potential
management bias, and the use of third-party pricing information.
First, the differences in requirements among the three estimates
standards suggest that revising PCAOB standards to set forth a more
uniform, risk-based approach to auditing estimates can lead to
improvements in auditing practices for responding to the risks of
material misstatement in accounting estimates, whether due to error or
fraud.
Second, because the subjective assumptions and measurement
uncertainty of accounting estimates make them susceptible to management
bias, the Board believes that PCAOB standards related to auditing
accounting estimates will be improved by emphasizing the application of
professional skepticism, including addressing potential management
bias.
[[Page 13400]]
Although the risk assessment standards and certain other PCAOB
standards address professional skepticism and management bias, the
estimates standards provide little or no specific direction on how to
address those topics in the context of auditing accounting estimates.
Third, existing requirements do not provide specific direction
about how to evaluate the relevance and reliability of pricing
information from third parties. PCAOB standards should be improved by
revising the requirements in this area to drive a level of work effort
commensurate with both the risks of material misstatement in the
valuation of financial instruments and the relevance and reliability of
the evidence obtained.
The Board received 38 comment letters on the proposal. A number of
commenters supported the Board's efforts to strengthen auditing
practices and update its standards related to estimates and fair value
measurements. For example, investor groups asserted that the proposal
will strengthen auditor responsibilities, improve audit quality, and
further investor protection. Other commenters pointed to better
integration and alignment with the risk assessment standards, noting,
for example, that a risk-based approach to auditing estimates will help
to resolve the differences in requirements among the current standards.
Some commenters supported combining the three existing standards into a
single standard, for example, because it would make the requirements
easier to navigate and comply with. Some commenters also expressed
support for the incremental direction in the proposal on matters
related to financial instruments, including the use of pricing
information from third parties as audit evidence.
Some commenters on the proposal challenged the relevance of
inspection experience to the Board's consideration of the new standard.
For example, two commenters questioned whether the existence of audit
deficiencies related to estimates warrant revision to the estimates
standards. Another commenter suggested that development of standards
should be based on areas where audit quality can be improved in order
to protect the public interest, not just through areas that have been
identified during the inspection process. In contrast, other commenters
expressed concern over continued audit deficiencies observed in this
area and supported the development of the proposal. Another commenter
argued that a lack of clarity in the estimates standards might be a
contributing factor to the persistence of audit deficiencies associated
with auditing estimates and fair value measurements.
The Board believes that a pattern of deficiencies over time raises
questions about whether professional skepticism is being appropriately
applied and about overall audit quality in this area, and supports the
view that estimates are a challenging area of the audit. More specific
direction should contribute to more consistent, risk-based execution
and improved audit quality.
Some commenters questioned the need for the proposal citing, among
other things, insufficient evidence that existing standards are
deficient and the loss of certain content from the estimates standards
that the commenters considered to be useful. One commenter argued that
the standards for fair value measurements should be differentiated from
the standards for other accounting estimates because the goals of the
standards are fundamentally different.
The Board believes it is appropriate to apply a more uniform
approach to the audit of accounting estimates, including fair value
measurements, including by bringing the requirements together into a
single standard. The estimates standards already reflect common
approaches to substantive testing. While the level of detail varies
across the three standards, these differences do not derive from
differences in the assessed risks of material misstatement. The Board
believes that a single standard will promote auditor performance that
is more consistently responsive to risk. The new standard also includes
an appendix on valuation of financial instruments that provides
specific direction in that area.
Some commenters asserted that the proposal would lead to
unnecessary expansion of procedures and thus increased costs. For
example, one of those commenters contended that the proposed
requirements could affect the ability of smaller accounting firms to
audit certain types of issuers. Another commenter cautioned against a
one-size-fits-all audit approach, expressing concern about expecting
the same level of rigor in developing accounting estimates from both
the largest and smallest public companies. One commenter challenged the
scalability of the proposal, arguing that auditors will assume that all
listed factors and considerations will have to be addressed in every
audit, and that nothing in the proposal directed the auditor to
consider cost-benefit implications or whether further testing and
analysis would meaningfully improve the auditor's ability to assess the
reasonableness of an estimate. Other commenters, however, asserted that
the standard is sufficiently scalable.
The Board believes that the new standard is well-tailored to
address an increasingly significant and challenging area of the audit.
The new standard is designed to be scalable because the necessary audit
evidence depends on the corresponding risks of material misstatement.
The new standard does not prescribe detailed procedures or the extent
of procedures, beyond the requirement to respond to risk, including
significant risk, and direction for applying the primary approaches to
testing. Rather, it builds on the existing requirements of AS 2301
under which the auditor designs procedures that take into account the
types of potential misstatements that could result from the identified
risks and the likelihood and magnitude of potential misstatement.\22\
Specific risk factors associated with the estimates--for example,
subjective assumptions, measurement uncertainty, or complex processes
or methods\23\--affect the auditor's risk assessment and in turn, the
required audit effort.
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\22\ AS 2301.09.
\23\ See paragraph AS 2110.60A, as amended, for examples of
specific risk factors.
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Aligning the new standard and related amendments with the risk
assessment standards directs auditors to focus on estimates with
greater risk of material misstatement. The new standard allows auditors
to tailor their approach to best respond to identified risks and
effectively obtain sufficient appropriate evidence. To the extent the
new standard results in increased audit effort, that effort should be
scaled in relation to the relevant risks, and any associated costs
should be justified in light of the benefits of appropriate audit
attention and the appropriate application of professional skepticism.
Some commenters also challenged the anticipated benefits of the
proposal, arguing that additional audit work would not improve the
quality of financial reporting, given the inherent uncertainty and
subjectivity surrounding estimates.
The new standard and related amendments acknowledge that estimates
have estimation uncertainty and that it affects the risks of material
misstatement. Neither the Board nor auditors are responsible for
placing limits on the range of estimation uncertainty. That uncertainty
is a function of the estimate's measurement requirements under the
applicable financial reporting framework, the economic phenomena
affecting that estimate, and the fact that it involves assessments of
future outcomes. Under
[[Page 13401]]
the new standard and related amendments, the auditor will consider
estimation uncertainty in assessing risk and performing procedures in
response to risk, which involves evaluating whether the accounting
estimates are reasonable in the circumstances and in conformity with
the applicable financial reporting framework, as well as evaluating
potential management bias in accounting estimates, and its effect on
the financial statements. These responsibilities align with the
auditor's overall responsibility for planning and performing financial
statement audits.
Commenters generally acknowledged the Board's efforts to emphasize
professional skepticism, including addressing management bias, in the
proposal and provided varying views on related aspects of the proposal.
Some commenters, for example, indicated that the proposal should place
even more emphasis on the need to challenge management or the
consideration of management bias, noting the existence of overly
optimistic or skewed estimates in financial statements. One commenter
advocated for more discussion within the standard of the various types
of bias that can affect auditing estimates.
In contrast, other commenters asserted that the proposal
overemphasized the need for professional skepticism, or had a negative
tone that assumed a predisposition to management bias. One commenter
pointed out other practices and requirements that, in the commenter's
view, mitigate the risk of management bias, among them CEO and CFO
certification, management reporting and auditor attestation on internal
control over financial reporting, internal audit, and audit committee
oversight. Some of these commenters expressed concern that the emphasis
on professional skepticism would lead to unnecessary expansion of audit
procedures.
A few commenters also argued that management bias is inherent in
accounting estimates and cannot be eliminated. One of the commenters
added that, for those reasons, the proposed requirements addressing
management bias should not apply to estimates made pursuant to the new
accounting standard on credit losses.\24\ Another commenter suggested
that the proposal should differentiate between limitations that an
auditor can address (e.g., analytical ability), those that can be
partially addressed (e.g., some features of management bias), and those
that cannot be addressed (e.g., time constraints, limits on available
information).
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\24\ See Financial Accounting Standards Board (``FASB'')
Accounting Standards Update No. 2016-13, Financial Instruments--
Credit Losses (Topic 326): Measurement of Credit Losses on Financial
Instruments (June 2016).
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The Board acknowledges that given the subjective assumptions and
measurement uncertainty inherent in many estimates, bias cannot be
eliminated entirely. However, a standard that reinforces the importance
of professional skepticism, including addressing the potential for
management bias, when auditing estimates will remind auditors of their
existing responsibilities to evaluate contradictory evidence and to
address the effects of bias on the financial statements.
Some commenters suggested that the standard include guidance on
identifying and testing relevant controls over accounting estimates.
For example, one commenter suggested guidance related to auditor
consideration of management's controls over selection and supervision
of a company specialist. Another commenter suggested additional
guidance on identification and testing of relevant controls, and
identification and response to risks of material misstatement due to
fraud in relation to auditing estimates.
The auditor's responsibilities for testing controls are already
addressed in AS 2110, AS 2301, and AS 2201, An Audit of Internal
Control Over Financial Reporting That Is Integrated with An Audit of
Financial Statements. These requirements apply to controls over
accounting estimates. Those responsibilities are not altered by the new
standard and related amendments. However, after considering the
comments, an amendment was made to provide additional direction on
testing controls related to auditing estimates.
Overview of Final Rules
The Board has adopted a single standard to replace the accounting
estimates standard, the fair value standard, and the derivatives
standard. As described in more detail below, AS 2501 (Revised) includes
a special topics appendix that addresses certain matters relevant to
auditing the fair value of financial instruments. In addition, several
PCAOB auditing standards will be amended to align them with the new
standard on auditing accounting estimates. The new standard and related
amendments will make the following changes to existing requirements:
Provide direction to prompt auditors to devote greater
attention to addressing potential management bias in accounting
estimates, as part of applying professional skepticism. In this regard,
the new standard and related amendments will:
Amend AS 2110 to require a discussion among the key
engagement team members of how the financial statements could be
manipulated through management bias in accounting estimates in
significant accounts and disclosures.
Emphasize certain key requirements to focus auditors on
their obligations, when evaluating audit results, to exercise
professional skepticism, including evaluating whether management bias
exists.
Remind auditors that audit evidence includes both
information that supports and corroborates the company's assertions
regarding the financial statements and information that contradicts
such assertions.
Require the auditor to identify significant assumptions
used by the company and describe matters the auditor should take into
account when identifying those assumptions.
Provide examples of significant assumptions (important to
the recognition or measurement of the accounting estimate), such as
assumptions that are susceptible to manipulation or bias.
Emphasize requirements for the auditor to 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.
Explicitly require the auditor, when developing an
independent expectation of an accounting estimate, to have a reasonable
basis for the assumptions and method he or she uses.
Require that the auditor obtain an understanding of
management's analysis of critical accounting estimates and take that
understanding into account when evaluating the reasonableness of
significant assumptions and potential management bias.
Recast certain existing requirements using terminology
that encourages maintaining a skeptical mindset, such as ``evaluate''
and ``compare'' instead of ``corroborate.''
Strengthen requirements for evaluating whether data was
appropriately used by a company that build on requirements in the fair
value standard, and include a new requirement for evaluating whether a
company's change in the source of data is appropriate.
Clarify the auditor's responsibilities for evaluating data
that build on the existing requirements in AS 1105.
Amend AS 2401, Consideration of Fraud in a Financial
Statement Audit,
[[Page 13402]]
to clarify the auditor's responsibilities when performing a
retrospective review of accounting estimates and align them with the
requirements in the new standard.
Extend certain key requirements in the fair value standard
to other accounting estimates in significant accounts and disclosures
to reflect a more uniform approach to substantive testing. For
estimates not currently subject to the fair value standard, this will:
Refine the three substantive approaches common to the
accounting estimates standard to include more specificity, similar to
the fair value standard.
Describe the auditor's responsibilities for testing the
individual elements of the company's process used to develop the
estimate (i.e., methods, data, and significant assumptions).
Set forth express requirements for the auditor to evaluate
the company's methods for developing the estimate, including whether
the methods are:
In conformity with the requirements of the applicable
financial reporting framework; and
Appropriate for the nature of the related account or
disclosure, taking into account the auditor's understanding of the
company and its environment.
Require the auditor to take into account certain factors
in determining whether significant assumptions that are based on the
company's intent and ability to carry out a particular course of action
are reasonable.
Further integrate requirements with the risk assessment
standards to focus auditors on estimates with greater risk of material
misstatement. The new standard and related amendments incorporate
specific requirements relating to accounting estimates into AS 2110 and
AS 2301 to inform the necessary procedures for auditing accounting
estimates. Specifically, the new standard and related amendments would:
Amend AS 2110 to include risk factors specific to
identifying significant accounts and disclosures involving accounting
estimates.
Align the scope of the new standard with AS 2110 to apply
to accounting estimates in significant accounts and disclosures.
Amend AS 2110 to set forth requirements for obtaining an
understanding of the company's process for determining accounting
estimates.
Require auditors to respond to significantly differing
risks of material misstatement in the components of accounting
estimates, consistent with AS 2110.
Remind auditors of their responsibility to evaluate
conformity with the applicable financial reporting framework,
reasonableness, and potential management bias and its effect on the
financial statements when responding to the risks of material
misstatement in accounting estimates in significant accounts and
disclosures.
Require the auditor, when identifying significant
assumptions, to take into account the nature of the accounting
estimate, including related risk factors, the applicable financial
reporting framework, and the auditor's understanding of the company's
process for developing the estimate.
Include matters relevant to identifying and assessing
risks of material misstatement related to the fair value of financial
instruments.
Add a note in AS 2301 to emphasize that performing
substantive procedures for the relevant assertions of significant
accounts and disclosures involves testing whether the significant
accounts and disclosures are in conformity with the applicable
financial reporting framework.
Add a note to AS 2301 providing that for certain estimates
involving complex models or processes, it might be impossible to design
effective substantive tests that, by themselves, would provide
sufficient appropriate evidence regarding the assertions.
Make other updates to the requirements for auditing
accounting estimates, including:
Update the description of what constitutes an accounting
estimate to encompass the general characteristics of the variety of
accounting estimates, including fair value measurements, in financial
statements.
Set forth specific requirements for evaluating data and
pricing information used by the company or the auditor that build on
the existing requirements in AS 1105.
Establish more specific requirements for developing an
independent expectation that vary depending on the source of data,
assumptions, or methods used by the auditor and build on AS 2810 to
provide a requirement when developing an independent expectation as a
range.
Relocate requirements in the derivatives standard for
obtaining audit evidence when the valuation of investments is based on
investee results as an appendix to AS 1105.
Provide specific requirements and direction to address
auditing the fair value of financial instruments, including:
Establish requirements to determine whether pricing
information obtained from third parties, such as pricing services and
brokers or dealers, provides sufficient appropriate evidence,
including:
Focus auditors on the relevance and reliability of pricing
information from third-party sources,\25\ regardless of whether the
pricing information was obtained by the company or the auditor.
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\25\ The requirements in this area focus primarily on pricing
information from pricing services and brokers or dealers, but also
cover pricing information obtained from other third-party pricing
sources, such as exchanges and publishers of exchange prices.
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Establish factors that affect relevance and reliability of
pricing information obtained from a pricing service.
Require the auditor to perform additional audit procedures
to evaluate the process used by the pricing service when fair values
are based on transactions of similar financial instruments.
Require the auditor to perform additional procedures on
pricing information obtained from a pricing service when no recent
transactions have occurred for either the financial instrument being
valued or similar financial instruments.
Establish conditions under which less information is
needed about particular methods and inputs of individual pricing
services in circumstances where prices are obtained from multiple
pricing services.
Establish factors that affect the relevance and
reliability of quotes from brokers or dealers.
Require the auditor to understand, if applicable, how
unobservable inputs were determined and evaluate the reasonableness of
unobservable inputs.
The Board seeks to improve the quality of auditing in this area and
believes these changes strengthen and enhance the requirements for
auditing accounting estimates.
Commenters largely supported a single, more uniform standard to
address auditing accounting estimates, including fair value
measurements. For example, one commenter observed that the existence of
three related standards in this area made it difficult for auditors to
navigate to be certain that all requirements were met. A few
commenters, however, asserted that fair value measurements and
derivatives are unique and involve different functions. One of those
commenters also expressed concern about applying audit procedures in
the fair value standard to other accounting estimates. The new standard
takes into account the unique
[[Page 13403]]
aspects of auditing fair value measurements, such as the use of
observable and unobservable inputs. Further, the new standard includes
a separate appendix that addresses auditing the fair value of financial
instruments.
Some commenters requested supplemental or implementation guidance
for various requirements presented in the proposed standard and the
related amendments. Several commenters also advocated for retaining
portions of the derivatives standard that, in their view, provided
helpful guidance. Two commenters suggested that the Board consider
issuing guidance specific to the audits of brokers and dealers.\26\
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\26\ See below for further discussion of the comments received
on specific requirements and additional guidance on the
implementation of the requirements in the new standard.
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A few commenters observed that the proposal did not explicitly
address how advances in technology, including use of data analytics,
could affect audit procedures. In its consideration of the new standard
and related amendments, the Board is mindful of the significant
advances in technology that have occurred in recent years, including
increased use of data analysis tools and emerging technologies. An
increased use of these technology-based tools, together with future
developments in the use of data and technology, could have a
fundamental impact on the audit process. The Board is actively
exploring these potential impacts through ongoing staff research and
outreach.\27\
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\27\ For example, the staff is currently researching the effects
on the audit of, among other things, data analytics, artificial
intelligence, and distributed ledger technology, assisted by a task
force of the SAG. See Data and Technology Task Force overview page,
available on the Board's website.
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In the context of this rulemaking, the Board considered how changes
in technology could affect the approaches to auditing accounting
estimates. The Board believes that the new standard and related
amendments are sufficiently principles-based and flexible to
accommodate continued advances in the use of data and technology by
both companies and auditors. The Board will continue to monitor
advances in this area and any implications related to the standard.\28\
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\28\ See PCAOB, Changes in Use of Data and Technology in the
Conduct of Audits, available at https://pcaobus.org/Standards/research-standard-setting-projects/Pages/technology.aspx.
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Some commenters advocated for greater alignment of the proposal
with the IAASB's exposure draft on International Standard on Auditing
540 (``ISA 540'') \29\ to achieve greater consistency in practice, and
suggested continued coordination of efforts in this area. The Board
considered the IAASB's ISA 540 project while developing the new
standard. While there is some commonality between the new standard and
ISA 540 Revised, the new standard is aligned with the Board's risk
assessment standards and designed for audits of issuers and SEC-
registered brokers and dealers.
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\29\ See IAASB Exposure Draft, Proposed ISA 540 (Revised),
Auditing Accounting Estimates and Related Disclosures, (Apr. 20,
2017). In October 2018, the IAASB released the final standard (``ISA
540 Revised'').
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Following is a discussion of significant comments received on the
proposal along with revisions made by the Board after consideration of
those comments and additional guidance on the implementation of the
requirements of the new standard. The subsections also include a
comparison of the final requirements with the analogous requirements of
the following standards issued by the IAASB and the Auditing Standards
Board (``ASB'') of the American Institute of Certified Public
Accountants:
ISA 540 Revised, adopted by the IAASB; and
AU-C Section 540, Auditing Accounting Estimates, Including
Fair Value Accounting Estimates, and Related Disclosures (``AU-C
Section 540''), adopted by the ASB of the American Institute of
Certified Public Accountants.
The comparison does not necessarily represent the views of the
IAASB or ASB regarding the interpretation of their standards.
Additionally, the information presented in the subsections does not
include the application and explanatory material in the IAASB standards
or ASB standards.\30\
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\30\ Paragraph A59 of ISA 200, Overall Objectives of the
Independent Auditor and the Conduct of an Audit in Accordance with
International Standards on Auditing, and paragraph .A64 of AU-C
Section 200, Overall Objectives of the Independent Auditor and the
Conduct of an Audit in Accordance with Generally Accepted Auditing
Standards, indicate that the related application and other
explanatory material ``does not in itself impose a requirement'' but
``is relevant to the proper application of the requirements'' of the
respective standards.
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AS 2501 (Revised)
Scope of the Standard
See Paragraphs .01-.02
As in the proposal, the new standard applies when auditing
accounting estimates in significant accounts and disclosures.
Commenters on this topic supported the scope set forth in the standard.
Comparison With Standards of Other Standard Setters
The scope and nature of accounting estimates described in ISA 540
Revised, AU-C Section 540, and the new standard share some common
concepts. However, the accounting estimates covered by the new standard
are expressly linked to significant accounts and disclosures.
Objective of the Standard
See Paragraph .03
In the proposal, the standard included a detailed objective
expressly addressing the fundamental aspects of auditing accounting
estimates under the estimates standards: Testing and evaluating whether
accounting estimates (1) are reasonable in the circumstances, (2) have
been accounted for and disclosed in conformity with the applicable
financial reporting framework, and (3) are free from bias that results
in material misstatement.
Commenters asserted that including the phrase ``free from bias that
results in material misstatement'' as a distinct element of the audit
objective was not clear, could imply absolute assurance, or could be
interpreted as a broader obligation than what is required under the
existing standards. Some commenters recommended deleting the reference
to bias from the objective, and others suggested revisions in order to
clarify the intent of including the reference to bias in the objective.
One commenter suggested that the objective should be for auditors to
determine whether accounting estimates and disclosures are reasonable
in the context of the applicable financial reporting framework, which
in the commenter's view would be broader than the proposed objective.
After consideration of comments, the Board has (1) revised the
objective to describe the overall purpose of the procedures required
under the new standard and other relevant procedures under the risk
assessment standards (specifically, to determine whether accounting
estimates in significant accounts and disclosures are properly
accounted for and disclosed in financial statements); \31\ (2)
relocated the description of more specific auditor responsibilities--
evaluating conformity with the applicable financial reporting
framework, reasonableness, and potential management bias--from the
[[Page 13404]]
objective to the requirements; \32\ and (3) provided additional context
in the requirements to enhance clarity, including citing corresponding
requirements in other PCAOB standards. In addition, for conciseness,
the new standard and amendments have been revised to consistently use
the phrase ``sufficient appropriate evidence,'' which has the same
meaning in PCAOB standards as the phrase ``sufficient appropriate audit
evidence.''
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\31\ This approach to formulating an objective is similar to the
approach in other PCAOB standards. See, e.g., paragraph .02 of AS
2410, Related Parties.
\32\ See first note to paragraph .05 of the new standard.
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As discussed in more detail below, the revised objective links more
closely with the requirements of the risk assessment standards \33\ and
continues to focus auditors on their existing obligations to evaluate
potential management bias in the context of auditing accounting
estimates.
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\33\ See supra note 3. The risk assessment standards set forth
requirements relating to the auditor's assessment of, and response
to, the risks of material misstatement in the financial statements.
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Comparison With Standards of Other Standard Setters
The objective of ISA 540 Revised is to obtain sufficient
appropriate audit evidence about whether accounting estimates and
related disclosures in the financial statements are reasonable in the
context of the applicable financial reporting framework. The objective
of AU-C Section 540 is substantially the same but also includes whether
related disclosures in the financial statements are adequate.
Identifying and Assessing Risks of Material Misstatement
See Paragraph .04
The proposed standard discussed how the auditor's responsibilities
regarding the process of identifying and assessing risks of material
misstatement, as set forth in AS 2110 apply to auditing accounting
estimates. The proposed requirement provided that, among other things,
identifying and assessing risks of material misstatement related to
accounting estimates includes determining whether the components of
estimates in significant accounts and disclosures are subject to
significantly differing risks, and which estimates are associated with
significant risks.\34\
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\34\ See AS 2110.70-.71.
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One commenter asserted that the term ``components'' should be
defined and another commenter observed that ``components of estimates''
could be interpreted to mean inputs used to develop the estimate, or
individual accounts that roll up into a financial statement line item.
AS 2501 (Revised) retains paragraph .04 as proposed, including the
reference to components of estimates. This reference is not new and
derives from the concept in the risk assessment standards that
components of a potential significant account or disclosure might be
subject to significantly differing risks \35\ which would need to be
taken into account in designing and performing audit procedures. For
example, a valuation allowance in the company's financial statements
may include a general component and a specific component with differing
risks.
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\35\ See AS 2110.63.
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Comparison With Standards of Other Standard Setters
In identifying and assessing the risks of material misstatement,
ISA 540 Revised requires the auditor to separately assess inherent risk
and control risk. The auditor is required to take into account, in
assessing inherent risk (a) the degree to which the accounting estimate
is subject to estimation uncertainty, and (b) the degree to which (i)
the selection and application of the method, assumptions and data in
making the accounting estimate; or (ii) the selection of management's
point estimate and related disclosures for inclusion in the financial
statements, are affected by complexity, subjectivity, or other inherent
risk factors.\36\
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\36\ ISA 540 Revised and AU-C Section 540 also include
requirements related to identification of significant risks related
to accounting estimates. AS 2110 sets forth requirements for
identifying significant risks under PCAOB standards.
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AU-C Section 540 requires the auditor to evaluate the degree of
estimation uncertainty associated with an accounting estimate in
identifying and assessing the risks of material misstatement.
Responding to the Risks of Material Misstatement
See Paragraphs .05-.07
The proposed standard explained how the basic requirement in AS
2301 to respond to the risks of material misstatement applies when
performing substantive procedures for accounting estimates in
significant accounts and disclosures. Additionally, the proposal
provided that responding to risks of material misstatement in the
context of accounting estimates involves, among other things, (1)
testing whether estimates in significant accounts and disclosures are
in conformity with the applicable financial reporting framework, (2)
responding to significantly differing risks of material misstatement in
the components of an accounting estimate, and (3) applying professional
skepticism in gathering and evaluating audit evidence, particularly
when responding to fraud risks. The proposed standard also reminded
auditors that, as the assessed risk of material misstatement increases,
the evidence that the auditor should obtain also increases. The
evidence provided by substantive procedures depends on the mix of the
nature, timing, and extent of those procedures.
Commenters provided views on various aspects of the proposed
requirements. One commenter asked for clarification on the role of
professional skepticism in relation to fraud risks and management bias.
Another commenter advocated for a framework against which auditor
skepticism can be evaluated. Other commenters suggested including
requirements to evaluate both corroborative and contradictory audit
evidence similar to AS 1105.02. A few commenters also requested
clarification of how substantive procedures related to accounting
estimates can be performed at an interim date.
The new standard retains the discussion of the auditor's
responsibilities for responding to risks associated with estimates
substantially as proposed. The statements in the new standard related
to responding to the risks of material misstatement are rooted in the
Board's risk assessment standards and drew no critical comments.
The new standard reflects two changes from the proposal. As noted
above, the description of more specific auditor responsibilities--
evaluating conformity with the applicable accounting framework,
reasonableness, and potential management bias--has been relocated from
the objective to paragraph .05 to provide additional context for
responding to risks of material misstatement. Specifically, the new
standard states that responding to risks of material misstatement
involves evaluating whether the accounting estimates are in conformity
with the applicable financial reporting framework and reasonable in the
circumstances, as well as evaluating potential management bias in
accounting estimates and its effect on the financial statements.
Notably, the added language regarding potential management bias is
aligned with paragraphs AS 2810.24-.27 to remind auditors of existing
requirements.
Additionally, the new standard now includes a reference to AS
1105.02, as suggested by some commenters, reminding auditors that audit
evidence consists of both information that
[[Page 13405]]
supports and corroborates management's assertions regarding the
financial statements and information that contradicts such assertions.
With respect to the comments regarding guidance on professional
skepticism and performing procedures at interim dates, other PCAOB
standards already address the auditor's responsibilities in those
areas, and the new standard does not change that direction with respect
to auditing estimates. For example, paragraphs .07-.09 of AS 1015, Due
Professional Care in the Performance of Work, paragraph .13 of AS 2401,
and AS 2301.07 address the appropriate application of professional
skepticism, and AS 2301.43-.46 discusses the auditor's responsibilities
when performing substantive procedures at an interim date. Those
standards apply when auditing accounting estimates.
Scalability of the Standard
In response to questions in the proposal, commenters expressed
mixed views on the scalability of the proposed requirements. Some
commenters indicated that the proposed requirements were sufficiently
scalable, while others identified challenges in scaling the auditor's
response to identified risks in accounting estimates and requested
additional guidance. For example, some commenters opined that it was
not clear how auditors would tailor their response to an estimate that
represented a significant risk of material misstatement compared with a
lower risk estimate. One commenter advocated for further guidance to
address situations where an estimate is deemed to have a low inherent
risk. Another commenter indicated that it is important to recognize
that the amount of evidence may not necessarily increase, but the
persuasiveness and sufficiency of the evidence should increase.
The new standard is designed to be scalable because the necessary
audit evidence depends on the corresponding risk of material
misstatement. The standard does not prescribe detailed procedures or
the extent of procedures, beyond the requirement to respond to the
risk, including significant risk, and the direction for applying the
primary approaches for testing. Rather, it builds on the requirements
of AS 2301 to design procedures that take into account the types of
potential misstatements that could result from the identified risks and
the likelihood and magnitude of potential misstatement.\37\ Specific
risk factors associated with the estimates--for example, subjective
assumptions, measurement uncertainty, or complex processes or methods
\38\--would affect the auditor's risk assessment and in turn, the
required audit effort. For example:
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\37\ AS 2301.09.
\38\ See AS 2110.60A, as amended, for examples of specific risk
factors.
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Testing a simple calculation of depreciation expense,
including evaluating remaining useful lives, for a group of assets of
the same type with similar usage and condition would generally require
less audit effort than testing asset retirement obligations that
involve significant assumptions about costs not yet incurred based on
estimation of the probability of future events.
In testing the valuation of assets acquired and
liabilities assumed in a business combination, more audit effort would
need to be directed to assets and liabilities whose valuation involves
more subjective assumptions, such as identifiable intangible assets and
contingent consideration, than to assets with readily determinable
values.
Additionally, the new standard echoes language from AS 2301.37 in
stating that, as the assessed risk of material misstatement increases,
the evidence from substantive procedures that the auditor should obtain
also increases. Consistent with AS 2301, for an individual accounting
estimate, different combinations of the nature, timing, and extent of
testing might provide sufficient appropriate evidence to respond to the
assessed risk of material misstatement for the relevant assertion.
Selection of Approaches
The proposed standard retained the requirement to test accounting
estimates using one or a combination of three basic approaches from the
estimates standards: (1) Testing the company's process, (2) developing
an independent expectation, and (3) evaluating audit evidence from
events or transactions occurring after the measurement date. The
proposed standard also included a note reminding auditors that their
understanding of the process the company used to develop the estimate,
along with results of tests of relevant controls, should inform the
auditor's decisions about the approach he or she takes to auditing an
estimate.
Several commenters expressed support for retaining the three common
approaches, as set forth in the proposal. Other commenters indicated
that the proposal should emphasize that testing the company's process
may not always be the best audit approach; with one commenter noting
that the proposed requirement may lead auditors to test management's
process substantively, regardless of whether another approach will
provide the same or more persuasive audit evidence. Two commenters
stressed the importance of developing an independent expectation and
suggested this approach be selected in addition to testing the
company's process. None of these commenters, however, suggested that
the selection of substantive approaches should be limited.
Some commenters sought further direction on how the auditor would
obtain sufficient evidence when using a combination of approaches, with
some commenters asserting that, for example, the proposed requirement
might result in inconsistent application or auditors unnecessarily
performing all procedures under each approach. One commenter asked the
Board to clarify whether documentation of a specific testing approach
is expected.
Some commenters also requested guidance on the application of
specific testing approaches. For instance, one commenter suggested that
the Board consider directing auditors to always evaluate audit evidence
from events or transactions occurring after the measurement date
related to the accounting estimate, as, in their view, there would be
limited circumstances in which this approach would not provide
appropriate audit evidence to determine whether accounting estimates
are reasonable. Another commenter added that events occurring after the
measurement date may effectively eliminate estimation uncertainty,
which affects risk assessment and the audit response related to
valuation. This commenter suggested the proposal clarify the extent of
additional procedures required, if any, when such events are considered
and tested.
One commenter suggested more guidance be provided about how an
auditor's understanding of management's process affects the auditor's
planned response to assessed risk in accordance with AS 2301. This
commenter also observed that the note to paragraph .07 may be read to
mean that relevant controls are expected to be tested in all audits and
suggested a footnote reference to relevant requirements of AS 2301.
The new standard retains the requirements for testing accounting
estimates substantially as proposed, allowing the auditor to determine
the approach or combination of approaches appropriate for obtaining
sufficient appropriate evidence to support a conclusion about the
particular accounting estimate being audited. The
[[Page 13406]]
new standard takes into account that accounting estimates vary in
nature and in how they are developed. Therefore, mandating a particular
testing approach may not be feasible or practical in the circumstances.
For example, in some cases, data and significant assumptions underlying
the estimate may be largely based on a company's internal information
(e.g., sales projections or employee data), or the estimate may be
generated using a customized company-specific model. In those
situations, the auditor may not have a reasonable alternative to
testing the company's process. Similarly, there may not be any events
or transactions occurring after the measurement date related to certain
estimates (e.g., the outcome of a contingent liability might not be
known for a number of years). Rather than imposing limits on the
selection of approaches, the new standard describes the auditor's
responsibilities for appropriately applying the selected approach, or
combination of approaches, to obtain sufficient appropriate evidence
and performing an appropriate evaluation of the evidence obtained.
As under the estimates standards, the new standard allows for the
auditor to use a combination of approaches to test an estimate. For
example, some estimates consist of multiple components (e.g., valuation
allowances) and the auditor may vary the approaches used for the
individual components. The auditor may also choose to develop an
independent expectation of a significant assumption used by the company
in conjunction with testing the company's process for developing the
estimate. Whether using a combination of approaches or a single
approach, the auditor is required to have a reasonable basis for using
alternative methods or deriving his or her own assumptions, as
discussed in more detail below. Similarly, when using information
produced by the company as audit evidence, the auditor is required to
evaluate whether that information is sufficient and appropriate for the
purposes of the audit, regardless of the approach the auditor uses to
test the estimate.\39\
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\39\ See AS 1105.10.
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The new standard also carries forward the point from the accounting
estimate standard that the auditor's understanding of the company's
process for developing the estimate, and, if relevant controls are
tested, the results of those tests, informs the auditor's decision
about which approach or approaches to take. AS 2301 describes the
auditor's responsibilities for testing controls in a financial
statement audit. The new standard does not change those
responsibilities, including the circumstances under which the auditor
is required to test controls. Rather, the standard emphasizes that the
results of the auditor's tests of controls can affect the nature,
timing and extent of planned substantive procedures. Further, the
auditor's understanding of the company's process related to an estimate
can provide insight into the nature and extent of available audit
evidence, and thus inform the auditor's selection of approaches.
Lastly, the new standard does not set forth requirements for audit
documentation. The auditor's responsibilities with respect to audit
documentation are addressed in AS 1215, Audit Documentation.
Accordingly, audit documentation relevant to selection of approaches
should be evident to an experienced auditor, having no previous
connection with the engagement.\40\
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\40\ See AS 1215.06.
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Comparison With Standards of Other Standard Setters
ISA 540 Revised requires the auditor's procedures to be responsive
to the assessed risks of material misstatement at the assertion level,
considering the reasons for the assessment given to those risks, and
include one or more of the three approaches to substantive testing
(similar to the new standard).\41\
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\41\ ISA 540 Revised also includes requirements for tests of
controls. AS 2301 sets forth requirements for tests of controls in
financial statement audits under PCAOB standards.
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ISA 540 Revised also includes a requirement for the auditor to take
into account that the higher the assessed risk of material
misstatement, the more persuasive the audit evidence needs to be. The
auditor is required to design and perform further audit procedures in a
manner that is not biased towards obtaining audit evidence that may be
corroborative or towards excluding audit evidence that may be
contradictory.
AU-C Section 540 requires the auditor to determine whether
management has appropriately applied the requirements of the applicable
financial reporting framework relevant to the accounting estimate. In
responding to the assessed risks of material misstatement, AU-C Section
540 also requires the auditor to undertake one or more of the three
approaches discussed above, as well as providing an approach to perform
a combination of tests of controls over the estimate along with
substantive procedures.
Testing the Company's Process Used To Develop the Accounting Estimate
See Paragraph .09
The proposed standard included an introductory statement explaining
the purpose of and steps involved in testing the company's process.
Specifically, the standard explained that testing the company's process
involves performing procedures to test and evaluate the methods, data,
and significant assumptions used to develop the company's estimate in
order to form a conclusion about whether the estimate is reasonable in
the circumstances, in conformity with the applicable financial
reporting framework, and free from bias that results in material
misstatement.
Similar to the comments received on the proposed objective, some
commenters expressed concerns about the phrase ``free from bias that
results in material misstatement'' when describing the auditor's
responsibilities in this area. One commenter also asked whether these
requirements would apply to assumptions, models, and data provided by a
company specialist. Another commenter sought clarification on the
meaning of the terms ``test,'' ``data,'' and ``assumptions.''
As with the objective of the standard, paragraph .09 of the new
standard was revised to describe an overarching concept for testing the
company's process--that is, to form a conclusion about whether the
estimate is properly accounted for and disclosed in financial
statements. These revisions are responsive to comments and link the
auditor's responsibilities more closely to the requirements of the
Board's risk assessment standards.
As discussed in more detail below, the new standard directs the
auditor to look to the requirements in Appendix A of AS 1105 \42\ for
the auditor's responsibilities with respect to using the work of a
company's specialist in the audit. This direction has been modified
from the proposal to align with changes to the Specialists Release.
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\42\ The auditor's responsibilities with respect to using the
work of a company specialist are presented as Appendix A of AS 1105.
See supra note 2.
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Finally, the meaning of the terms ``test,'' ``data,'' and
``assumptions'' in the new standard is consistent with the meaning of
these terms used in the estimates standards and other PCAOB standards.
Comparison With Standards of Other Standard Setters
ISA 540 Revised provides that, as part of testing how management
made the accounting estimate, the auditor is
[[Page 13407]]
required to perform procedures to obtain sufficient appropriate audit
evidence regarding the risks of material misstatement relating to (a)
selection and application of the methods, significant assumptions and
the data used by management in making the accounting estimate, and (b)
how management selected the point estimate and developed related
disclosures about estimation uncertainty.\43\
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\43\ The Board's risk assessment standards address the auditor's
responsibilities for responding to risks of material misstatement
and obtaining sufficient appropriate evidence.
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AU-C Section 540 provides that as part of testing how management
made the accounting estimate and the data on which it is based, the
auditor should evaluate whether the method of measurement used is
appropriate in the circumstances, the assumptions used by management
are reasonable in light of the measurement objectives of the applicable
financial reporting framework, and the data on which the estimate is
based is sufficiently reliable for the auditor's purposes.
Evaluating the Company's Methods
See Paragraphs .10-.11
The proposed standard provided that the auditor should evaluate
whether the methods used by the company are (1) in conformity with the
applicable financial reporting framework, including evaluating whether
the data and significant assumptions are appropriately applied; and (2)
appropriate for the nature of the related account or disclosure and the
company's business, industry, and environment. The proposed
requirements were similar to certain requirements of the fair value
standard.\44\
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\44\ See AS 2502.15 and .18.
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A number of commenters expressed concerns about the requirement to
evaluate whether the company's methods are appropriate for the
company's ``business, industry, and environment'' because in their
view, the requirement seemed to suggest all companies within a
particular industry use, or should use, the same method. Two commenters
also suggested adding specific requirements--to evaluate models used by
the company and test the mathematical accuracy of the calculations used
by the company to translate its assumptions into the accounting
estimate. One commenter sought clarification on the intent of the
requirement to evaluate whether the data and significant assumptions
are appropriately applied under the applicable financial reporting
framework.
The new standard retains substantially as proposed the requirement
to evaluate whether the methods used by the company are in conformity
with the applicable financial reporting framework, including evaluating
whether the data is appropriately used and significant assumptions are
appropriately applied under the framework. The applicable financial
reporting framework may prescribe a specific method to develop an
estimate or allow for alternative methods, or provide guidance on how
to apply the method, including guidance on the selection or use of
assumptions or data. Evaluating whether the company's method is in
conformity with the financial reporting framework involves evaluating
whether the data is appropriately used and significant assumptions are
appropriately applied by the method, which, if applicable, would
include testing the mathematical accuracy of the calculations under the
method.
The methods used by the company may involve the use of a model
(e.g., expected future cash flows). The new standard does not prescribe
specific procedures for testing models, as suggested by one
commenter.\45\ The Board believes that requirements specific to models
are not necessary because evaluating the method, as discussed above,
includes consideration of models to the extent necessary to reach a
conclusion on the appropriateness of the method. Under the new
standard, the necessary audit procedures to evaluate the method used by
the company (which, as appropriate, include models involved in the
method) are commensurate with the assessed risks associated with the
estimate. For example, the risks associated with a method that uses a
commercially available valuation model may relate to whether the model
is appropriate for the related estimate under the applicable financial
reporting framework, whereas the risks associated with a method that
uses an internally-developed company model may include additional risks
associated with how the model was developed. In this example, the
internally-developed model scenario would require greater audit effort
to respond to the broader range of risks, as compared to the
commercially available model scenario. In either case, the auditor
would evaluate whether the method was used appropriately, including
whether adjustments, if any, to the output of the model were
appropriate.
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\45\ This commenter advocated for the approach taken by the
IAASB regarding models. ISA 540 Revised requires that, when
management's application of the method involves complex modeling,
the auditor's procedures address whether judgments have been applied
consistently and, when applicable, whether (1) the design of the
model meets the measurement objective of framework, is appropriate
in the circumstances, and changes from the prior period's model are
appropriate in the circumstances; and (2) adjustments to the output
of the model are consistent with the measurement objective and are
appropriate in circumstances.
---------------------------------------------------------------------------
After consideration of comments, the requirement regarding
evaluating the appropriateness of the method was revised to remove the
reference to the company's business and industry. Under the new
standard, the auditor is required to evaluate whether the company's
method is appropriate for the nature of the related account or
disclosure, taking into account the auditor's understanding of the
company and its environment. This revised requirement is consistent
with the risk assessment standards because the auditor's evaluation of
the method (a substantive procedure) is informed by the auditor's
understanding of the company and its environment (obtained through the
auditor's risk assessment procedures).\46\ Notably, part of the
auditor's procedures for obtaining an understanding of the company and
its environment include obtaining an understanding of relevant
industry, regulatory, and other external factors, and evaluating the
company's selection and application of accounting principles.\47\
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\46\ Additionally, AS 2301.05d requires the auditor to evaluate
whether the company's selection and application of significant
accounting principles, particularly those related to subjective
measurements and complex transactions, are indicative of bias that
could lead to material misstatement of the financial statements.
\47\ AS 2110.09 and .12-.13.
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The proposed standard also addressed circumstances in which a
company has changed its method for developing an accounting estimate by
requiring the auditor to determine the reasons for and evaluate the
appropriateness of such change.
One commenter asserted that it would be more appropriate to require
the auditor to evaluate whether the company's reasons for making the
change are appropriate. This commenter also sought clarification on
what constitutes a change in method and on the auditor's responsibility
when the company has not made a determination about whether different
methods result in significantly different estimates. Another commenter
expressed concern that, because of a lack of clarity about the
definition of ``method'' and what
[[Page 13408]]
constitutes a change, the proposed requirement could result in
potentially onerous documentation necessary to support changes to
methods. Finally, one commenter suggested adding a requirement for the
auditor to evaluate whether the company failed to revise its method to
recognize changes in facts and circumstances.
The new standard retains as proposed the requirements for the
auditor to (1) determine the reasons for changes to the method used by
the company and evaluate the appropriateness of such change, and (2)
evaluate the appropriateness of methods selected by the company in
circumstances where the company has determined that different methods
could result in significantly different estimates. The requirements in
the new standard are similar to those in the fair value standard \48\
and consistent with the auditor's responsibilities to obtain an
understanding of the company's process used to develop the estimate,
including the methods used.\49\ These requirements also take into
account that, in some cases, more than one method may be used to
develop a particular estimate. It is important for the auditor to
understand the basis for the company's change to its method, as changes
that are not based on new information or other changes in the company's
circumstances could be indicative of management bias (e.g., changing
the method to achieve a favorable financial result).\50\
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\48\ AS 2502.19.
\49\ See AS 2110.28, as amended.
\50\ See AS 2810 for requirements related to evaluating bias in
accounting estimates.
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With respect to other comments raised above, a separate requirement
to evaluate whether the company failed to revise its method to
recognize changes in facts and circumstances is unnecessary as auditors
would make this determination when evaluating appropriateness of the
method for the nature of the account or disclosure, taking into account
the auditor's understanding of the company and its environment. That
understanding should inform the auditor about conditions which might
indicate that a change in method is needed. For example, the use of a
discounted cash flow method to value a financial instrument may no
longer be appropriate once an active market is introduced for the
instrument. Moreover, changes to the method could result in a change to
the corresponding estimate and affect the consistency of the financial
statements (as discussed in AS 2820, Evaluating Consistency of
Financial Statements).\51\ In addition, contrary to the views of one
commenter, the new standard does not impose any new documentation
requirements to the existing provisions of AS 1215.
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\51\ See also FASB Accounting Standards Codification Topic 250,
Accounting Changes and Error Corrections.
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Comparison With Standards of Other Standard Setters
ISA 540 Revised provides that the auditor's procedures shall
address (a) whether the method selected is appropriate in the context
of the applicable financial reporting framework, and, if applicable,
whether changes from the method used in prior periods are appropriate;
(b) whether judgments made in selecting the method give rise to
indicators of possible management bias; (c) whether the calculations
are applied in accordance with the method and are mathematically
accurate; and (d) whether the integrity of the significant assumptions
and the data has been maintained in applying the method.\52\
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\52\ See supra note 45 for additional requirements related to
models.
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AU-C Section 540 requires the auditor to determine whether the
methods for making the accounting estimate are appropriate and have
been applied consistently, and whether changes, if any, in accounting
estimates or in the method for making them from the prior period are
appropriate in the circumstances. Further, AU-C Section 540 provides
that as part of testing how management made the accounting estimate,
and the data on which it is based, the auditor evaluates whether the
method of measurement used is appropriate in the circumstance.
Testing Data Used
See Paragraphs .12-.14
The proposed standard discussed the auditor's responsibilities for
testing and evaluating both internal and external data. This included
(1) reiterating existing requirements in AS 1105 to test the accuracy
and completeness of information produced by the company, or to test the
controls over the accuracy and completeness of that information; \53\
and (2) requiring the auditor to evaluate the relevance and reliability
\54\ of data from external sources.
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\53\ AS 1105.10.
\54\ AS 1105.07-.08.
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The proposed standard also provided that the auditor should
evaluate 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.
A few commenters called for clarification of various aspects of the
proposed requirements pertaining to data. For example, one commenter
suggested the requirements clarify that company data supplied to a
third party or company specialist is not considered to be data from an
external source. This commenter also asked for a framework for
evaluating whether the source of the company's data has changed from
the prior year and, if so, whether the change is appropriate. Another
commenter sought more clarity on whether the requirement applies to all
data or may be limited to significant data.
Some commenters also suggested additional requirements in this
area. For example, one commenter asserted that the existing
requirements related to completeness and accuracy of data in AS 1105 do
not themselves constitute a procedure that addresses risks of material
misstatement and instead, suggested an express requirement to evaluate
whether the data used in the estimate is accurate and complete. Another
commenter pointed to the existence of data analytics tools as an
alternative to sampling, and advocated for some acknowledgement in the
requirements of the importance of the integrity of these tools and the
controls over their development. One commenter suggested a requirement
to assess whether management has appropriately understood or
interpreted significant data.
The new standard retains the requirements for testing and
evaluating data substantially as proposed, including requirements to
evaluate whether the data is relevant to the measurement objective,
internally consistent, and whether the source of the company's data has
changed from the prior year and if so, whether the change is
appropriate. The new standard builds on the auditor's responsibilities
established by AS 1105, including requirements to test the accuracy and
completeness of information produced by the company. Contrary to the
views of one commenter, AS 1105 currently includes an obligation for
the auditor to test company-produced data. Accordingly, an additional
requirement to evaluate whether the data used in the estimate is
accurate and complete is not necessary. Furthermore, the determination
of the data to be tested--and the nature, timing, and extent of that
testing--
[[Page 13409]]
should be based on and responsive to the assessed risks of material
misstatement.
Consistent with the proposed standard, AS 2501 (Revised) makes a
distinction between procedures to be performed regarding internal data
and procedures regarding data from external sources used by the company
to develop accounting estimates. Examples of internal data include the
company's historical warranty claims and historical losses on defaulted
loans. Examples of external data include economic, market, or industry
data. Company data supplied by the company to a third party or company
specialist is not data from an external source. The new standard also
points auditors to Appendix B of AS 1105 for situations in which the
valuation of an investment is based on the investee's financial
results.
The new standard also retains substantially as proposed
requirements to evaluate whether the data was used appropriately by the
company. Evaluating the manner in which data was used by the company
necessarily builds on the auditor's understanding of the company's
process used to develop the estimate. This includes evaluating whether
the company's selection and use of data is in conformity with the
requirements of the financial reporting framework. Further, devoting
audit attention to changes in the data source might reveal potential
contradictory evidence and help the auditor identify potential
management bias. For example, while a new source of data might result
in an estimate that better reflects a company's specific circumstances,
a change in data source could also be used by a company to achieve a
desired financial result. The new standard has been modified to clarify
that evaluating whether the data is used appropriately includes
evaluating whether the data is internally consistent with its use by
the company in other significant accounts and disclosures based on
similar example procedures in the fair value standard.\55\
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\55\ See AS 2502.39.
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As noted by one commenter, significant advances in technology have
occurred in recent years, including increased use of data analysis
tools. The Board considered how changes in technology could affect the
approaches to auditing accounting estimates and believes that the new
standard and related amendments are sufficiently principles-based and
flexible to accommodate continued advances in the use of data and
technology by both companies and auditors.
Comparison With Standards of Other Standard Setters
ISA 540 Revised provides that the auditor's procedures shall
address (a) whether the data is appropriate in the context of the
applicable financial reporting framework, and, if applicable, changes
from prior periods are appropriate; (b) whether judgments made in
selecting the data give rise to indicators of possible management bias;
(c) whether the data is relevant and reliable in the circumstances; and
(d) whether the data has been appropriately understood or interpreted
by management, including with respect to contractual terms.
AU-C Section 540 provides that in testing how management made the
accounting estimate, and the data on which it is based, the auditor
should evaluate whether the data on which the estimate is based is
sufficiently reliable for the auditor's purposes.
Identification of Significant Assumptions
See Paragraph .15
The proposed standard provided that the auditor should identify
which of the assumptions used by the company are significant
assumptions to the estimate and provided criteria to assist the auditor
in making this determination. Furthermore, the proposed standard
provided that, if the company has identified significant assumptions
used in an estimate, the auditor's identification of significant
assumptions should also include those assumptions.
Some commenters expressed concern about one of the factors to be
considered in identifying significant assumptions--whether an
assumption relates to an identified and assessed risk of material
misstatement. The commenters opined that the factor was too broad and
could result in an excessive number of assumptions being identified as
significant. Some of those commenters suggested adding a note to
describe how all of the factors set forth in the proposal work
together. A few commenters made other suggestions with respect to this
requirement including (1) incorporating the requirement to identify
assumptions used by the company which are important to the recognition
or measurement of the accounting estimate in the financial statements
into AS 2110.28e, as amended; (2) adding a qualifying phrase, such as
``as applicable,'' to the factors because some factors may not always
be relevant or may vary in significance; and (3) incorporating the
concept described in AS 2502.33 that significant assumptions cover
matters that materially affect the estimate.
Some commenters also voiced concerns that the proposed requirement
to include as significant those assumptions that the company has
identified as significant may not be appropriate because (1) management
is not required to designate assumptions as significant, and (2)
auditors and company management may reach different conclusions about
which assumptions are significant. One commenter expressed the view
that the omission of a requirement to identify assumptions beyond what
management identified may be inconsistent with the requirements of AS
2110, and suggested the Board clarify the auditor's responsibilities
when, for example, management has not considered a specific assumption
needed to correctly apply the applicable accounting framework. Another
commenter suggested that assumptions identified by the company as
significant should be reflected as an additional factor relevant to
identifying significant assumptions rather than a requirement.
After consideration of comments received, the requirement was
revised. Specifically, the factor regarding whether an assumption
relates to an identified and assessed risk of material misstatement was
removed. Instead, the new standard requires the auditor to take into
account the nature of the accounting estimate, including related risk
factors,\56\ the requirements of the applicable financial reporting
framework, and the auditor's understanding of the company's process for
developing the estimate when identifying significant assumptions.
Further, the remaining factors from the proposal--sensitivity to
variation, susceptibility to manipulation and bias, unobservable data
or adjustments, and dependence on the company's intent and ability to
carry out specific courses of action--have been reframed in the new
standard as examples of assumptions that would ordinarily be
significant. The examples provided are not intended to be an exhaustive
list of significant assumptions or a substitute for taking into account
the auditor's understanding of the nature of the estimate, including
risk factors, the requirements of the applicable financial reporting
framework, and his or her understanding of the company's process for
developing the estimate. Rather, the examples are provided to
illustrate how the concepts in the new standard can be applied to
identify significant assumptions that are important to the
[[Page 13410]]
recognition or measurement of an accounting estimate. The revised
formulation provides better context for the application of the
requirement, as suggested by some commenters, and prompts auditors to
consider those assumptions that drive or are associated with identified
risks of material misstatement.
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\56\ See AS 2110.60-.60A, as amended.
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The auditor is not expected to document a detailed comparison of
each assumption used in the estimate to each factor or example
described above. Instead, consistent with AS 1215, the auditor should
document the significant assumptions identified and the auditor's
rationale for that determination.
In addition, the proposed note--requiring auditors to include as
significant those assumptions that the company has identified as
significant assumptions--was not included in the new standard. As
discussed above, the new standard requires the auditor, in identifying
significant assumptions, to take into account the auditor's
understanding of the company's process for developing the estimate,
which would include understanding the assumptions used by the company
in that estimate (whether expressly identified or implicit in the
nature of the estimate or method used). This approach addresses
commenter concerns about whether the Board was imposing a
responsibility on management to identify significant assumptions.
The intent of the proposed requirement to include significant
assumptions identified by the company was to provide the auditor with a
starting point for the auditor's evaluation (consistent with the fair
value standard). However, since the revised requirement already focuses
the auditor on understanding the assumptions used by the company to
develop the estimate and the associated risk factors, the new standard
does not include a new factor for assumptions identified as significant
by management, as suggested by a commenter.
Lastly, the requirement to identify significant assumptions was not
relocated to AS 2110.28, as suggested by one commenter, because
identifying significant assumptions is an inherent part of testing the
company's process for developing estimates.
Evaluation of Significant Assumptions
See Paragraphs .16-.18
The proposed standard set forth requirements to evaluate the
reasonableness of significant assumptions used by the company, both
individually and in combination, including evaluating whether (1) the
company has a reasonable basis for those assumptions and, when
applicable, the company's selection of assumptions from a range of
potential assumptions; and (2) significant assumptions are consistent
with, among other things, the company's objectives, historical data,
the economic environment, and market information. In circumstances when
the auditor develops an expectation of an assumption to evaluate its
reasonableness, the proposed standard also provided that the auditor
should have a reasonable basis for that expectation.
Some commenters asked for clarification of certain aspects of the
requirement. For example, a few commenters asked for clarification on
the requirement to assess whether management has a reasonable basis for
its assumptions. Another commenter asked for an explanation of what
``reasonable'' is intended to mean in the context of accounting
estimates. One commenter sought clarification on how to evaluate
differences between management's assumption and the auditor's
expectation in circumstances where the auditor develops an expectation
of an assumption to evaluate its reasonableness. Another commenter
requested that the requirement address factors relevant to evaluating
reasonableness of forward-looking information in anticipation of the
new accounting standard on credit losses.\57\
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\57\ See FASB Accounting Standards Update No. 2016-13, Financial
Instruments--Credit Losses (Topic 326): Measurement of Credit Losses
on Financial Instruments (June 2016).
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With respect to evaluating consistency with baseline information
described in the standard, one commenter asked for clarification of how
the requirement to evaluate factors in paragraph .16 works with the
requirement to ``test'' in paragraph .09. This commenter also asked for
clarification of the extent of the procedures to be performed when
evaluating the consistency of significant assumptions with the
contextual information set forth in the standard, where relevant,
asserting that the requirement may be difficult to apply in practice.
Another commenter suggested that the auditor be required to consider
whether the assumptions are consistent with the information provided in
order to better align the provision with language used by the IAASB.
One commenter suggested inclusion of a specific requirement to
assess significant assumptions for management bias.
The new standard retains the requirements for evaluating
reasonableness of significant assumptions substantially as proposed.
The requirements recognize that estimates are generally developed using
a variety of assumptions and focus the auditor on how the company
selects its assumptions.
The auditor's assessment of whether the company has a reasonable
basis for a significant assumption (including an assumption based on
forward-looking information) relates to whether the assumption used by
the company is based on an analysis of relevant information, or
determined arbitrarily, with little or no such analysis. The auditor's
assessment also involves considering whether the company considered
relevant evidence, regardless of whether it corroborates or contradicts
the company's assumption.
Under the new standard, the auditor should evaluate whether the
significant assumptions are consistent with relevant information such
as the company's objectives; historical experience (e.g., prior years'
assumptions and past practices), taking into account changes in
conditions affecting the company; and other significant assumptions in
other estimates tested (e.g., assumptions are consistent with each
other and other information obtained). This requirement is consistent
with requirements in the fair value standard.\58\ In making this
evaluation, the auditor uses his or her understanding of the company
and its environment, the assessed risks of material misstatement, and
his or her understanding of the process used to develop the estimates.
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\58\ See generally AS 2502.29-.36.
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In circumstances where the auditor develops an expectation of an
assumption to evaluate reasonableness, the auditor is required to have
a reasonable basis for that expectation (consistent with the
requirements regarding developing independent expectations), taking
into account relevant information, including the information set forth
in the requirement. The new standard does not prescribe specific
follow-up procedures when there are differences between the auditor's
expectation and the company's significant assumptions. The nature and
extent of procedures would depend on relevant factors such as the
reason for the difference and the potential effect of the difference on
the accounting estimate.\59\
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\59\ See AS 2501.30-.31 (Revised).
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[[Page 13411]]
With respect to the comment regarding management bias, the new
standard was revised to provide that responding to risks of material
misstatement involves, among other things, evaluating potential
management bias in accounting estimates, and its effect on the
financial statements (in paragraph .05). Furthermore, the requirements
in paragraphs .30-.31 of the new standard, as well as AS 2810.27
address the evaluation of bias in accounting estimates. Therefore, an
explicit requirement to evaluate bias as part of evaluating
reasonableness of significant assumptions is not necessary.
Intent and Ability
As part of evaluating the reasonableness of significant
assumptions, the proposed standard provided that the auditor take into
account factors (e.g., company's past history of carrying out stated
intentions, written plans or other documentation, stated reasons for
course of action, and the company's ability to carry out action based
on financial resources, legal restrictions, etc.) that affect the
company's intent and ability to carry out a particular course of action
when such action is relevant to the significant assumption.
One commenter asserted that compliance with the proposed
requirements would not be possible when information described in
factors does not exist and suggested adding the phrase ``as
applicable'' to the requirement.
The new standard retains, as proposed, the requirement to take into
account specific factors in evaluating the reasonableness of
significant assumptions when the significant assumption is based on the
company's intent and ability to carry out a particular course of
action. As in other PCAOB standards, the auditor takes factors into
account to the extent they are relevant.
Critical Accounting Estimates
With respect to critical accounting estimates, the proposed
standard provided that the auditor should obtain an understanding of
how management analyzed the sensitivity of its significant assumptions
\60\ to change, based on other reasonably likely outcomes that would
have a material effect, and to take that understanding into account
when evaluating the reasonableness of the significant assumptions and
potential for management bias.
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\60\ For the purposes of this requirement, significant
assumptions identified by the company may not necessarily include
all of those identified by the auditor as significant.
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Some commenters expressed concern that the proposed requirement may
place undue emphasis on, or create an inappropriate linkage with, a
company's management discussion and analysis (``MD&A'') disclosure. One
commenter also suggested that the requirement may not always apply (if,
for example, management were unable to perform a sensitivity analysis),
and suggested clarification that the intent was for the auditor to
understand whether, and if so, how, management analyzed the sensitivity
of significant assumptions to change.
Some commenters suggested the proposed requirement be recast or
aligned as a risk assessment procedure. For example, one commenter
observed that the auditor's and management's judgment can differ with
respect to critical accounting estimates. That commenter also stated
that it was unclear whether the auditor should obtain this
understanding if choosing a substantive-only testing strategy. One
commenter suggested limiting the proposed requirement to critical
accounting estimates with significant risks. Another commenter sought
clarification that the requirement does not alter the auditor's
responsibilities under AS 2710, Other Information in Documents
Containing Audited Financial Statements.
The new standard retains the requirement substantially as proposed.
In consideration of comments, the requirement was clarified to better
align with the SEC's requirement for critical accounting estimates \61\
by describing that the sensitivity of management's significant
assumptions to change is based on other reasonably likely outcomes that
would have a material effect on the company's financial condition or
operating performance.
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\61\ See Commission Guidance Regarding Management's Discussion
and Analysis of Financial Condition and Results of Operations,
Release No. 33-8350 (Dec. 19, 2003), 68 FR 75056 (Dec. 29, 2003), at
Section V (``Critical Accounting Estimates'') for management's
responsibilities related to critical accounting estimates.
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Under the new standard, the auditor is not expected to evaluate the
company's compliance with the SEC's MD&A requirements, but rather to
obtain an understanding of management's analysis of critical accounting
estimates and to use this understanding in evaluating the
reasonableness of the significant assumptions and potential for
management bias in accordance with AS 2810.27. In the Board's view, the
sensitivity analysis used by the company in developing the critical
accounting estimates disclosures for the year under audit can provide
important information about the significant assumptions underlying
those estimates.
The Board considered recasting the requirement to obtain an
understanding of management's analysis of its critical accounting
estimates as a risk assessment procedure, as suggested by some
commenters. However, this understanding is a necessary part of
evaluating the reasonableness of significant assumptions and the
potential for management bias in critical accounting estimates, which
is a substantive procedure. Moreover, MD&A disclosures regarding
critical accounting estimates might not be available until late in the
audit, and therefore could affect the timing of related audit
procedures.
The requirements in the new standard with respect to critical
accounting estimates would not change the auditor's responsibilities
under AS 2710 regarding other information in documents containing
audited financial statements.
Although there may be significant overlap between estimates with
significant risks identified by the auditor and the critical accounting
estimates identified by management, the requirements for auditors under
paragraph .18 of the new standard are not limited to estimates with
significant risks as suggested by one commenter. Rather, the paragraph
is consistent with the requirements to evaluate the reasonableness of
assumptions in significant accounts and disclosures. The MD&A
disclosures regarding critical accounting estimates can provide
relevant information to inform the auditor's evaluation of the
reasonableness of the significant assumptions and potential for
management bias.
Comparison With Standards of Other Standard Setters
ISA 540 Revised provides that the auditor's procedures shall
address (a) whether the significant assumptions are appropriate in the
context of the applicable financial reporting framework, and, if
applicable, changes from prior periods are appropriate; (b) whether
judgments made in selecting the significant assumptions give rise to
indicators of management bias; (c) whether the significant assumptions
are consistent with each other and with those used in other accounting
estimates, or with related assumptions used in other areas of the
entity's business activities, based on the auditor's knowledge obtained
in the
[[Page 13412]]
audit; and (d) when applicable, whether management has the intent to
carry out specific courses of action and has the ability to do so.
ISA 540 Revised also requires the auditor to address whether, in
the context of the applicable financial reporting framework, management
has taken appropriate steps to (a) understand estimation uncertainty;
and (b) address estimation uncertainty by selecting an appropriate
point estimate and by developing related disclosures about estimation
uncertainty. When, in the auditor's judgment based on the audit
evidence obtained, management has not taken appropriate steps to
understand or address estimation uncertainty, ISA 540 Revised requires
the auditor to, among other things, request management to perform
additional procedures to understand estimation uncertainty or to
address it by reconsidering the selection of management's point
estimate or considering providing additional disclosures relating to
the estimation uncertainty, and evaluate management's response. If the
auditor determines that management's response to the auditor's request
does not sufficiently address estimation uncertainty, to the extent
practicable, the auditor is required to develop an auditor's point
estimate or range.
AU-C Section 540 provides that as part of testing how management
made the accounting estimate, and the data on which it is based, the
auditor shall evaluate whether the assumptions used by management are
reasonable in light of the measurement objectives of the applicable
financial reporting framework. Further, for accounting estimates that
give rise to significant risks, AU-C Section 540 requires the auditor
to evaluate: (a) How management considered alternative assumptions or
outcomes and why it rejected them, or how management has otherwise
addressed estimation uncertainty in making accounting estimates; (b)
whether the significant assumptions used by management are reasonable;
and (c) where relevant to the reasonableness of the significant
assumptions used by management or the appropriate application of the
applicable financial reporting framework, management's intent to carry
out specific courses of action and its ability to do so.
AU-C Section 540 further provides that if, in the auditor's
professional judgment, management has not addressed adequately the
effects of estimation uncertainty on the accounting estimates that give
rise to significant risks, the auditor should, if considered necessary,
develop a range with which to evaluate the reasonableness of the
accounting estimate.
Company's Use of a Specialist or Third-Party Pricing Information
See Paragraphs .19-.20
The proposed standard would have required the auditor to also take
into account the work of a company's specialist used in developing an
accounting estimate when determining the evidence needed in testing the
company's process. The proposed standard also referenced Appendix B of
AS 1105 \62\ for testing and evaluating the work of a company's
specialist when that work is used to support a conclusion regarding a
relevant assertion, such as a relevant assertion related to an
accounting estimate.
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\62\ In a separate proposal, the Board proposed to amend its
standards regarding the auditor's use of the work of specialists,
including specialists employed or engaged by the company
(``company's specialist''). See Proposed Amendments to Auditing
Standards for the Auditor's Use of the Work of Specialists, PCAOB
Release No. 2017-003 (``Specialists Proposal''). The Specialists
Proposal set forth these amendments in Appendix B of AS 1105.
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In addition, when third-party pricing information used by the
company is significant to the valuation of financial instruments, the
proposed standard required the auditor to evaluate whether the company
has used that information appropriately and whether it provides
sufficient appropriate evidence.
One commenter expressed concern that the proposed requirement would
result in practical challenges as it would require the auditor to test
the methods, data, and significant assumptions used or developed by a
company specialist in the same manner that the auditor would if the
accounting estimate was developed without the assistance of a company
specialist. Another commenter advocated for closer alignment with the
proposed requirements of Appendix B of AS 1105, citing, for example,
requirements for testing the accuracy and completeness of company-
produced data used by the specialists and evaluating the relevance and
reliability of data obtained from external sources.
One commenter advocated for requiring auditors to consider whether
company specialists possess specific credentials as part of auditing
estimates under the proposed standard.
With respect to circumstances when third-party pricing information
used by the company is significant to the valuation of financial
instruments, one commenter requested additional guidance or criteria
for evaluating whether the company has used third-party pricing
information ``appropriately'' when assessing whether the information
provides sufficient appropriate evidence.
In consideration of comments (including those received on the
Specialists Proposal), the new standard requires the auditor to look to
the requirements of Appendix A of AS 1105 that discuss the auditor's
responsibilities for using the work of company specialists.\63\
Appendix A of AS 1105 sets forth, among other things, procedures to be
performed in evaluating the data, assumptions, and methods used by a
company's specialist. Further, rather than addressing specific
credentials of the specialist, Appendix A of AS 1105 requires the
auditor to assess the knowledge, skill, and ability of the company's
specialist.
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\63\ The auditor's responsibilities with respect to using the
work of a company's specialist are presented as Appendix A of AS
1105. See Specialists Release, supra note 2. The analogous proposed
requirements were originally presented as Appendix B of AS 1105 in
the Specialists Proposal.
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The new standard retains as proposed the requirement to evaluate,
when third-party pricing information used by the company is significant
to the valuation of financial instruments, whether the company has used
third-party pricing information appropriately and whether it provides
sufficient appropriate evidence. The auditor's determination as to
whether third-party pricing information was used appropriately by the
company includes whether the information is in conformity with the
applicable financial reporting framework.
Comparison With Standards of Other Standard Setters
ISA 540 Revised provides that when using the work of a management's
expert, the requirements in paragraphs 21-29 of ISA 540 Revised \64\
may assist the auditor in evaluating the appropriateness of the
expert's work as audit evidence for a relevant assertion in accordance
with paragraph 8(c) of ISA 500, Audit Evidence.\65\ In evaluating the
work of the management's expert, the nature, timing, and extent of the
further audit procedures are affected by the auditor's
[[Page 13413]]
evaluation of the expert's competence, capabilities and objectivity,
the auditor's understanding of the nature of the work performed by the
expert, and the auditor's familiarity with the expert's field of
expertise.
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\64\ Paragraphs 21-29 of ISA 540 Revised describe the
requirements for obtaining audit evidence from events occurring up
to the date of the auditor's report; testing how management made the
accounting estimate; and developing an auditor's point estimate or
range.
\65\ ISA 540 Revised provides that in obtaining audit evidence
regarding the risks of material misstatement relating to accounting
estimates, irrespective of the sources of information to be used as
audit evidence, the auditor shall comply with the relevant
requirements in ISA 500.
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Developing an Independent Expectation of the Estimate
See Paragraph .21
The proposal sought to retain the general approach in the estimates
standards for developing an independent expectation,\66\ and more
explicitly tailored the requirements to the different sources of the
methods, data, and assumptions used by the auditor. Those sources
include (1) independent assumptions and methods of the auditor, (2)
data and assumptions obtained from a third party, and (3) the company's
data, assumptions, or methods.
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\66\ See AS 2501.12, AS 2502.40, and AS 2503.40.
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Additionally, while seeking to retain the requirement under the
fair value standard for an auditor to understand management's
assumptions to ensure that his or her independent estimate takes into
consideration all significant variables,\67\ the proposal expressly
required the auditor to take into account the requirements of the
applicable financial reporting framework.
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\67\ See AS 2502.40.
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The proposal also replaced certain terms used in the estimates
standards to describe audit procedures with more neutral language (such
as replacing ``corroborate'' with ``compare'') to reduce the risk of
confirmation bias or anchoring bias when auditing accounting estimates.
Commenters on this topic were generally supportive of the proposed
requirement for developing an independent expectation, indicating that
the requirement is clear and sufficient. One commenter asked the Board
to clarify situations where developing an independent expectation of
the estimate would be appropriate. Another commenter indicated that
using the phrase ``developing an independent expectation'' implies that
the auditor would reach this expectation independently, without
reference to management's methods, data, and assumptions, and
recommended that the Board consider changing this phrasing to
developing a ``comparative estimate'' or a ``point estimate'' to better
reflect the procedures described.
After consideration of these comments, the requirement is adopted
substantially as proposed. The determination of when to use an approach
or a combination of approaches is at the auditor's discretion based on
the relevant facts and circumstances. In addition, the use of the
phrase ``developing an independent expectation of the estimate'' is
consistent with the concept in the estimates standards. The intention
of the requirement is not to imply that the auditor could (or should)
develop an expectation of the estimate without reference to the
company's methods, data, and assumptions, but rather to more explicitly
acknowledge that, in developing an independent expectation of the
estimate, an auditor could use methods, data, and assumptions obtained
from different sources.
Consistent with the proposal, the new standard tailors the
requirements to develop an independent expectation to the different
sources of the methods, data, and assumptions used by the auditor as
set forth in the table below and discussed further in the sections that
follow.
------------------------------------------------------------------------
Auditor's independent expectation Auditor responsibility under
developed using: the new standard:
------------------------------------------------------------------------
Assumptions and methods of the auditor. Have a reasonable basis for the
assumptions and methods.
Data and assumptions obtained from a Evaluate the relevance and
third party. reliability of the data and
assumptions.
Company data, assumptions, or methods.. Test and evaluate in the same
manner as when testing the
company's process.
------------------------------------------------------------------------
This approach provides more direction to auditors in light of the
various ways in which auditors develop an independent expectation of
accounting estimates.
The new standard also expressly prompts the auditor to take into
account the requirements of the applicable financial reporting
framework when developing an independent expectation. By taking into
account the requirements of applicable financial reporting framework,
the auditor might identify additional considerations relevant to the
estimate that the company did not take into account in its own process
for developing the estimate. As with the proposal, the new standard
also uses more neutral terms, such as ``evaluate'' and ``compare'' to
mitigate the risk of confirmation bias or anchoring bias when auditing
accounting estimates. For example, the new standard requires the
auditor to compare the auditor's independent expectation to the
company's accounting estimate instead of developing an independent fair
value estimate ``for corroborative purposes.'' \68\
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\68\ See AS 2502.40.
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Independent Assumptions and Methods of the Auditor
See Paragraph .22
The proposal recognized that, when developing an independent
expectation of an estimate, the auditor can independently derive
assumptions or use a method that differs from the company's method. In
those situations, the auditor should have a reasonable basis for his or
her assumptions and methods used.
Commenters on this topic were generally supportive of the proposed
requirement that the auditor have a reasonable basis for the
assumptions and methods used when developing an independent expectation
of the estimate. The requirement is adopted as proposed.
Under the new requirement, the auditor is required to have a
reasonable basis for the assumptions and methods used to develop an
independent expectation. Having a reasonable basis would reflect
consideration of, among other things, the nature of the estimate;
relevant requirements of the applicable financial reporting framework;
the auditor's understanding of the company, its environment, and the
company's process for developing the estimate; and other relevant audit
evidence, regardless of whether the evidence corroborates or
contradicts the company's assumptions.
Data and Assumptions Obtained From a Third Party
See Paragraph .23
The proposal directed the auditor to the existing requirements in
AS 1105 when evaluating the relevance and reliability of data or
assumptions obtained from a third party. This approach is consistent
with the requirements for evaluating data from external sources as
described above.
The proposal also directed the auditor to comply with the
requirements of proposed AS 1210 when the third party
[[Page 13414]]
is a specialist engaged by the auditor.\69\ The proposal did not set
forth specific requirements related to methods obtained from a third
party that is not a specialist.
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\69\ See paragraph .08 of the proposed standard.
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One commenter expressed concern that the proposed requirements were
too restrictive and somewhat impractical and that it may not be
possible or necessary to obtain data and assumptions from a third party
and to create assumptions independent of those of the company. The
commenter recommended that the Board retain the extant direction
allowing the auditor to use management's assumptions when developing
independent expectations.
After consideration of the comment, the requirement is adopted as
proposed. As described below, consistent with the estimates standards
and the proposal, the new requirement continues to allow the use of
company data, assumptions, or methods while also allowing the auditor
to use other sources.\70\
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\70\ Appendix A of AS 2501 (Revised) applies when the auditor
develops an independent expectation of the fair value of financial
instruments using pricing information from a third party. These
requirements are discussed further below.
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Also consistent with the proposal, the new standard does not set
forth specific requirements related to methods obtained from a third
party, as the Board understands that auditors typically use either the
company's methods or their own (which may include specialists' methods)
in developing an independent expectation.
Use of Company Data, Assumptions, or Methods
See Paragraph .24
The proposal sought to retain the existing requirements for the
auditor to test data from the company and evaluate the company's
significant assumptions for reasonableness, when used by the auditor to
develop an independent estimate.\71\ The proposal also required the
auditor to evaluate the company's method, if the auditor uses that
method to develop an independent expectation. The proposal recognized
that auditors may use a portion or a combination of data, assumptions,
and method provided by the company in developing their expectations. If
the company's data, assumptions, or methods are those of a company's
specialist, the proposal also directed the auditor to comply with the
requirements in proposed Appendix B of AS 1105 for using the work of a
company specialist as audit evidence.
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\71\ See AS 2502.40.
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One commenter suggested that the Board clarify that when developing
an independent expectation of an estimate, the auditor's testing of
management's process is limited to those areas on which the auditor
intends to rely for purposes of developing the expectation.
This provision is adopted substantially as proposed. Under the new
standard, when an auditor chooses to develop an independent expectation
using certain of the company's data, significant assumptions, or
methods, the auditor is required to test such data or evaluate such
assumptions or methods, using the corresponding procedures that apply
when the auditor tests the company's process. In response to comments,
the text was revised from the proposal to clarify the scope of the
obligation to test. The new standard also includes a note referring the
auditor to look to the requirements in Appendix A of AS 1105 in
situations where the company's data, assumptions or methods were those
of a company's specialist.\72\
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\72\ See Specialists Release, supra note 2.
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Comparison With Standards of Other Standard Setters
When the auditor develops a point estimate or a range to evaluate
management's point estimate and related disclosures about estimation
uncertainty, ISA 540 Revised provides that the auditor's further audit
procedures include procedures to evaluate whether the methods,
assumptions or data used are appropriate in the context of the
applicable financial reporting framework. ISA 540 Revised also provides
that regardless of whether the auditor uses management's or the
auditor's own methods, assumptions or data, further audit procedures be
designed and performed to address the matters in paragraphs 23-25 of
ISA 540 Revised.\73\
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\73\ Paragraphs 23-25 of ISA 540 Revised describe the auditor's
further procedures for addressing methods, significant assumptions,
and data.
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AU-C Section 540 provides that if the auditor uses assumptions or
methods that differ from management's, the auditor shall obtain an
understanding of management's assumptions or methods sufficient to
establish that the auditor's point estimate or range takes into account
relevant variables and to evaluate any significant differences from
management's point estimate.
Developing an Independent Expectation as a Range
See Paragraph .25
The proposal provided that, if the auditor's independent
expectation consisted of a range rather than a point estimate, the
auditor should determine that the range was appropriate for identifying
a misstatement of the company's accounting estimate and was supported
by sufficient appropriate audit evidence.\74\
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\74\ The estimates standards provide for the development of an
independent point estimate as one approach for testing accounting
estimates, but these standards do not discuss developing an
independent expectation as a range of estimates. AS 2810 provides
for developing a range of possible estimates for purposes of the
auditor's evaluation of misstatements relating to accounting
estimates.
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Some commenters asked for clarification or guidance on how to
determine that a range is appropriate for identifying a misstatement.
Some commenters stated that the proposed requirement implied a level of
precision within a range that may not be feasible. Some commenters
suggested expressly acknowledging situations where the range is greater
than the materiality threshold by including, for example, language
similar to IAASB's Exposure Draft, Proposed ISA 540 (Revised) (``ED
540''), paragraph A134.\75\ One of these commenters argued that for
certain highly judgmental estimates, additional audit work cannot
reduce the size of the range below the materiality threshold, and that
the proposed requirement could lead to excessive work. Another
commenter suggested that the proposed standard did not sufficiently
address estimation uncertainty, including what constitutes a reasonable
range of estimation uncertainty and how auditors are to address and
disclose such uncertainty.
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\75\ ED 540, paragraph A134 stated that ``In certain
circumstances, the auditor's range for an accounting estimate may be
multiples of materiality for the financial statements as a whole,
particularly when materiality is based on operating results (for
example, pre-tax income) and this measure is relatively small in
relation to assets or other balance sheet measures. In these
circumstances, the auditor's evaluation of the reasonableness of the
disclosures about estimation uncertainty becomes increasingly
important. Considerations such as those included in paragraphs A133,
A144, and A145 may also be appropriate in these circumstances.''
Substantially similar guidance appears in paragraph A125 of ISA 540
Revised.
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After considering the comments, the requirement has been revised to
clarify that, when establishing an independent expectation as a range,
the auditor should determine that the range encompasses only reasonable
outcomes, in conformity with applicable financial reporting framework,
and is supported by sufficient appropriate evidence.
Also, a footnote has been added to paragraph .26 of the new
standard reminding auditors that, under AS 2810.13, if a range of
reasonable estimates is supported by sufficient appropriate evidence
and the recorded estimate is outside of the range of
[[Page 13415]]
reasonable estimates, the auditor should treat the difference between
the recorded accounting estimate and the closest reasonable estimate as
a misstatement.
The requirement that the range should be supported by sufficient
appropriate evidence is consistent with the principle in the new
standard that the auditor should have a reasonable basis for the data,
assumptions, and methods used in developing an independent expectation.
The sufficiency and appropriateness of the evidence needed will depend
on the relevant circumstances, including the nature of the accounting
estimate, the requirements of the applicable financial reporting
framework, and the number and nature of significant assumptions and
data used in the independent expectation.
Notably, the new standard does not restrict the size of the
auditor's range to the level of materiality for the financial
statements as a whole determined under AS 2105 (``financial statement
materiality''). An appropriate range in accordance with paragraph .25
of the new standard might be very large, even exceeding financial
statement materiality. For example, under certain market conditions,
comparable transactions for some assets, even after appropriate
adjustment, might indicate a wide range of fair value measurements. As
another example, some accounting estimates are highly sensitive to one
or more assumptions, such that a small change in an assumption can
result in a large change in the value of the estimate. In those
situations, the auditor's responsibility is to determine an appropriate
range based on the criteria set forth in the new standard.
The Board considered the comments asking for a statement in the
standard acknowledging that an independent expectation as a range could
exceed the materiality level determined under AS 2105. However, such a
statement was not added because it would not have changed the auditor's
responsibility under the new standard.
Finally, with respect to estimation uncertainty, the new standard
and related amendments acknowledge that estimates have estimation
uncertainty, which affects the risks of material misstatement. Neither
the Board nor auditors are responsible for placing limits on the range
of estimation uncertainty. That uncertainty is a function of the
estimate's measurement requirements under the applicable financial
reporting framework, the economic phenomena affecting that estimate,
and the fact that estimates involve assessments of future outcomes.
Under the new standard, the auditor's responsibility is to consider
estimation uncertainty in assessing risk and performing procedures in
response to risk, which involves evaluating whether the accounting
estimates are reasonable in the circumstances and in conformity with
the applicable financial reporting framework, as well as evaluating
management bias in accounting estimates, and its effect on the
financial statements. These responsibilities are better aligned with
the auditor's overall responsibility for planning and performing
financial audits.\76\
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\76\ Auditors may also have disclosure and reporting
responsibilities in relation to these matters. See AS 3101, The
Auditor's Report on an Audit of Financial Statements When the
Auditor Expresses an Unqualified Opinion, and AS 1301,
Communications with Audit Committees.
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Comparison With Standards of Other Standard Setters
ISA 540 Revised provides that if the auditor develops an auditor's
range, the auditor shall (a) determine that the range includes only
amounts that are supported by sufficient appropriate audit evidence and
have been evaluated by the auditor to be reasonable in the context of
the measurement objectives and other requirements of the applicable
financial reporting framework; and (b) design and perform further audit
procedures to obtain sufficient appropriate audit evidence regarding
the assessed risks of material misstatement relating to the disclosures
in the financial statements that describe the estimation uncertainty.
AU-C Section 540 provides that if the auditor concludes that it is
appropriate to use a range, the auditor should narrow the range, based
on audit evidence available, until all outcomes within the range are
considered reasonable.
Comparing the Auditor's Independent Expectation to the Company's
Accounting Estimate
See Paragraph .26
The proposal set forth the requirement for the auditor to compare
the auditor's independent expectation to the company's estimate and
evaluate the differences in accordance with AS 2810.13.\77\
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\77\ See additional discussion of evaluating audit results
below.
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No comments were received on this topic. The requirement is adopted
substantially as proposed, with an expanded footnote reminding auditors
that under AS 2810.13, if a range of reasonable estimates is supported
by sufficient appropriate evidence and the recorded estimate is outside
of the range of reasonable estimates, the auditor should treat the
difference between the recorded accounting estimate and the closest
reasonable estimate as a misstatement.
Evaluating Audit Evidence From Events or Transactions Occurring After
the Measurement Date
See Paragraphs .27-.29
The proposal noted that events and transactions that occur after
the measurement date can provide relevant evidence to the extent they
reflect conditions at the measurement date. The proposal provided that
the auditor should evaluate whether the audit evidence from events or
transactions occurring after the measurement date is sufficient,
reliable, and relevant to the company's accounting estimate and whether
the evidence supports or contradicts the company's estimate.
Commenters were generally supportive of the proposed requirements,
indicating they were clear and sufficient. Two commenters requested
additional clarity regarding the assessment of whether the audit
evidence is sufficient, reliable, and relevant to the company's
accounting estimate, one in the context of subsequent events and one
more generally. Another commenter suggested including cautionary
language with respect to fair value estimates indicating that fair
value measurements are derived from information that would be known or
knowable to a market participant at the measurement date.
The Board considered these comments and determined that the
requirements in the proposal are sufficiently clear and has adopted the
requirements as proposed.
The new standard, as with the proposal, requires the auditor to
evaluate whether audit evidence from events or transactions occurring
after the measurement date is sufficient, reliable, and relevant to the
company's accounting estimate and whether the evidence supports or
contradicts the company's estimate. This would include evaluating
pertinent information that is known or knowable at the measurement
date. For example, the sale of a bond shortly after the balance-sheet
date (which in this case is also the measurement date) may provide
relevant evidence regarding the company's fair value measurement of the
bond as of the balance sheet date if the intervening market conditions
remain the same. As another example, when a business combination
occurred during the year, events occurring
[[Page 13416]]
subsequent to the measurement date, such as the cash settlement of
short-term receivables, may provide relevant evidence about the
accounting estimate as of the measurement date if they reflect
conditions at the measurement date. In those situations, the audit
procedures would be focused on evaluating the relevance and reliability
of the evidence provided by the subsequent event, including the extent
to which the subsequent event reflects conditions existing at the
measurement date.
Additionally, the new standard requires the auditor to take into
account changes in the company's circumstances and other relevant
conditions between the event or transaction date and the measurement
date. It also notes that as the length of time from the measurement
date increases, the likelihood that events and conditions have changed
during the intervening period also increases.
Comparison With Standards of Other Standard Setters
The corresponding ISA 540 Revised requirement provides that when
the auditor's further audit procedures include obtaining audit evidence
from events occurring up to the date of the auditor's report, the
auditor shall evaluate whether such audit evidence is sufficient and
appropriate to address the risks of material misstatement relating to
the accounting estimate, taking into account that changes in
circumstances and other relevant conditions between the event and the
measurement date may affect the relevance of such audit evidence in the
context of the applicable financial reporting framework.
AU-C Section 540 provides that the auditor should determine whether
events occurring up to the date of the auditor's report provide audit
evidence regarding the accounting estimate.
Evaluating Audit Results
See Paragraphs .30-.31
The proposed standard incorporated existing requirements of AS 2810
for evaluating the results of audit procedures performed on accounting
estimates, including evaluating bias in accounting estimates (both
individually and in the aggregate).
One commenter noted that the requirements could be interpreted as a
presumption that bias always exists in accounting estimates or a
requirement to determine whether actual bias exists, and suggested that
the standard include the word ``potential'' when referencing bias,
similar to the requirements of AS 2810. Another commenter sought
clarification as to whether the proposed standard required the auditor
to evaluate bias in individual assumptions.
The new standard retains paragraphs .30 and .31 regarding
evaluating audit results substantially as proposed. In consideration of
comments, paragraphs .30 and .31 were revised to include a reference to
potential bias, consistent with AS 2810.24-.27. The requirements in the
new standard are intended to remind auditors of their existing
responsibilities to evaluate potential bias in accounting estimates
(both individually and in the aggregate) and its effect on the
financial statements. For example, indicators of management bias may
affect the assessed risk of material misstatement and the auditor's
conclusions about whether accounting estimates are reasonable in the
circumstances. As discussed above, individual assumptions that are
susceptible to manipulation or bias are ordinarily considered
significant and evaluated for reasonableness.\78\
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\78\ See discussion of identification of significant assumptions
above.
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Comparison With Standards of Other Standard Setters
ISA 540 Revised requires the auditor to evaluate whether judgments
and decisions made by management in making the accounting estimates
included in the financial statements, even if they are individually
reasonable, are indicators of possible management bias. When indicators
of possible management bias are identified, the auditor shall evaluate
the implications for the audit. Where there is intention to mislead,
management bias is fraudulent in nature.\79\
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\79\ ISA 540 Revised further requires the auditor to evaluate,
based on the audit procedures performed and audit evidence obtained,
whether (a) the assessments of the risks of material misstatement at
the assertion level remain appropriate, including when indicators of
possible management bias have been identified; (b) management's
decisions relating to the recognition, measurement, presentation and
disclosure of these accounting estimates in the financial statements
are in accordance with the applicable financial reporting framework;
and (c) sufficient appropriate audit evidence has been obtained.
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AU-C Section 540 requires the auditor to review the judgments and
decisions made by management in the making of accounting estimates to
identify whether indicators of possible management bias exist.
Both ISA 540 Revised and AU-C Section 540 provide that the auditor
should determine whether the accounting estimates and related
disclosures are reasonable in the context of the applicable financial
reporting framework, or are misstated.
Appendix A--Special Topics
Introduction
Appendix A of the proposed standard set forth requirements for the
auditor to perform specific procedures when auditing the fair value of
financial instruments, focusing on the use of pricing information from
third parties such as pricing services and brokers or dealers. The
proposal also incorporated and built on topics discussed in the
derivatives standard, including certain procedures for auditing the
valuation of derivatives and securities measured at fair value. The
proposed requirements were informed by outreach, including the Pricing
Sources Task Force, and publications of other standard setters.
Paragraph .A1 of Appendix A prompts the auditor to obtain an
understanding of the nature of the financial instruments being valued
in order to identify and assess risks of material misstatement related
to the fair value of those instruments. Paragraph .A2 provides the
general framework, specifically, the auditor's responsibility to
determine whether the pricing information from a third party \80\
provides sufficient appropriate evidence to respond to the risks of
material misstatement.
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\80\ Appendix A focuses primarily on pricing information from
pricing services and brokers or dealers, but paragraph .A2 also
covers pricing information obtained from other third-party sources,
such as exchanges and publishers of exchange prices.
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Paragraphs .A3-.A9 provide more specific direction for cases where
pricing information from pricing services and brokers or dealers are
used. Paragraph .A10 sets forth factors for the auditor to take into
account when obtaining an understanding of how unobservable inputs were
determined and evaluating the reasonableness of unobservable inputs
when the unobservable inputs are significant to the valuation of
financial instruments.
A number of commenters expressed general support for the proposed
Appendix A but commented on specific aspects of the proposed
requirements. These comments are addressed below in a section-by-
section discussion of the proposal and the new standard. In addition,
there were two areas of comment that relate to several aspects of the
proposed Appendix: (1) The extent to which audit procedures could be
performed over groups or classes of financial instruments, rather than
individual instruments; and (2) the role played by centralized groups
within an accounting firm, such as a pricing desk, in performing
procedures related to
[[Page 13417]]
testing the fair value of financial instruments.
On the first area of comment, commenters asked for clarification on
whether all of the required procedures in Appendix A were to be applied
to financial instruments individually; expressing concerns that doing
so would lead to excessive work. Some commenters suggested clarifying
changes to the proposed Appendix, such as inserting ``type of'' or
``types of'' before the term ``financial instrument'' in various
requirements in the appendix. One commenter suggested adding a note
indicating that the procedures in paragraphs .A4-.A8 of the proposal
were not required to be applied to each individual financial
instrument. Another commenter suggested that auditors be allowed to
understand and evaluate the methods and inputs used by pricing services
at the level of the asset class for financial instruments with lower
estimation uncertainty.
The Board did not intend that all required procedures in Appendix A
be applied to individual financial instruments in all cases. Rather,
the Board intended that financial instruments with similar
characteristics and risks of material misstatement could be grouped for
purposes of applying substantive procedures. In some circumstances,
however, it may not be appropriate to group financial instruments (for
example, where financial instruments are dissimilar, or where the
auditor does not have a reasonable basis upon which to base the
grouping). As discussed in greater detail below, Appendix A of the new
standard has been revised to clarify areas where it may be appropriate
for procedures to be performed over groups of financial instruments
rather than individual financial instruments.
On the second area, commenters asked for additional guidance about
the role of centralized groups that the largest accounting firms often
use to assist in performing procedures related to testing the fair
value of financial instruments. The specific services performed and the
nature and level of detail of information provided by centralized
groups to engagement teams can vary. Some commenters suggested that the
proposal further address how the requirements apply when a centralized
pricing desk is used and raised specific issues regarding the use of
centralized groups under the proposed requirements. One commenter
advocated for more precise requirements about the degree to which
procedures may be executed by a centralized group. The new standard
does not prescribe the role or responsibilities of centralized pricing
groups in audits, and Appendix A does not provide specific direction in
that regard. Instead, the new standard allows engagement teams to
continue seeking assistance from centralized groups when performing the
procedures required under the new standard. This approach gives audit
firms the flexibility to determine the most appropriate way to use
their centralized pricing groups on an audit to satisfy the requirement
of the new standard.
As under the proposal, centralized groups within the firm that
assist engagement teams with evaluating the specific methods and
assumptions related to a particular instrument, identifying and
assessing risks of material misstatement, or evaluating differences
between a company's price and a pricing service's price generally would
be subject to the supervision requirements of AS 1201.\81\
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\81\ Additionally, centralized groups may periodically provide
general information within the firm about a pricing service's
controls and methodologies or general information on current market
conditions for different types of securities. Such general
information may inform engagement teams' risk assessments, to the
extent that the information is reliable and relevant to their
engagements. The activities of centralized groups to obtain and
communicate such general information are different in nature from
the engagement-specific services provided by the centralized groups,
which are subject to supervision. Thus, it is important for firm
quality control systems to have policies and procedures related to
the accuracy of such general information from centralized groups.
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Identifying and Assessing Risks of Material Misstatement Related to the
Fair Value of Financial Instruments
See Paragraph .A1
Under the proposal, the auditor was to obtain an understanding of
the nature of the financial instruments being valued to identify and
assess the risks of material misstatement related to their fair value,
taking into account specified matters.
Commenters were generally supportive of the proposed requirement.
One commenter suggested that the auditor should be permitted to
stratify financial instruments into groups as part of identifying and
assessing risks of material misstatement, and suggested reframing one
of the required procedures to refer to the type of financial
instruments. Paragraph .A1 is not intended to require auditors to
obtain an understanding of each financial instrument one-by-one. The
language has been revised to refer to financial instruments (plural) or
type of financial instruments to make this clear. The new standard
allows auditors, where appropriate, to stratify financial instruments
into groups with similar characteristics for purposes of performing
procedures to evaluate pricing information for financial instruments.
In those situations, the auditor's stratification is to be based on his
or her understanding of the nature of the financial instruments
obtained under paragraph .A1.
Use of Pricing Information From Third Parties as Audit Evidence
See Paragraphs .A2-.A3
The proposal addressed pricing information from organizations that
routinely provide uniform pricing information to users, generally on a
subscription basis (pricing services), and brokers or dealers. The
proposal provided that when the auditor uses pricing information from a
third party to develop an independent expectation or tests pricing
information provided by a third party used by management, the auditor
should perform procedures to determine whether the pricing information
provides sufficient appropriate audit evidence to respond to the risks
of material misstatement.
Commenters on this topic were generally supportive of the proposed
requirement. One commenter questioned whether the use of the word
``tests'' is appropriate in relation to pricing information provided by
a third party used by management, because it might be inconsistent with
other requirements in the proposed standard. The commenter requested
clarification as to whether the use of the word ``tests'' in paragraph
.A2 is intended to set out a different work effort than what AS 1105
would require to evaluate information from external sources.
Another commenter questioned whether receiving prices from a third-
party service, in and of itself, amounts to using a service
organization. The commenter claimed that, based solely on the criteria
in paragraph .03 of AS 2601, Consideration of an Entity's Use of a
Service Organization, without the context provided by AS 2503.11-.14,
it is likely that third-party pricing services would often be
considered service organizations, and that this outcome is not
warranted given the relatively low risks involved. The same commenter
asked about how paragraph .A3 would be applied to situations in which
pricing services prepare pricing information upon client request, but
follow uniform procedures that cause the preparer of the specific
information to be unaware of the identity of the user, such that bias
of the user would not be introduced.
[[Page 13418]]
Paragraphs .A2 and .A3 of the standard are adopted as proposed,
except for the revision discussed below. Under the new standard, as
with the proposal, when the auditor uses pricing information from a
third party to develop an independent expectation or evaluates pricing
information provided by a third party that is used by the company, the
auditor is required to perform procedures to determine whether the
pricing information provides sufficient appropriate evidence to respond
to the risks of material misstatement. This approach focuses auditors
on assessing the relevance and reliability of the pricing information
regardless of whether it is obtained by the company or the auditor,
which should lead to more consistency in practice. The new standard
also includes a reminder that under AS 2301.09, the auditor should
design audit procedures to obtain more persuasive audit evidence the
higher the auditor's assessment of risk. This added reminder reinforces
the principle that the required procedures are scalable based on the
assessed risks of material misstatement. In general, fair values of
financial instruments based on trades of identical financial
instruments in an active market have a lower risk of material
misstatement than fair values derived from observable trades of similar
financial instruments or unobservable inputs. Thus, the necessary audit
response would also differ. For example, for exchange-traded securities
in active markets, quoted prices obtained from a stock exchange may
provide sufficient appropriate evidence.
After consideration of comments, the word ``tests'' has been
replaced with ``evaluates'' to clarify that the requirement is
consistent with the work effort ordinarily required by AS 1105 when
evaluating information from external sources.
As is the case under existing PCAOB standards, a pricing service
would continue to be a service organization if the services it provides
to a subscriber are part of the subscriber's information system over
financial reporting.\82\ In those instances, the auditor would apply
the requirements of the new standard when performing substantive
testing and look to the requirements of AS 2601 regarding his or her
responsibilities for understanding and evaluating controls of the
pricing service. The Board does not intend that the new standard would
change practice in this area, given that the criteria for being a
service organization under PCAOB standards have not changed.
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\82\ See AS 2601.03.
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The applicability of either Appendix A or the requirements for
using the work of specialists to pricing services depends on the nature
of the service provided and the characteristics of the instrument being
valued. Appendix A applies when the auditor uses uniform pricing
information from pricing services that is routinely provided to their
users, generally on a subscription basis. This pricing information may
be generated at various points in time and is available to all
subscribers including both companies and audit firms. In general,
financial instruments covered by these services tend to be those with
more direct or indirect observable inputs.
As with the proposal, the new standard includes a footnote
providing that, when a pricing service is engaged by a company or
auditor to individually develop a price for a specific financial
instrument not routinely priced for subscribers, the requirements in
Appendix A of AS 1105 (company-engaged specialists) or AS 1210
(auditor-engaged specialists) apply, depending on who engaged the
pricing service.\83\ In general, financial instruments covered by these
services have few direct or indirect observable market inputs (for
example, because of an issuer's default, a delisting, or a major change
in liquidity of the related asset class).
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\83\ See Specialists Release, supra note 2.
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Using Pricing Information From Pricing Services
See Paragraph .A4
The proposal set forth a number of factors that affect the
reliability of pricing information provided by a pricing service. These
factors built on existing requirements for evaluating the reliability
of audit evidence under AS 1105.
Some commenters suggested changes to or asked for clarification of
the proposed factors for assessing the reliability of pricing
information from pricing services. For example, some commenters asked
for clarification or guidance regarding the required work effort to
evaluate the pricing service, such as the nature and extent of
procedures to evaluate the expertise and experience of the pricing
service and whether the required procedures were to be applied
separately for each financial instrument. Also, one commenter made
specific suggestions regarding factors to be considered in evaluating
the reliability and relevance of third-party pricing information. One
commenter argued that the requirements of paragraphs .A4b, .A5c, and
.A7 are unrealistic in some cases because auditors will not have access
to the details of pricing service methodology, data, and assumptions.
According to the commenter, requiring auditors to perform additional
procedures in such cases without further guidance on procedures to be
performed is unhelpful to the smaller companies who, in the commenter's
view, are most likely to be unable to obtain an independent valuation,
and to smaller audit firms without a pricing desk.
Additionally, some commenters requested guidance on how the auditor
should determine that the pricing service, broker or dealer does not
have a relationship with the company that could directly or indirectly
or significantly influence the pricing service or broker or dealer.
Other commenters suggested that auditors consider the results of their
procedures regarding related parties under AS 2410 when considering the
relationship of a pricing service or broker or dealer to the issuer.
Other commenters suggested clarifying that a price challenge by
management based on substantive information that causes the pricing
service to change its price should not generally be deemed significant
influence by management.
After consideration of the comments received, the new standard has
been revised as follows:
The requirements have been revised to clarify that the
procedures in this paragraph are not required to be applied separately
for each instrument (e.g., through the use of phrases such as ``types
of financial instruments'').
The new standard includes a note \84\ clarifying that
procedures performed under AS 2410 should be taken into account in
determining whether the pricing service has a relationship with the
company by which company management has the ability to directly or
indirectly control or significantly influence the pricing service as
described in paragraph .A4c. The Board believes that pricing
information from parties not considered to be related parties would
ordinarily be more reliable than pricing information from sources
determined to be related parties. The results of procedures performed
under AS 2410 would provide information about whether the pricing
service is a related party and, if so, the nature of relationships
between the company and the pricing service. The
[[Page 13419]]
nature and extent of further procedures that might be needed depend on
the relevant circumstances. For example, if the results of AS 2410
procedures identified relationships between the company and pricing
service, the auditor would need to evaluate whether the relationships
gave company management the ability to directly or indirectly control
or significantly influence the pricing service. Also, additional
procedures might be needed to ascertain whether the pricing service was
economically dependent on the company's business, if the pricing
service was a smaller entity with few subscribers.
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\84\ See first note to paragraph .A4 in AS 2501 (Revised).
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The new standard also includes a note \85\ clarifying that
the existence of a process by which subscribers can challenge a pricing
service's pricing information does not, by itself, mean that company
management has the ability to directly or indirectly control or
significantly influence that pricing service. The Board agrees with
commenters that the existence of such a price challenge process
ordinarily would not, on its own, suggest significant influence over
the pricing service.
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\85\ See second note to paragraph .A4 in AS 2501 (Revised).
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The new standard also includes a note \86\ indicating that
if the auditor performs procedures to assess the reliability of pricing
information provided by a pricing service at an interim date, the
auditor should evaluate whether the pricing service has changed its
valuation process relative to the types of financial instruments being
valued, and, if so, the effect of such changes on the pricing
information provided at period end. The Board understands that firms
may perform procedures at various times during the year with respect to
the methodology used by pricing service. The note reminds auditors that
if the pricing service changes its process, e.g., because of changes in
market conditions, it is important for the auditor to evaluate the
effect of such changes on the pricing information provided at period
end to determine whether the pricing service continues to provide
relevant evidence at that date.
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\86\ See third note to paragraph .A4 in AS 2501 (Revised).
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As with the proposal, the new standard recognizes that pricing
information that is routinely provided by a pricing service with
experience and expertise relative to the type of financial instrument
being valued is generally more reliable than a price developed by a
pricing service that has limited or no experience. The Board agrees
with the commenters that the number and financial industry experience
levels of evaluators employed by the pricing service, the extent of
informational resources that the pricing service provides to assist
users in understanding its data and evaluation methodologies, and the
pricing service's evaluation quality controls and price challenge
processes, among other things, are relevant considerations when
evaluating experience and expertise. However, the absence of lengthy
experience pricing a particular instrument does not necessarily mean
that the pricing service is incapable of providing relevant audit
evidence. The evaluation of experience and expertise should be based on
the relevant facts and circumstances including the need to obtain more
persuasive audit evidence as the assessed risk of material misstatement
increases.
Similar to the proposal, the new standard contemplates that pricing
services use different methodologies to determine fair value. The Board
understands, based on observation from oversight activities and
outreach that many pricing services provide information to their
subscribers about their methodology, which can be assessed to determine
whether that methodology is in conformity with the applicable financial
reporting framework. Under the new standard, the evaluation of pricing
service methodology can be performed for groups of financial
instruments, provided that certain conditions set forth in the Appendix
are met. When an auditor is unable to obtain information about the
methodology used by the pricing service to determine fair values of the
types of financial instruments being valued, additional or alternative
procedures to obtain the necessary evidence may include, for example,
obtaining and evaluating pricing information from a different pricing
source, obtaining evidence about the inputs used from public data about
similar trades, or developing an independent expectation.
The new standard, as with the proposal, also provides that the
procedures in Appendix A apply to pricing information obtained from
pricing sources used by the company in their estimation process as well
as from those obtained by the auditor for the purpose of developing an
independent expectation.\87\ This approach focuses on assessing the
relevance and reliability of the pricing information obtained, rather
than of the third party itself, and is better aligned with the assessed
risks of material misstatement.
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\87\ An auditor's ability to use sampling methodologies and
pricing information obtained from pricing sources used by the
company may differ under other requirements, such as interpretive
releases issued by the SEC. See, e.g., SEC, Codification of
Financial Reporting Policies Section 404.03, Accounting, Valuation
and Disclosure of Investment Securities, Accounting Series Release
No. 118 (Dec. 23, 1970), which provides requirements for audits of
SEC-registered investment companies.
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See Paragraph .A5
The proposal set forth certain factors that are important to the
auditor's assessment of the relevance of pricing information provided
by a pricing service.
Two commenters suggested that the description of the factors seemed
to indicate that auditors need to understand how each financial
instrument in the portfolio is valued individually, whereas in their
view, auditors should be able to assess these factors based on the
asset class and other characteristics.
The Board did not intend to require auditors to assess the factors
set forth in this paragraph individually for each financial instrument
in all cases, but rather, where applicable, to allow auditors to
consider the factors for groups of financial instruments with similar
characteristics and risks of material misstatement. Accordingly, the
new standard has been revised to use the plural term ``financial
instruments'' to clarify where a broader application is intended.
Like the proposal, the new standard provides direction on
evaluating the relevance of pricing information provided by a pricing
service, building on the requirements related to the relevance of audit
evidence under AS 1105.\88\ Under the new standard, the procedures to
be performed generally depend on whether there is available information
about trades in the same or similar securities.
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\88\ See AS 1105.07.
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Fair values based on quoted prices in active markets for identical
financial instruments. The relevance of pricing information depends on
the extent to which the information reflects market data as of the
measurement date. Recent trades of identical financial instruments
generally provide relevant audit evidence.
Fair values based on transactions of similar financial instruments.
Only a fraction of the population of financial instruments is traded
actively. For many financial instruments, the available audit evidence
consists of market data for trades of similar financial
[[Page 13420]]
instruments or trades of the identical instruments in an inactive
market. This is the context in which the Board thinks it is most likely
that procedures would be performed for groups of financial instruments
of a similar nature (taking into account the matters in paragraph .A1)
that are priced by the pricing service using the same process.
How a pricing service identifies and considers transactions
comparable to the financial instrument being valued affects the
relevance of the pricing information provided as audit evidence. When
fair values are based on transactions of similar instruments, the new
standard requires the auditor to perform additional audit procedures to
evaluate the process used by the pricing service, including evaluating
how transactions are identified, considered comparable, and used to
value the types of financial instruments selected for testing, as
discussed below.
No recent transactions have occurred for the same or similar
financial instruments. When no recent transactions have occurred for
either the financial instrument being valued or similar financial
instruments, pricing services may develop prices using broker quotes or
models. How a pricing service develops prices for these financial
instruments, including whether the inputs used represent the
assumptions that market participants would use when pricing the
financial instruments, affects the relevance of the pricing information
provided as audit evidence.
When pricing information from a pricing service indicates no recent
trades for the financial instrument being valued or similar
instruments, the new standard requires the auditor to perform
additional audit procedures, including evaluating the appropriateness
of the valuation method and the reasonableness of the observable and
unobservable inputs used by the pricing service, as discussed below.
These types of financial instruments would generally be valued
individually.
See Paragraph .A6
The proposal provided that when the fair values are based on
transactions of similar financial instruments, the auditor should
perform additional audit procedures to evaluate the process used by the
pricing service.
Some commenters requested clarification or guidance on the
additional procedures to be performed when evaluating the process used
by a pricing service, and guidance for situations in which the auditor
is unable to perform the procedures. Another commenter asked for
clarification regarding firm-level due diligence over pricing services,
arguing that the standard as proposed would preclude the use of
centralized pricing desks or firm-level due diligence procedures in
evaluating a pricing service's process.
After consideration of comments received, this paragraph in the new
standard has been revised in two respects. First, a phrase was added to
clarify that the additional procedures to be performed relate to how
transactions of similar instruments are identified, considered
comparable, and used to value the types of financial instruments
selected for testing.
Second, in light of previously discussed comments requesting
clarification about the unit of testing, a note was added to paragraph
.A6 of the new standard providing that that when a pricing service uses
the same process to price a group of financial instruments, the audit
procedures to evaluate the process can be performed for those financial
instruments as a group, rather than for each instrument individually,
if the financial instruments are similar in nature (taking into account
the matters in paragraph .A1 of the new standard). The note was
included with this paragraph because, as previously noted, these are
the situations in which the Board believes auditors would be most
likely to perform procedures at a group level. To address the use of
group-level procedures in other contexts, a footnote was added to the
note indicating that other procedures required by the Appendix may also
be performed at a group level, provided that the conditions described
in the note are met.
The new standard does not prescribe detailed procedures because the
necessary audit procedures will vary in nature and extent depending on
a number of factors, including the relevant risks and the process used
by the pricing service (e.g., matrix pricing, algorithm, or cash flow
projections). For example, evaluating the reasonableness of a fair
value based on the estimated cash flows from a pool of securitized
mortgage loans would differ from evaluating an input derived from
adjusted observable data. Procedures may include for example,
evaluating how comparable transactions are selected and monitored or
how matrix pricing is developed.
Additionally, the new standard does not prescribe who is to perform
the procedures with respect to pricing services. It is the Board's
understanding of current practice that, in large firms, firm-level due
diligence over pricing services is typically performed centrally by a
national-level pricing desk and not undertaken by each engagement team.
The determination of whether the due diligence procedures over a
pricing service should be performed by an engagement team or by the
national office centralized group is at the discretion of the auditor,
based on the relevant facts and circumstances. The Board does not
intend that the new standard would give rise to a change in current
practice in this area.
See Paragraph .A7
The proposal provided that when there are no recent transactions
either for the financial instrument being valued or for similar
financial instruments, the auditor should perform additional audit
procedures, including evaluating the appropriateness of the valuation
method and the reasonableness of observable and unobservable inputs
used by the pricing service.
One commenter requested clarification or guidance on the additional
procedures to be performed in circumstances when no recent transactions
have occurred for either the financial instrument or similar financial
instruments, expressing concern about smaller firms' ability to comply
with the proposed requirement.
The requirement has been adopted substantially as proposed. Given
the diverse nature of financial instruments that fall into this
category, prescribing detailed procedures is impractical. The necessary
audit procedures to evaluate the valuation methods and inputs will vary
based on the relevant risks, type of inputs, and valuation methods
involved.
Additionally, when an auditor is unable to obtain information from
a pricing service about the method or inputs used to develop the fair
value of a financial instrument when no recent transactions have
occurred for either the financial instrument being valued or for
similar financial instruments, the auditor is required under the new
standard to perform additional procedures, such as obtaining and
evaluating pricing information from a different pricing source,
obtaining evidence about the inputs used from public data about similar
trades, or developing an independent expectation.
Using Pricing Information From Multiple Pricing Services
See Paragraph .A8
The proposal provided direction for using pricing information from
multiple pricing services to assess the valuation of financial
instruments. Specifically, the proposal set forth certain conditions
[[Page 13421]]
under which less information is needed about the particular methods and
inputs used by the individual pricing services when pricing information
is obtained from multiple pricing services. In general, these factors
relate to situations in which there is reasonably consistent pricing
information available from several sources with ample observable
inputs.
Commenters on this paragraph generally supported the underlying
principle that less evidence may be needed when pricing information is
obtained from multiple pricing services. Some commenters questioned one
of the conditions set forth in the proposal, related to the methods
used to value the financial instruments. Those commenters suggested
that requiring the auditor to understand the valuation methods used was
inconsistent with the concept of obtaining less information. One
commenter suggested that sufficient appropriate audit evidence could be
obtained solely on the basis of two of the conditions: That the
instruments are routinely priced by several pricing services, and the
prices obtained are reasonably consistent. Some commenters asked for
clarification on whether the conditions can be applied on a group basis
or would be required to be applied to individual financial instruments,
expressing concern that the latter approach would lead to excessive
work.
Other commenters sought clarification or offered suggestions
regarding the wording of some of the conditions set forth in the
proposal. One commenter suggested consistently using the terms
``multiple'' and ``several'' in relation to pricing services. Another
commenter asked for clarification of the meaning of the phrase
``reasonably consistent between or among the pricing services from
which pricing information is obtained,'' specifically, whether the
phrase referred to consistent over a period of time or as of a point in
time.
Another commenter suggested a different set of conditions for when
less evidence may be needed. In that commenter's view, the auditor
would have obtained sufficient appropriate audit evidence with respect
to the valuation of a financial instrument if: (i) The auditor assesses
the financial instrument to have ``lower estimation uncertainty''
(e.g., based on the asset class and other characteristics of the
financial instrument), (ii) the auditor obtains multiple prices from
pricing services for the financial instrument, (iii) those pricing
services routinely price that type of financial instrument, (iv) the
prices obtained are reasonably consistent, and (v) the auditor has
obtained an understanding of the pricing services' methodologies at an
asset class level of the financial instrument.
Another commenter suggested that the standard should require taking
the average of a reasonable number of available prices, excluding
outliers, and that procedures such as those outlined in paragraph .A4
should be performed for at least one pricing source. The same commenter
also requested clarification of whether and how pricing sources like
Google and Yahoo Finance may be used.
After consideration of the comments received, paragraph .A8 in the
new standard has been revised to remove the reference to valuation
methods and to make other wording changes that, along with the footnote
to paragraph .A6, clarify that procedures under this paragraph can be
performed at a group level, provided that the conditions described in
the note to paragraph .A6 are met.
Regarding the comment on usage of the terms ``multiple'' and
``several'' in Paragraph .A8, the term ``multiple'' refers to more than
one pricing service. The term ``several'' is used to clarify that,
under the condition in paragraph .A8, pricing information is to be
obtained from more than two pricing services, all of which routinely
price the instruments.
The new standard includes the condition that prices obtained are
reasonably consistent across pricing services (as of a relevant point
in time), taking into account the nature and characteristics of the
financial instruments being valued and market conditions. For example,
the range of prices that would be reasonably consistent would be
narrower for a type of financial instrument with a number of observable
market inputs, such as recent trades of identical or substantially
similar instruments, than for a type of instrument with relatively few
observable market inputs.
The suggestion to compute averages of prices from different sources
was not included in the new standard because averages could obscure a
wide range of price variation and no consideration would be given to
whether certain prices are more indicative of the fair value of the
instrument than others. The Board considered the other factors
suggested by commenters and determined that those factors generally
were similar in nature to requirements in Appendix A. For example, the
suggested factor based on lower estimation uncertainty is, in the
Board's view, subsumed in the other listed factors.
Websites that publish, for the general public, prices for exchange-
traded securities in active markets are not pricing services as
described in the new standard, and the auditor's responsibility for
information from those sources is set forth in paragraph .A2 of the new
standard. Evaluating whether securities prices from these websites
provide sufficient appropriate evidence includes evaluating whether the
websites obtain the prices directly from original sources (e.g., stock
exchanges).
Using Pricing Information From a Broker or Dealer
See Paragraph .A9
The proposal set forth certain factors that affect the relevance
and reliability of the evidence provided by a quote from a broker or
dealer. In addition, the proposal included an amendment to AS 1105.08
to more broadly address restrictions, limitations, and disclaimers in
audit evidence from third parties.
Some commenters asked for guidance on the proposed requirement to
evaluate the relationship of the source of the pricing information with
the company, including the factors to be evaluated. Another commenter
suggested that the standard state that the list of factors affecting
relevance and reliability is not all inclusive, although the commenter
did not suggest additional factors to be included. One commenter
asserted that the proposal would result in a significant change in
practice, and suggested that the Board should consider whether there
were lower risk circumstances for which a broker quote may be
sufficient appropriate audit evidence without meeting all criteria.
Another commenter noted that the first sentence of the paragraph reads
as though it applies only when the auditor tests the company's price
based on a quote from a broker or dealer. The commenter suggested that
the proposal should clarify whether the requirement would also apply
when the auditor develops an independent expectation using a broker
quote.
The new standard has been revised to include a note providing that
auditors should take into account the results of the procedures
performed under AS 2410, Related Parties, when determining whether the
broker or dealer has a relationship with the company by which company
management has the ability to directly or indirectly control or
significantly influence the broker or dealer. Otherwise, the
requirements in the new standard have been adopted substantially as
proposed. The Board believes that the factors set forth in the
[[Page 13422]]
standard provide sufficient direction to the auditor to evaluate the
relevance and reliability of the evidence provided by the quote, in
order to determine whether the quote provides sufficient appropriate
evidence in light of the risks of material misstatement.
The requirements in the proposal were framed in terms of when the
company's fair value measurement is based on a quote from a broker or
dealer because the Board understands that this is the situation
typically encountered in practice. However, the factors set forth in
the standard relate to the relevance and reliability of audit evidence
from those quotes, and thus are equally applicable to those less common
situations when the auditor uses a broker quote to develop an
independent expectation. The requirement in the new standard has been
revised to remove the reference to the ``company's'' measurement.
If the broker quote does not provide sufficient appropriate
evidence, the auditor would be required to perform procedures to obtain
relevant and reliable pricing information from another source (for
example, obtaining a quote from a different broker or dealer, obtaining
pricing information from a pricing service, or developing an
independent expectation).
Unobservable Inputs
See Paragraph .A10
The proposal set forth a requirement for the auditor to obtain an
understanding of how unobservable inputs were determined and to
evaluate the reasonableness of those inputs. This understanding would
involve, among other things, taking into account the assumptions that
market participants would use when pricing the financial instrument,
including assumptions about risk, and how the company determined its
fair value measurement, including whether it appropriately considered
available information. For example, if management adjusts interest
rates, credit spread, or yield curves used to develop a fair value
measurement, the auditor would be required to evaluate whether the
adjustments reflect the assumptions that market participants would
ordinarily use when pricing that type of financial instrument.
The two commenters on this paragraph expressed opposing views. One
commenter supported the requirement while the other commenter suggested
deleting the paragraph.
The requirement is adopted as proposed. By providing factors that
the auditor takes into account, the new standard provides additional
direction in an area that is inherently subjective and judgmental in
nature and therefore poses a higher risk of material misstatement.
Additional Amendments to PCAOB Auditing Standards
The Board has also adopted amendments to several of its existing
auditing standards to conform to the new standard, as reflected in
Exhibit A to the SEC Filing Form 19b-4, available on the Board's
website at https://pcaobus.org/Rulemaking/Pages/docket-043-auditing-accounting-estimates-fair-value-measurements.aspx and at the
Commission's Public Reference Room. Significant amendments are
described below.\89\
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\89\ The discussion that follows excludes conforming amendments
that make reference to the new standard.
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Amendments to AS 1015, Due Professional Care in the Performance of Work
The proposed amendments to AS 1015.11 included two changes to the
discussion of reasonable assurance when auditing accounting estimates
(1) clarifying that many (although not all) accounting presentations
contain accounting estimates, the measurement of which is inherently
uncertain and depends on the outcome of future events; and (2)
providing that, in auditing accounting estimates, the auditor considers
information through the date of the auditor's report, which under PCAOB
standards is a date no earlier than the date on which the auditor has
obtained sufficient appropriate evidence.\90\
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\90\ See paragraph .01 of AS 3110, Dating of the Independent
Auditor's Report.
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One commenter advocated for including language in AS 1015 that
explains inherent limitations that an auditor may face with regard to
identifying and evaluating management bias in accounting estimates. In
this commenter's view, financial reporting frameworks do not
distinguish between reasonable judgment latitude, subconscious
management bias, and willful biased manipulation.
The amendments are adopted substantially as proposed. The Board
acknowledges that various circumstances can give rise to management
bias and that, given the subjective assumptions and uncertainty
inherent in many estimates, bias cannot be eliminated entirely. The new
standard, as well as other PCAOB standards, address the auditor's
responsibilities for evaluating potential management bias in accounting
estimates and its effect on financial statements.
Amendments to AS 1105, Audit Evidence
The proposed amendment to AS 1105.08 would require the auditor to
evaluate the effect of any restrictions, limitations, or disclaimers
imposed by a third party on the reliability of evidence provided by
that party.
A few commenters sought guidance on how to apply the requirement,
including how the auditor would determine if the evidence was
sufficiently reliable.
The amendment to AS 1105.08 is adopted as proposed. Third-party
information often contains restrictions, limitations, or disclaimers as
to the use of such information and its conformity with the applicable
financial reporting framework. The nature of the restriction,
limitation, or disclaimer and how the information provided is being
used would inform the auditor's assessment of whether the evidence
provided by the third-party information is sufficiently reliable, or
whether additional procedures need to be performed (and, if so, the
nature and extent of such procedures). For example, language in a
business valuation disclaiming responsibility for company-provided data
used to prepare the valuation may not affect the reliability of that
valuation as long as the auditor performs audit procedures to test
company-provided data used.
Appendix B, Audit Evidence Regarding Valuation of Investments Based on
Investee Financial Results
The proposal set forth amendments to add Appendix A, Audit Evidence
Regarding Valuation of Investments Based on Investee Financial
Condition or Operating Results, to AS 1105. The proposed amendments
would have retained and updated certain requirements from the
derivatives standard for situations in which the valuation of an
investment selected for testing is based on the investee's financial
condition or operating results, including certain investments accounted
for by the equity method and investments accounted for by the cost
method for which there is a risk of material misstatement regarding
impairment.
Commenters expressed concerns that the updated requirements in the
proposal were written in a manner that was overly prescriptive,
impracticable, burdensome, or inconsistent with the application of a
risk-based approach. For example, commenters asserted that certain
procedures involving interaction
[[Page 13423]]
with investee management or the investee auditor were not practicable
because the investor company's auditor might not have access to those
parties. Commenters also sought clarification on the intent and
application of several procedures set forth in the appendix.
After consideration of comments, the Board has decided to retain
the existing requirements from the derivatives standard, with only
limited conforming changes. The requirements are set forth as Appendix
B, Audit Evidence Regarding Valuation of Investments Based on Investee
Financial Results, to AS 1105. The intent of updating the requirements
from the derivatives standard was to better align the required
procedures with the risk assessment standards, not to substantively
change audit practice in this area. Retaining the language of the
existing requirements is consistent with the intention not to change
audit practice. The requirements of the risk assessment standards
continue to be applicable to investments audited under Appendix B of AS
1105.
Amendment to AS 1205, Part of the Audit Performed by Other Independent
Auditors
AS 1205.14 discusses the applicability of that standard to
situations where the company being audited has an investment accounted
for under the equity method or the cost method and the investee is
audited by another auditor. In consideration of comments on the
appendix to AS 1105 discussed above, the Board is also amending AS 1205
to help auditors determine the appropriate standard to apply in those
situations. Specifically, the amendment provides that the auditor
should look to the requirements of Appendix B of AS 1105 for situations
in which the valuation of an investment selected for testing is based
on the investee's financial results and neither AS 1201 nor AS 1205
applies. The amendment clarifies that Appendix B of AS 1105 applies
when AS 1205, by its terms, does not apply and the investee auditor is
not supervised under AS 1201.
Amendments to AS 2110, Identifying and Assessing Risks of Material
Misstatement
The proposal included a number of amendments to AS 2110 related to:
Obtaining an understanding of the processes used to
develop accounting estimates and evaluating the use of service
organizations that are part of a company's information system;
Discussing how the financial statements could be
manipulated through management bias; and
Assessing additional risk factors specifically for
accounts and disclosures involving accounting estimates.
One commenter suggested that requirements related to identifying
and assessing risks of material misstatements in accounting estimates
should be in one standard (i.e., new standard) rather than amending the
various risk assessment standards. In contrast, another commenter
expressed support for amending other PCAOB standards as a result of a
new standard on accounting estimates.
The amendments to AS 2110, described in more detail below, are
adopted substantially as proposed.
Information and Communication
The proposed amendment to AS 2110.28 would require the auditor, as
part of obtaining an understanding of a company's information system
and related business processes, to obtain an understanding of the
processes used to develop accounting estimates, including (1) the
methods used, which may include models; (2) the data and assumptions
used, including the source from which they are derived; and (3) the
extent to which the company uses specialists or other third parties,
including the nature of the service provided and the extent to which
the third parties use company data and assumptions.
The proposed amendment also included a note emphasizing that the
requirements in AS 2601 with respect to the auditor's responsibilities
for obtaining an understanding of controls at a service organization
would apply when the company uses a service organization that is part
of the company's information system over financial reporting. In
addition, for critical accounting estimates, the proposed amendment
referenced a requirement in the proposed standard for the auditor to
obtain an understanding of how management analyzed the sensitivity of
its significant assumptions to change, based on other reasonably likely
outcomes that would have a material effect.
One commenter suggested a requirement for the auditor to obtain an
understanding of how management identifies and addresses the risk of
management bias. Another commenter suggested adding language similar to
the existing note on evaluation of risk and controls within the
information system to clarify that a service organization is part of
the evaluation, not a separate consideration.
In light of related amendments to AS 2110 in the Board's rulemaking
on the auditor's use of specialists, the amendment to AS 2110.28 was
revised to clarify that the auditor's understanding of the processes
used to develop accounting estimates includes the extent to which the
company uses third parties other than specialists.\91\
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\91\ See the Specialists Release, supra note 2, for a discussion
of auditors' responsibilities with respect to specialists.
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The amendment emphasizes elements of assessing the risks of
material misstatement that are specifically relevant to accounting
estimates, recognizing that the methods, data and assumptions used by
the company in its process to develop accounting estimates, including
how they are selected and applied, drive the risk associated with the
estimate. In addition, as part of obtaining an understanding the
information system, the amendment reminds the auditor to consider
whether the requirements of AS 2601 are applicable to the third party
used by the company in developing an accounting estimate.
A separate requirement for the auditor to obtain an understanding
of how management identifies and addresses the risk of management bias
was not necessary as the new standard requires the auditor to evaluate
management bias and its effect on financial statements as part of
responding to risks of material misstatements in accounting estimates.
Comparison With Standards of Other Standard Setters
Similar to this amendment, ISA 540 Revised sets forth requirements
to obtain an understanding of how management identifies the relevant
methods, assumptions or sources of data, and the need for changes in
them, that are appropriate in the context of the applicable financial
reporting framework, including how management (a) selects or designs,
and applies, the methods used, including the use of models; (b) selects
the assumptions to be used, including consideration of alternatives,
and identifies significant assumptions; and (c) selects the data to be
used.
Discussion of the Potential for Material Misstatement Due to Fraud
AS 2110.52 requires the key engagement team members to discuss the
potential for material misstatement due to fraud. The proposed
amendment to AS 2110.52 would require the auditor to include, as part
of this discussion, how the financial statements could be manipulated
through management bias in accounting estimates in significant accounts
and disclosures.
[[Page 13424]]
Commenters that addressed this topic were generally supportive of
the amendment but provided some suggestions for refinements. One
commenter suggested that the standard include discussion of different
types of bias. Another commenter also indicated that, in their view,
the consideration of bias may be better placed in paragraphs .49-.51 of
AS 2110 as part of the overall discussion of the susceptibility of the
financial statements to material misstatement. Further, in one
commenter's view, the requirement implied that the auditor should seek
out bias in every accounting estimate. This commenter suggested the
language be revised to focus on estimates that are ``more susceptible''
to material misstatement from management bias or where management bias
is ``more likely to'' result in a material misstatement.
The amendment to AS 2110.52 is adopted as proposed. Contrary to the
view of one commenter, the requirement does not direct the auditor to
seek out bias in each estimate. Rather, by including the potential for
management bias (regardless of type) as part of the engagement team's
overall brainstorming discussion, the requirement focuses the auditor's
attention on a risk that is particularly relevant to accounting
estimates in significant accounts and disclosures. In addition,
including the requirement as part of paragraph .52 provides additional
context as to the nature of the discussion about susceptibility of the
company's financial statements to material misstatement due to fraud.
Identifying Significant Accounts and Disclosures and Their Relevant
Assertions
AS 2110.60 provides risk factors relevant to the identification of
significant accounts and disclosures and their relevant assertions. The
proposed amendment to AS 2110.60 provided the auditor with additional
risk factors that are relevant to identifying significant accounts and
disclosures involving accounting estimates, including (1) the degree of
uncertainty associated with the future occurrence or outcome of events
and conditions underlying the assumptions; (2) the complexity of the
process for developing the accounting estimate; (3) the number and
complexity of significant assumptions associated with the process; (4)
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 (5) if
forecasts are important to the estimate, the length of the forecast
period and degree of uncertainty regarding trends affecting the
forecast.
One commenter suggested including additional factors such as (1)
the extent to which the process involves specialized skills or
knowledge; (2) the complexity of the data used for developing the
accounting estimate, including the difficulty, if any, in obtaining
relevant and reliable data and maintaining the integrity of the data;
and (3) the potential for management bias. Another commenter questioned
whether the Board intends management bias to extend beyond a fraud
risk, suggesting the requirement highlight management bias as a
specific risk factor. A different commenter asked for clarification on
how instances of high measurement uncertainty are contemplated.
One commenter sought clarity on whether the above risk factors are
intended to be considered when identifying and assessing the risks of
material misstatement related to accounting estimates (in addition to
identifying significant accounts and disclosures).
The amendment to AS 2110.60 is adopted as proposed. The additional
risk factors included in the amendment describe those characteristics
and conditions that are associated with accounting estimates and that
can affect the auditor's determination of the likely sources of
potential misstatement. While the factors assist the auditor in
identifying significant accounts and disclosures and their relevant
assertions, these factors also prompt auditors to appropriately assess
the associated risks in the related accounts and disclosures and
develop appropriate audit responses. As discussed above, AS 2810
requires the auditor to evaluate management bias and its effect on the
financial statements. In circumstances where management bias gives rise
to a fraud risk, the auditor looks to the requirements of AS 2301 to
respond to those risks.
The factors were not expanded to include extent of specialized
skills used, potential for management bias, or complexity of the data
used, as suggested by one commenter. These characteristics are already
captured within the factors presented in the amendment or elsewhere in
the risk assessment standards. For example, assessing the complexity of
the process for developing an accounting estimate would necessarily
include understanding the data and assumptions that are used within the
process. Further, as discussed above, the new standard and related
amendments recognize that the degree of uncertainty associated with
some estimates affect the assessed risks and direct auditors to plan
and perform audit procedures to respond to those risks.
Amendments to AS 2301, the Auditor's Responses to the Risks of Material
Misstatement
The proposal included a note to AS 2301.36 emphasizing that
performing substantive procedures for the relevant assertions of
significant accounts and disclosures involves testing whether the
significant accounts and disclosures are in conformity with the
applicable financial reporting framework.
Commenters did not express concerns with the proposed amendment.
However, some commenters called for additional guidance on identifying
and testing relevant controls over accounting estimates. For example,
one commenter suggested guidance related to auditor consideration of
management controls over selection and supervision of a company
specialist. Another commenter suggested additional guidance on
identification and testing of relevant controls, and identification and
response to risks of material misstatement due to fraud in relation to
auditing estimates. This commenter expressed the view that testing the
operating effectiveness of controls, including controls over complex
models or methods used, can be critical in auditing accounting
estimates and, in some circumstances, may be required (e.g., in
situations in which substantive procedures alone do not provide
sufficient appropriate evidence).
The auditor's responsibilities for testing controls are addressed
in AS 2110, AS 2301, and AS 2201, An Audit of Internal Control Over
Financial Reporting That Is Integrated with An Audit of Financial
Statements. These requirements would apply to controls over accounting
estimates. Nonetheless, in the Board's view, providing additional
direction on the need to test controls related to accounting estimates
could help promote an appropriate audit response in cases where only a
financial statement audit is performed. Accordingly, after
consideration of comments, the Board is amending AS 2301.17 to include
a note reminding auditors that for certain accounting estimates
involving complex models or processes, it might be impossible to design
effective substantive tests that, by themselves, would provide
sufficient appropriate evidence regarding relevant assertions.
The amendment to AS 2301.36 is also adopted as proposed.
[[Page 13425]]
Amendments to AS 2401, Consideration of Fraud in a Financial Statement
Audit
To better align requirements with the scope of the proposed
standard, the proposed amendment to AS 2401.64 would have deleted
reference to ``significant accounting estimates reflected in the
financial statements'' and clarified that, when an auditor performs a
retrospective review, the review should be performed for accounting
estimates in significant accounts and disclosures. The proposed
amendment would also have clarified that the retrospective review
involves a comparison of the prior year's estimates to actual results,
if any, to determine whether management's judgments and assumptions
relating to the estimates indicate a possible bias on the part of
management.
Some commenters expressed concern that the proposed amendment would
expand the population of accounting estimates subject to retrospective
review, resulting in excessive work. Other commenters suggested either
including the requirement to perform a retrospective review within the
proposed standard, or providing a clearer linkage between the proposed
standard and the requirements for retrospective review in AS 2401. One
commenter suggested a requirement to evaluate the accuracy of
management's prior estimates going back a minimum of three years.
After consideration of comments, the amendment to AS 2401.64 was
revised to further clarify that the accounting estimates selected for
testing should be those for which there is an assessed fraud risk. The
scope of the retrospective review, as amended, is better aligned with
the new standard and focuses the auditor on accounting estimates
already identified through the risk assessment process as being
susceptible to material misstatement due to fraud.
A separate requirement for performing a retrospective review is not
necessary in the new standard as the requirement in AS 2401 would
achieve the same objective. Further, for some estimates, the outcome of
the estimate may not be known within a reporting period to facilitate
such a review. Similarly, requiring a review over multi-year period
would not be feasible for some estimates. Obtaining an understanding of
the company's process for developing an estimate would necessarily
provide information about the company's ability to make the estimate.
In addition, the new standard requires the auditor to evaluate whether
the company has a reasonable basis for significant assumptions used in
accounting estimates.
Comparison With Standards of Other Standard Setters
ISA 540 Revised requires the auditor to review the outcome of
previous accounting estimates, or, where applicable, their subsequent
re-estimation to assist in identifying and assessing the risks of
material misstatement in the current period. The auditor shall take
into account the characteristics of the accounting estimates in
determining the nature and extent of that review. The review is not
intended to call into question judgments about previous period
accounting estimates that were appropriate based on the information
available at the time they were made.
AU-C Section 540 includes a similar requirement.
Amendment to AS 2805, Management Representations
The proposed amendment to AS 2805.06 would require the auditor to
obtain specific representations related to accounting estimates in
connection with an audit of financial statements presented in
conformity with generally accepted accounting principles. Consistent
with the fair value standard, the auditor would obtain representations
about the appropriateness of the methods, the consistency in
application, the accuracy and completeness of data, and the
reasonableness of significant assumptions used by the company in
developing accounting estimates. Commenters did not address the
requirement and the Board has adopted this amendment as proposed.
Amendment To Rescind AI 16, Auditing Accounting Estimates: Auditing
Interpretations of AS 2501
As discussed in the proposal, the Board is rescinding AI 16. That
interpretation addresses performance and reporting guidance related to
fair value disclosures, primarily voluntary disclosures including fair
value balance sheets. Fair value disclosure requirements in the
accounting standards have changed since the issuance of this
interpretation, and fair value balance sheets covered by the
interpretation are rarely included in issuer financial statements.
Accordingly, this interpretation is unnecessary. Commenters did not
object to rescinding this interpretation.
Effective Date
The Board determined that AS 2501 (Revised) and related amendments
will take effect, subject to approval by the SEC, for audits of
financial statements for fiscal years ending on or after December 15,
2020.
The Board sought comment on the amount of time auditors would need
before the proposed standard and amendments would become effective, if
adopted by the Board and approved by the SEC. A number of commenters
recommended that the Board provide an effective date two years after
SEC approval, which they asserted would give firms the necessary time
to update firm methodologies, develop and implement training, and
ensure effective quality control process to support implementation.
Some commenters supported an earlier effective date, with one commenter
indicating that the proposed standard should be effective
contemporaneously with the implementation of the new accounting
standard on credit losses. One commenter also suggested a phased in
approach for EGCs. Two commenters noted that the proposal should be
effective at the same time as any amendments related to the auditor's
use of the work of specialists.
While recognizing other implementation efforts, the effective date
determined by the Board is designed to provide auditors with a
reasonable period of time to implement the new standard and related
amendments, without unduly delaying the intended benefits resulting
from these improvements to PCAOB standards. The effective date is also
aligned with the effective date of the amendments being adopted in the
Specialists Release.
D. Economic Considerations and Application to Audits of Emerging Growth
Companies
The Board is mindful of the economic impacts of its standard
setting. The economic analysis describes the baseline for evaluating
the economic impacts of the new standard, analyzes the need for the
changes adopted by the Board, and discusses potential economic impacts
of the new standard and related amendments, including the potential
benefits, costs, and unintended consequences. The analysis also
discusses the alternatives considered. There are limited data and
research findings available to estimate quantitatively the economic
impacts of discrete changes to auditing standards in this area, and
furthermore, no additional data was identified by commenters that would
allow the Board to generally quantify the expected economic impacts
(including expected incremental costs related to the
[[Page 13426]]
proposal) on audit firms or companies. Accordingly, the Board's
discussion of the economic impact is qualitative in nature.
The Board sought information relevant to economic consequences over
the course of the rulemaking. The Board has considered all the comments
received and has developed an economic analysis that evaluates the
potential benefits and costs of the final requirements and facilitates
comparison to alternative actions considered.
Commenters who discussed the economic analysis in the Board's
proposal provided a range of views. A number of commenters agreed with
the economic analysis relating to the need for the proposal. Some
commenters agreed with the potential benefits outlined in the proposal,
including an increase in investor confidence and consistency in the
application of requirements. At the same time, other commenters
cautioned against raising expectations among investors about the impact
of the proposal on audit quality by noting various inherent limitations
that the auditor faces in auditing estimates. A number of commenters
suggested that additional audit work required by the new standard would
increase cost without necessarily improving audit quality related to
auditing estimates. In addition, some commenters expressed concern that
some of the increase in cost might be passed through to companies in
the form of increased audit fees.
Baseline
Section C above discusses the Board's current requirements for
auditing accounting estimates, including fair value measurements, and
current practices in the application of those requirements. This
section expands on the current practices of the profession and
currently observed patterns.
As discussed in Section C, the PCAOB has historically observed
numerous deficiencies in auditing accounting estimates. PCAOB staff
gathered data from reported inspection findings related to issuer
audits between 2008 and 2016 for the eight accounting firms that have
been inspected every year since the PCAOB's inspection program
began.\92\ The chart below shows the number of audits with deficiencies
related to the accounting estimates standard and fair value standard
based on the 2008-2016 reported inspection findings \93\ for those
eight firms.\94\
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\92\ The eight accounting firms are BDO USA, LLP; Crowe Horwath
LLP; Deloitte & Touche LLP; Ernst & Young LLP; Grant Thornton LLP;
KPMG LLP; PricewaterhouseCoopers, LLP; and RSM US LLP (formerly
McGladrey, LLP).
\93\ Deficiencies related to the derivatives standard were
infrequent over the inspection period reviewed, and therefore
considered insignificant for purposes of this analysis.
\94\ The chart identifies the audits with deficiencies reported
in the public portion of inspection reports. It shows the relative
frequency of audits with deficiencies citing the existing accounting
estimates standard or the existing fair value standard compared to
the total audits with deficiencies for that year. For example, in
inspection year 2010, 66% of all audits with deficiencies had at
least one deficiency related to the accounting estimates standard or
the fair value standard (total 2016 reported inspection findings are
based on preliminary results).
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[GRAPHIC] [TIFF OMITTED] TN04AP3.000
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[[Page 13427]]
Audits that had deficiencies related to the estimates standards
represent a significant number of total audits with deficiencies
(including deficiencies in audits of internal control over financial
reporting) although the overall percentage has declined since 2011.\95\
This is consistent with a recent PCAOB Staff Inspection Brief, which
observed that during the 2016 inspection cycle, inspections staff
continued to find high numbers of deficiencies and ``identify instances
in which auditors did not fully understand how the issuer's estimates
were developed or did not sufficiently test the significant inputs and
evaluate the significant assumptions used by management.'' \96\ Given
the pattern of the data, one can conclude that, although deficiencies
were increasing in the early periods, more recently they have declined.
Despite this recent decline, the deficiencies have remained high over
an extended period.
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\95\ PCAOB inspection reports for the same eight firms covering
the inspection period from 2004 to 2009 similarly found deficiencies
in auditing fair value measurements, including impairments and other
estimates. See also Bryan Church and Lori Shefchik, PCAOB
Inspections and Large Accounting Firms, 26 Accounting Horizons 43
(2012).
\96\ See PCAOB Staff Inspection Brief, Preview of Observations
from 2016 Inspections of Auditors of Issuers, at 7. For a more
detailed discussion of observations from audit inspections, see
Section C.
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Accounting estimates are prevalent and significant in financial
reporting, as confirmed by academic research and supported with
empirical evidence. For example, Griffith et al. note that complex
accounting estimates, including fair value measurements, impairments,
and valuation allowances, are increasingly important to financial
statements.\97\ In addition, some studies provide evidence on the
significance of accounting estimates by using large samples of critical
accounting policy (``CAP'') disclosures and critical accounting
estimate (``CAE'') disclosures.\98\ Levine and Smith, using a large
sample of CAP disclosures from annual filings, estimate that on average
issuers disclose 6.46 policies as critical, with a median of 6.\99\
Their analysis shows that issuers most frequently disclose policies
relating to fair value measurements and estimates.\100\ Glendening, in
his 2017 study, uses a large sample of CAE disclosures data covering
2002-2010 and finds that on average about half of the issuers in his
sample disclose such estimates every year, with the disclosure rate
increasing over time.\101\ In Glendening's sample, on average, firms
disclose between two and three critical accounting estimates. Also,
commenters generally agreed with the characterization that financial
reporting has continued to require more accounting estimates that
involve complex processes and have a significant impact on companies'
operating results and financial positions.
---------------------------------------------------------------------------
\97\ See Emily Griffith, Jacqueline S. Hammersley, Kathryn
Kadous, and Donald Young, Auditor Mindsets and Audits of Complex
Estimates, 53 Journal of Accounting Research 49 (2015).
\98\ Disclosure in Management's Discussion and Analysis about
the Application of Critical Accounting Policies, Release No. 33-8098
(May 10, 2002), 67 FR 35619 (May 20, 2002); and Commission Guidance
Regarding Management's Discussion and Analysis of Financial
Condition and Results of Operations, Release No. 33-8350.
\99\ See Carolyn B. Levine and Michael J. Smith, Critical
Accounting Policy Disclosures, 26 Journal of Accounting, Auditing &
Finance 39, 48 (2011).
\100\ Id. at 49-50.
\101\ See Matthew Glendening, Critical Accounting Estimate
Disclosures and the Predictive Value of Earnings, 31 (4) Accounting
Horizons 1, 12 (2017).
---------------------------------------------------------------------------
Academic research also confirms the challenges auditors face in
auditing estimates, including fair value measurements. Griffith et al.,
in providing a brief summary of the relevant literature, note that,
while accounting estimates are increasingly important to financial
statements, auditors experience ``difficulty in auditing complex
estimates, suggesting that audit quality may be low in this area.''
\102\ Martin, Rich, and Wilks attribute much of the difficulty in
auditing fair value measurements to estimation based on future
conditions and events and also note that auditors face many of the same
challenges when auditing other accounting estimates.\103\ Cannon and
Bedard, using a survey of auditors, find that features such as
``management assumptions, complexity, subjectivity, proprietary
valuations, and a lack of verifiable data . . . all contribute to the
challenges in auditing [fair value measurements].'' \104\ Other studies
point to the lack of sufficient knowledge on the part of auditor or
management as a contributing factor to auditing challenges. Griffith et
al. report that ``[i]nsufficient valuation knowledge is problematic in
that relatively inexperienced auditors, who also likely lack knowledge
of how their work fits into the bigger picture, perform many audit
steps, even difficult ones such as preparation of independent
estimates.'' \105\ Glover et al. find similar issues with expertise
from management's side, with results that indicate that a majority of
audit partners participating in their survey reported encountering
problems with ``management's lack of valuation process knowledge.''
\106\
---------------------------------------------------------------------------
\102\ See Griffith et al., Auditor Mindsets and Audits of
Complex Estimates 50.
\103\ See Roger D. Martin, Jay S. Rich, and T. Jeffrey Wilks,
Auditing Fair Value Measurements: A Synthesis of Relevant Research,
20 Accounting Horizons 287, 289 (2006).
\104\ See Nathan Cannon and Jean C. Bedard, Auditing Challenging
Fair Value Measurements: Evidence from the Field, 92 The Accounting
Review 81, 82 (2017).
\105\ See Emily Griffith, Jacqueline S. Hammersley, and Kathryn
Kadous, Audits of Complex Estimates as Verification of Management
Numbers: How Institutional Pressures Shape Practice, 32 Contemporary
Accounting Research 833, 836 (2015).
\106\ See Steven M. Glover, Mark H. Taylor, and Yi-Jing Wu,
Current Practices and Challenges in Auditing Fair Value Measurements
and Complex Estimates: Implications for Auditing Standards and the
Academy, 36 Auditing: A Journal of Practice & Theory 63, 82 (2017).
---------------------------------------------------------------------------
In addition to the findings regarding auditing challenges, academic
research provides evidence on auditors' use of the available approaches
for testing an accounting estimate. A study by Griffith et al. suggests
that, among the three approaches available under current standards,
auditors primarily choose to test management's process, rather than use
subsequent events or develop an independent estimate.\107\ In doing so,
some auditors tend to verify management's assertions on a piecemeal
basis; the authors of the study argue that this may result in
overreliance on management's process rather than a critical analysis of
the estimate. Another study by Glover et al., however, finds that
auditors primarily use the approach of testing management's process
when auditing lower-risk or typical complex estimates and are more
likely to use a combination of substantive approaches as the complexity
and associated risk of the estimate increase.\108\
---------------------------------------------------------------------------
\107\ See Griffith et al., Audits of Complex Estimates as
Verification of Management Numbers: How Institutional Pressures
Shape Practice 841.
\108\ See Glover et al., Current Practices and Challenges in
Auditing Fair Value Measurements and Complex Estimates: Implications
for Auditing Standards and the Academy 65. See also Cannon and
Bedard, Auditing Challenging Fair Value Measurements: Evidence from
the Field 81, 82-83. Glover et al. provide additional insight
regarding auditor's selection of substantive testing approaches,
specifically, the use of developing independent estimates and
reviewing subsequent events and transactions. Glover et al., Current
Practices and Challenges in Auditing Fair Value Measurements and
Complex Estimates: Implications for Auditing Standards and the
Academy 69, 71. The study shows that, in developing independent
estimates, availability of independent data, availability of
verifiable data, and the reliability of management's estimates are
the most commonly cited factors that drive auditors' decisions to
use management's versus the audit team's assumptions. Regarding the
use of reviewing subsequent events and transactions, over 96% of the
participating auditors in the study report using the most recent
trades that have occurred in the market to support the fair values
of recorded securities.
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[[Page 13428]]
Need for the Rulemaking
From an economic perspective, the primary reasons to improve PCAOB
standards for auditing accounting estimates are as follows:
The subjective assumptions and measurement uncertainty of
accounting estimates make them susceptible to potential management
bias. The Board believes that PCAOB standards related to auditing
accounting estimates will be improved by emphasizing the application of
professional skepticism, including addressing potential management
bias. Although the risk assessment standards and certain other PCAOB
standards address professional skepticism and management bias, the
estimates standards provide little or no specific direction on how to
address those topics in the context of auditing accounting estimates.
Existing requirements do not provide specific direction
about how to evaluate the relevance and reliability of pricing
information from third parties and might have led to additional work
and cost for some audits. PCAOB standards should be improved by
revising the requirements in this area to drive a level of work effort
commensurate with both the risks of material misstatement in the
valuation of financial instruments and the relevance and reliability of
the evidence obtained.
The differences among the three existing estimates
standards suggest that revising PCAOB standards to set forth a more
uniform, risk-based approach to auditing estimates should lead to
improvements in auditing practices in responding to the risks of
material misstatement in accounting estimates, whether due to error or
fraud.
Economic theory provides an analytical framework for the Board's
consideration of these potential needs, as discussed below.
Principal-Agent Problems and Bounded Rationality
Principal-agent theory is commonly used to describe the economic
relationship between investors and managers, and the attendant
information and incentive problems that result from the separation of
ownership and control.\109\ The presence of information asymmetry \110\
in such a principal-agent relationship results in an inherent incentive
problem (moral hazard) \111\ where the objectives of the agent
(management) may differ from the objectives of the principal
(investors), such that the actions of management may be suboptimal from
the investors' perspective. For example, academic research suggests
that management may engage in earnings management, in which they choose
reporting methods and estimates that do not adequately reflect their
companies' underlying economics, for a variety of reasons, including to
increase their own compensation and job security.\112\ The information
asymmetry between investors and managers also leads to an information
problem (adverse selection) \113\ resulting in a higher cost of
capital,\114\ because investors may not be able to accurately assess
the quality of management or of management reporting.
---------------------------------------------------------------------------
\109\ For studies of principal-agent relationships and the
attendant information and incentive problems in the context of the
separation of ownership and control of public companies and its
implications in financial markets, see, e.g., Michael C. Jensen and
William H. Meckling, Theory of the Firm: Managerial Behavior, Agency
Costs and Ownership Structure, 3 Journal of Financial Economics 305
(1976).
\110\ Economists often describe ``information asymmetry'' as an
imbalance, where one party has more or better information than
another party. For a discussion of the concept of information
asymmetry, see, e.g., George A. Akerlof, The Market for ``Lemons'':
Quality Uncertainty and the Market Mechanism, 84 The Quarterly
Journal of Economics 488 (1970).
\111\ The moral hazard problem is also referred to as a hidden
action, or agency problem in economics literature. The term ``moral
hazard'' refers to a situation in which an agent could take actions
(such as not working hard enough) that are difficult to monitor by
the principal and would benefit the agent at the expense of the
principal. To mitigate moral hazard problems, the agent's actions
need to be more closely aligned with the interests of the principal.
Monitoring is one mechanism to mitigate these problems. See, e.g.,
Bengt Holmstr[ouml]m, Moral Hazard and Observability, 10 The Bell
Journal of Economics 74 (1979).
\112\ See Paul M. Healy and James M. Wahlen, A Review of the
Earnings Management Literature and Its Implications for Standard
Setting, 13 (4) Accounting Horizons 365 (1999). For a seminal work
on the agency problem between managers and investors, see Jensen and
Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Structure.
\113\ Adverse selection (or hidden information) problems can
arise in circumstances where quality is difficult to observe,
including in principal-agent relationships where the principal's
information problem means it cannot accurately assess the quality of
the agent or the agent's work. In addition to diminishing the
principal's ability to optimally select an agent, the problem of
adverse selection can manifest in markets more broadly, leading to
an undersupply of higher-quality products. For a discussion of the
concept of adverse selection, see, e.g., Akerlof, The Market for
``Lemons'': Quality Uncertainty and the Market Mechanism.
\114\ See, e.g., Richard A. Lambert, Christian Leuz, and Robert
E. Verrecchia, Information Asymmetry, Information Precision, and the
Cost of Capital, 16 (1) Review of Finance 1, 21 (2012).
---------------------------------------------------------------------------
In addition to the potential incentive problem, cognitive biases,
such as management optimism or overconfidence, can manifest themselves
in managerial behavior.\115\ The academic literature suggests that
individuals often overstate their own capacity and rate their
attributes as better than average.\116\ Moreover, evidence indicates
that, on average, CEOs and CFOs tend to be more optimistic than the
broader population.\117\ For example, managerial overconfidence has
been linked to aggressive earnings forecasts by management.\118\
---------------------------------------------------------------------------
\115\ For a discussion of the manifestation of overconfidence in
managerial behavior, see, e.g., Anwer S. Ahmed and Scott Duellman,
Managerial Overconfidence and Accounting Conservatism, 51 (1)
Journal of Accounting Research 1 (2013); Itzhak Ben-David, John R.
Graham, and Campbell R. Harvey, Managerial Miscalibration, 128 (4)
The Quarterly Journal of Economics 1547 (2013); and Catherine M.
Schrand and Sarah L.C. Zechman, Executive Overconfidence and the
Slippery Slope to Financial Misreporting, 53 Journal of Accounting
and Economics 311, 320 (2012).
\116\ This and other biases are discussed in, among others,
Gilles Hilary and Charles Hsu, Endogenous Overconfidence in
Managerial Forecasts, 51 Journal of Accounting and Economics 300
(2011).
\117\ See John R. Graham, Campbell R. Harvey, and Manju Puri,
Managerial Attitudes and Corporate Actions, 109 Journal of Financial
Economics 103, 104 (2013). Managerial attitude has been linked to a
variety of corporate decisions, including corporate investment and
mergers & acquisitions. See Ulrike Malmendier and Geoffrey Tate, CEO
Overconfidence and Corporate Investment, 60 The Journal of Finance
2661 (2005); and Ulrike Malmendier and Geoffrey Tate, Who Makes
Acquisitions? CEO Overconfidence and the Market's Reaction, 89
Journal of Financial Economics 20 (2008).
\118\ See Paul Hribar and Holly Yang, CEO Overconfidence and
Management Forecasting, 33 Contemporary Accounting Research 204
(2016).
---------------------------------------------------------------------------
Given the degree of subjectivity in many financial statement
estimates, these incentive and information issues, coupled with
cognitive biases, present particular problems in the context of
estimates. Managerial biases (conscious or otherwise) may lead managers
to pick a more favorable estimate within the permissible range.\119\
That is, incentive problems and cognitive biases may push management
toward the most favorable estimates, either with respect to specific
accounts or in the overall presentation.
---------------------------------------------------------------------------
\119\ For purposes of this discussion, a ``favorable'' estimate
can reflect either an upward or a downward bias, for example in
earnings, depending on management incentives.
---------------------------------------------------------------------------
Audits are one of the mechanisms for mitigating the information and
incentive problems arising in the investor-management
relationship.\120\ Audits are intended to provide a check of
management's financial statements, and thus reduce management's
potential
[[Page 13429]]
incentive to prepare and disclose biased or inaccurate financial
statements. Audit reports and auditing standards provide information to
the market that may affect perceptions about the reliability of the
financial statements and therefore mitigate investors' information
problem, potentially lowering the company's cost of capital.\121\
---------------------------------------------------------------------------
\120\ See Paul M. Healy and Krishna G. Palepu, Information
Asymmetry, Corporate Disclosure, and the Capital Markets: A Review
of the Empirical Disclosure Literature, 31 Journal of Accounting and
Economics 405, 406 (2001). See also Mark DeFond and Jieying Zhang, A
Review of Archival Auditing Research, 58 Journal of Accounting and
Economics 275 (2014).
\121\ See, e.g., Richard A. Lambert, Christian Leuz, and Robert
E. Verrecchia, Accounting Information, Disclosure, and the Cost of
Capital, 45 Journal of Accounting Research 385 (2007).
---------------------------------------------------------------------------
The auditor is also an agent of investors, however, and the
information asymmetry between investors and auditors can also give rise
to risks of moral hazard and adverse selection. Auditors have
incentives that align their interests with those of investors, such as
legal considerations, professional responsibilities, and reputational
concerns. However, they may also have incentives to behave sub-
optimally from investors' point of view by, for example, (1) not
sufficiently challenging management's estimates or underlying
assumptions in order not to disturb the client relationship; (2)
shirking, if they are not properly incentivized to exert the effort
considered optimal by shareholders; or (3) seeking to maximize profits
and/or minimize costs--sometimes at the expense of audit quality. As a
result of such misaligned incentives, auditors may engage in practices
that do not align with investors' needs and preferences.
In addition to the auditor's potential moral hazard problem, the
presence of bounded rationality can inject another layer of challenges
into auditing estimates. In economic theory, bounded rationality refers
to the idea that when individuals make decisions, their rationality may
be limited by certain bounds, such as limits on available information,
limits on analytical ability, limits on the time available to make the
decision, and inherent cognitive biases.\122\ Even if incentives
between principal and agent are aligned, the agent, being boundedly
rational, may be unable to execute appropriately. Hence, some auditors
may find auditing certain estimates challenging because, like all
individuals, they may have limits on their ability to solve complex
problems and to process information,\123\ especially when faced with
time constraints.\124\ Research has shown that even sell-side research
analysts, generally understood to be sophisticated financial experts,
have trouble assessing the impact on earnings of companies' derivative
instruments, where the associated financial reporting involves fair
value measurements.\125\
---------------------------------------------------------------------------
\122\ For a seminal work in this field, see Herbert A. Simon, A
Behavioral Model of Rational Choice, 69 The Quarterly Journal of
Economics 99 (1955). Simon introduced this theory and argued that
individuals cannot assimilate and process all the information that
would be needed to maximize their benefits. Individuals do not have
access to all the information required to do so, but even if they
did, they would be unable to process it properly, since they are
bound by cognitive limits.
\123\ Daniel Kahneman refers to the mind as having two systems,
System 1 and System 2. ``System 1 operates automatically and quickly
. . . '' System 2 is the slower one that ``can construct thoughts in
an orderly series of steps.'' System 2 operations ``require
attention and are disrupted when attention is drawn away.'' Daniel
Kahneman, Thinking, Fast and Slow 4, 20-22 (1st ed. 2011). Examples
of System 2 operations include ``[f]ill[ing] out a tax form'' and
``[checking] the validity of a complex logical argument,'' both of
which require time and attention. Without time, one cannot dedicate
attention to a task and fully engage System 2, and hence is left
with the automatic instinctual operation of System 1, which can lead
to use of rules of thumb (heuristics) and ``biases of intuition.''
Id.
\124\ Time is an essential limitation to problem solving, being
fundamental to the definition of bounded rationality--``[t]he
principle that organisms have limited resources, such as time,
information, and cognitive capacity, with which to find solutions to
the problems they face.'' Andreas Wilke and R. Mata, Cognitive Bias,
as published in The Encyclopedia of Human Behavior 531 (2nd ed.
2012).
\125\ See Hye Sun Chang, Michael Donohoe, and Theodore
Sougiannis, Do Analysts Understand the Economic and Reporting
Complexities of Derivatives? 61 Journal of Accounting and Economics
584 (2016). For a discussion of the bounded rationality of audit
judgments, see Brian Carpenter and Mark Dirsmith, Early Debt
Extinguishment Transactions and Auditor Materiality Judgments: A
Bounded Rationality Perspective, 17 (8) Accounting, Organizations
and Society 709, 730 (1992) (``[T]he self-reported actions taken by
auditors on actual engagements appear to reveal less complexity in
the sense that they are boundedly rational and tend to emphasize
only a single judgment criterion than do the cognitive judgment
processes of which they are capable.'').
---------------------------------------------------------------------------
In the context of auditing estimates, one such bound may be the
ability of auditors to analyze and integrate different existing
standards or process the information required to audit estimates that
involve complex processes, which may require sophisticated analytical
and modeling techniques. In the presence of bounded rationality,
individuals may resort to heuristics (i.e., rules of thumb).\126\ In
particular, auditors facing challenges in auditing an accounting
estimate may resort to simplifications that might increase the
potential for biases or errors that have seeped into financial
statements to go undetected.\127\
---------------------------------------------------------------------------
\126\ ``The essence of bounded rationality is thus to be a
`process of thought' rather than a `product of thought': Individuals
have recourse to reasonable procedures rather than to sophisticated
computations which are beyond their cognitive capacities.'' Bertrand
Munier, Reinhard Selten, D. Bouyssou, P. Bourgine et al., Bounded
Rationality Modeling, 10 Marketing Letters 233, 234 (1999). In
``[s]ituations where evolved task-general procedures are helpful
(heuristics, chunks) . . . agents have difficulty finding even
qualitatively appropriate responses . . . agents are then left with
heuristics . . . '' Id. at 237.
\127\ For a discussion and examples of heuristics used by
auditors, see, e.g., Stanley Biggs and Theodore Mock, An
Investigation of Auditor Decision Processes in the Evaluation of
Internal Controls and Audit Scope Decisions, 21 (1) Journal of
Accounting Research 234 (1983).
---------------------------------------------------------------------------
The literature has linked cognitive issues to auditors' actions and
attitudes, specifically to professional skepticism.\128\ For example,
``research in psychology and accounting has identified that auditors'
judgments are vulnerable to various problems, such as difficulty
recognizing patterns of evidence, applying prior knowledge to the
current judgment task, weighting evidence appropriately, and preventing
incentives from affecting judgment in unconscious ways.'' \129\ As a
result, cognitive limitations may pose a threat to professional
skepticism \130\ and ``[b]ias-inducing tendencies can lead even the
brightest, most experienced professionals, including auditors, to make
suboptimal judgments.'' \131\ Accordingly, the existence of bounded
rationality and, in particular, some inherent cognitive biases might
affect auditor judgment when auditing accounting estimates, even
separate from any potential conflict of interest.
---------------------------------------------------------------------------
\128\ Nelson argues that ``[p]roblem-solving ability, ethical
predisposition, and other traits like self-confidence and tendency
to doubt are all related to [professional skepticism] in judgment
and action,'' and, furthermore ``[c]ognitive limitations affect
[professional skepticism] in predictable ways.'' Mark Nelson, A
Model and Literature Review of Professional Skepticism in Auditing,
28 Auditing: A Journal of Practice & Theory 1, 2 (2009).
\129\ Id. at 6.
\130\ ``[A]uditors' judgments can be flawed because, like all
people, sometimes they do not consistently follow a sound judgment
process and they fall prey to systematic, predictable traps and
biases. People, including experienced professionals . . . often
unknowingly use mental ``shortcuts'' . . . to efficiently navigate
complexity . . . [S]ituations can arise where they systematically
and predictably lead to suboptimal judgments and potentially inhibit
the application of appropriate professional skepticism.'' Steven M.
Glover and Douglas F. Prawitt, Enhancing Auditor Professional
Skepticism (Nov. 2013) (a report commissioned by the Standards
Working Group of the Global Public Policy Committee), at 10.
\131\ Id.
---------------------------------------------------------------------------
Some of the biases that might affect auditors include, but are not
limited to:
Anchoring Bias--decision makers anchor or overly rely on
specific information or a specific value and then adjust to that value
to account for other elements of the circumstance, so that there is a
bias toward that value. In the auditing of estimates, the potential
exists for anchoring on management's
[[Page 13430]]
estimates.\132\ This can be seen as a manifestation of findings that
auditors may, at times, experience difficulties weighting evidence
appropriately.\133\
---------------------------------------------------------------------------
\132\ For a discussion on anchoring biases and some evidence,
see, e.g., Robert Sugden, Jiwei Zheng, and Daniel John Zizzo, Not
All Anchors Are Created Equal, 39 Journal of Economic Psychology 21
(2013).
\133\ Nelson, A Model and Literature Review of Professional
Skepticism in Auditing 6.
---------------------------------------------------------------------------
Confirmation Bias--a phenomenon wherein decision makers
have been shown to actively seek out and assign more weight to evidence
that confirms their hypothesis, and ignore or underweight evidence that
could disconfirm their hypothesis. As such, confirmation bias can be
thought of as a form of selection bias in collecting evidence. It
becomes even more problematic in the presence of anchoring bias, since
auditors may anchor on management's estimate and may only seek out
information to corroborate that value (or focus primarily on
confirming, rather than challenging, management's model).\134\ For
example, in the accounting estimates standard, as one of the available
three approaches in evaluating the reasonableness of an estimate, the
auditor is instructed to ``develop an independent expectation of the
estimate to corroborate the reasonableness of management's estimate''
(emphasis added).\135\
---------------------------------------------------------------------------
\134\ For a discussion of confirmation bias, see, e.g., Raymond
S. Nickerson, Confirmation Bias: A Ubiquitous Phenomenon in Many
Guises, 2 Review of General Psychology 175 (1998). For a discussion
of the manifestation of this bias in auditing, see, e.g., Griffith
et al., Audits of Complex Estimates as Verification of Management
Numbers: How Institutional Pressures Shape Practice.
\135\ AS 2501.10b.
---------------------------------------------------------------------------
Familiarity Bias--``Familiarity is associated with a
general sense of comfort with the known and discomfort with--even
distaste for and fear of--the alien and distant.'' \136\ In the context
of auditing accounting estimates, auditors may be biased toward
procedures, methods, models, and assumptions that seem more familiar to
them, and auditors' familiarity with management may lead them to tend
to accept management's assertions without sufficient challenge or
consideration of other options.\137\
---------------------------------------------------------------------------
\136\ Gur Huberman, Familiarity Breeds Investment, 14 Review of
Financial Studies 659, 678 (2001).
\137\ Academic research also argues and provides evidence that
some level of auditor familiarity with the client can help the
auditing process. See Wuchun Chi and Huichi Huang, Discretionary
Accruals, Audit-Firm Tenure and Audit-Partner Tenure: Empirical
Evidence from Taiwan, 1 (1) Journal of Contemporary Accounting and
Economics 65, 67 (2005). Although the study does not address
familiarity bias, the results indicate that auditor familiarity with
the client produces higher earnings quality as it has an effect on
learning experience and increases client-specific knowledge, while
excessive familiarity impairs audit quality, resulting in lower
earnings quality.
---------------------------------------------------------------------------
All of these cognitive biases would pose a threat to the proper
application of professional skepticism and an appropriate focus on the
potential for management bias in accounting estimates. Academic
research illustrates how cognitive biases may affect auditing. Griffith
et al. find that auditors focus primarily on confirming, rather than
challenging, management's model, and appear to accept management's
model as a starting point and then verify aspects of that model.\138\
None of the auditors in the study indicated that he or she considered
whether additional factors beyond the assumptions made by management
should be included in management's model. This type of behavior is
suggestive of anchoring bias.\139\
---------------------------------------------------------------------------
\138\ See Griffith et al., Audits of Complex Estimates as
Verification of Management Numbers: How Institutional Pressures
Shape Practice.
\139\ The problem resulting from this bias can be ameliorated,
but not completely eliminated. The audit, by its nature, uses the
company's financial statements as a starting point. For that reason,
starting with management's number is often unavoidable since the
auditor is opining on whether the company's financial statements are
fairly presented, in all material respects, in conformity with the
applicable financial reporting framework. When reference is made to
anchoring bias in this release, it is therefore not intended to
refer to the auditor's responsibility to start with management's
financial statements, but instead to the auditor's potential failure
to effectively challenge management.
---------------------------------------------------------------------------
Importantly, bounded rationality and the associated biases exist in
addition to any incentive problems (moral hazard). Cognitive biases and
moral hazard could work in the same direction to increase the
likelihood of auditors agreeing with management, not considering
contradictory evidence, or discounting the potential importance or
validity of alternative methods, data, and assumptions. It is important
for auditors to be wary of their own biases as well as management's
biases when auditing accounting estimates (e.g., in order to avoid
merely searching for evidence that corroborates management's
assertions).\140\
---------------------------------------------------------------------------
\140\ See, e.g., Martin et al., Auditing Fair Value
Measurements: A Synthesis of Relevant Research.
---------------------------------------------------------------------------
It is also logical to conclude that the potential for bias
increases in the presence of measurement uncertainty, since there is
more latitude in recording an estimate in such circumstances. Academic
studies find that the measurement uncertainty associated with
accounting estimates can be substantial.\141\ Martin, Rich, and Wilks
point out that fair value measurements frequently incorporate forward-
looking information as well as judgments, and that, since future events
cannot be predicted with certainty, an element of judgment is always
involved.\142\ The measurement uncertainty inherent in estimates allows
room for both management bias and error to affect preparers' valuation
judgments, and estimates become less useful to capital market
participants as they become less reliable.\143\
---------------------------------------------------------------------------
\141\ See, e.g., Brant E. Christensen, Steven M. Glover, and
David A. Wood, Extreme Estimation Uncertainty in Fair Value
Estimates: Implications for Audit Assurance, 31 Auditing: A Journal
of Practice & Theory 127 (2012); Cannon and Bedard, Auditing
Challenging Fair Value Measurements: Evidence from the Field.
\142\ See Martin et al., Auditing Fair Value Measurements: A
Synthesis of Relevant Research.
\143\ See, e.g., Russell Lundholm, Reporting on the Past: A New
Approach to Improving Accounting Today, 13 Accounting Horizons 315
(1999); and Griffith et al., Audits of Complex Estimates as
Verification of Management Numbers: How Institutional Pressures
Shape Practice.
---------------------------------------------------------------------------
To help auditors overcome, or compensate for, potential biases and
identify situations where management is consistently optimistic, and to
discourage shirking, the new standard emphasizes the auditor's existing
responsibility to apply professional skepticism, including addressing
potential management bias. It does so by emphasizing these professional
obligations in the specific context of auditing accounting estimates.
It also includes revised terminology to describe the nature of the
auditor's responsibility and the new requirements described in Section
C to guide the auditor in the appropriate application of professional
skepticism, including addressing potential management bias, when
auditing estimates.
Some commenters on the proposal were supportive of a new standard
taking into consideration management bias and emphasizing the
application of professional skepticism while some others highlighted
the difficulties in evaluating and identifying management bias in
accounting estimates due to the uncertainty and subjectivity involved.
Some commenters were critical of ``negative'' tone or overemphasis on
management bias and the application of professional skepticism. Some
commenters, on the other hand, recommended that the new standard
further expand the discussion and emphasis of management bias and the
need to challenge management's assertions. As discussed above, the
Board believes that reinforcing the importance of professional
skepticism when auditing estimates, in light of the potential for
management bias, will remind auditors of their responsibilities to
evaluate contradictory evidence and
[[Page 13431]]
to address the effects of bias on the financial statements.
Fostering a More Efficient Audit
Tailoring Requirements for Different Types of Pricing Information
The new standard requires different audit procedures for the
different types of third-party pricing information used for fair value
measurements of financial instruments, and is intended to drive a level
of work effort commensurate with both the risks of material
misstatement in the valuation of financial instruments and the
relevance and reliability of the evidence obtained. Existing
requirements do not provide specific direction about how to evaluate
the relevance and reliability of pricing information from third parties
and might have led to additional work and cost for some audits and
insufficient work and effort for some audits. Under the new standard,
auditors will be prompted to direct more effort toward pricing
information that may be more subject to bias or error based on the type
of instrument being valued and how or by whom the pricing information
is generated. For certain types of third parties--specifically, pricing
services and brokers or dealers--the new standard provides more
specific direction.
The Board understands that pricing information generated by pricing
services generally tends to have three main characteristics not shared
by other estimates (1) uniformity of product (with little to no
differentiation across users, so there is less risk of inherent bias);
(2) work of the pricing service that, in most cases, is not prepared at
the direction of a particular client; and (3) buyers of the product
with little, if any, market power. These characteristics reduce the
risk of bias, unless the pricing service has a relationship with the
company by which company management has the ability to directly or
indirectly control or significantly influence the pricing service. The
potential for bias is further attenuated for pricing services since
there is monitoring by the market as a whole, and most of the prices
provided by these services are for traded securities or for securities
for which quotes are available or for which similar securities are
traded. Overall, the Board believes that these characteristics
contribute to a lower risk of bias in information provided by pricing
services relative to other estimates and warrant tailored audit
requirements.
The Board believes that there also are differences between the
information provided by pricing services on the one hand, and brokers
or dealers on the other, that warrant differential treatment. Based on
outreach and observations from the Board's oversight activities, the
Board understands that pricing services tend to accumulate overall
market information, rather than engage directly in market transactions,
and typically have well-defined methodologies that are used
consistently over time. Therefore, they tend to provide customers with
more uniform pricing information. Brokers or dealers, on the other
hand, are in the business of providing liquidity to the market (by
acting as a buyer or seller) and connecting buyers and sellers. As
such, it is likely their pricing is more idiosyncratic (i.e., dependent
on the party asking for a quote, timing, and other factors related to
the business operations of the broker or dealer) and brokers or dealers
may occasionally be less transparent in pricing the instruments. In
addition, not all brokers or dealers necessarily have a firm-wide
methodology, as they typically provide prices on an as-requested basis.
Therefore, the Board believes that auditors' consideration of pricing
information obtained from a broker or dealer should differ from their
consideration of pricing information from a pricing service.
The issue of different types of pricing information provided by
third-party sources is addressed in the special topics appendix of the
new standard. This appendix more broadly addresses auditing financial
instruments and includes procedures specific to an auditor's use of
evidence from third-party pricing sources. These procedures allow the
auditor to use pricing information from pricing sources used by the
company in some circumstances (e.g., generally in cases where the
company uses a pricing service based on trades of similar instruments
to value securities with a lower risk of material misstatement). This
would be an appropriate risk-based audit response, since there is a
lower chance of management bias when the company uses a pricing
service.
One commenter who provided views on the third-party pricing
information agreed that the reliability of the pricing information from
the third-party pricing sources may differ and that factors covered in
the proposal captured that variability. A few commenters also asserted
that third-party pricing services generally provide pricing that is
free from influence of any one user of the services, and one of these
commenters opined that this absence of management bias increased the
relevance and reliability of the evidence. In addition, one commenter
suggested inclusion of differences in valuation approaches of pricing
services as an additional factor in evaluating reliability. Although
the differences in valuation approaches could create biased valuations,
auditors are required to evaluate the relevance and reliability of
pricing information provided by pricing services.
Multiple Standards With Overlapping Requirements
Having multiple standards with similar approaches but varying
levels of detail in procedures may create unnecessary problems.
Perceived inconsistencies among existing standards may result in (1)
different auditor responsibilities for accounts for which a similar
audit approach would seem appropriate; (2) inconsistent application of
standards; and (3) inappropriate audit responses.
Academic research speaks to the undesirable nature of overlapping
standards addressing the same issue, which adds to task difficulty
\144\ and may, therefore, create unnecessary additional costs, as it is
costly to sift through the standards and reconcile potential conflicts.
These costs may exacerbate the principal-agent and cognitive challenges
discussed above. For example, auditors might, consciously or otherwise,
apply the standards in a manner that satisfies their objectives but not
those of investors (e.g., auditors may choose an approach with fewer
procedures and requirements to minimize audit cost, or for expediency,
hence maximizing their profits). The existence of overlapping
requirements might also lead to uncertainty about compliance, if
auditors do not understand what is required. Finally, overlapping
requirements may increase perceived uncertainty about audit quality,
since market participants may not fully understand what standard is
being, or even should be, applied.
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\144\ See Brian Bratten, Lisa Milici Gaynor, Linda McDaniel,
Norma R. Montague, and Gregory E. Sierra, The Audit of Fair Values
and Other Estimates: The Effects of Underlying Environmental, Task,
and Auditor-Specific Factors, 32 Auditing: A Journal of Practice &
Theory 7, 15-16 (2013).
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To address the issues stemming from having multiple, overlapping
estimates standards, the new standard replaces the existing three
standards related to auditing accounting estimates. Moreover, it aligns
the requirements with the risk assessment standards through targeted
amendments to promote the development of appropriate responses to the
risks of material
[[Page 13432]]
misstatement related to accounting estimates.
A number of commenters supported the development of a single
standard to replace the three existing standards. For example, some
noted that a single, consistent set of requirements aligned with the
risk assessment standards would provide greater uniformity and clarity
and eliminate the need to navigate among three related standards in
order to ensure that all requirements were met. On the other hand, one
commenter cautioned that a single standard would lead to a one-size-
fits-all audit approach and not allow the tailoring of audit procedures
based on the issuer-specific risks of material misstatement. By
aligning with the risk assessment standards and describing the basic
requirements for testing and evaluating estimates, the Board believes
the new standard is designed to allow auditors to tailor their
procedures in order to respond to specific risks of material
misstatement.
Lack of Market Solutions
The issues discussed above are not, and cannot efficiently be,
addressed through market forces alone because the auditor may not be
fully incentivized to address them and market forces may not be
effective in making the auditor more responsive to investors' concerns
regarding the auditing of estimates. The auditor may not be fully
incentivized because auditors may incur additional costs to produce
higher audit quality but would earn lower profits on the audit, since
audit quality may not be observable \145\ and auditors may be unable to
charge more for better audits.\146\ Furthermore, because investors are
diverse and geographically distributed, they face a potential
collective action problem that creates additional barriers to jointly
negotiating with auditors over requirements for auditing accounting
estimates.
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\145\ An ``audit is a credence service in that its quality may
never be discovered by the company, the shareholders or other users
of the financial statements. It may only come into question if a
`clean' audit report is followed by the collapse of the company.''
See Alice Belcher, Audit Quality and the Market for Audits: An
Analysis of Recent UK Regulatory Policies, 18 Bond Law Review 1, 5
(2006). Credence services are difficult for users of the service
(such as investors in the context of company audit services) to
value because their benefits are difficult to observe and measure.
See also Monika Causholli and W. Robert Knechel, An Examination of
the Credence Attributes of an Audit, 26 Accounting Horizons 631
(2012).
\146\ The general effect of cost pressures on audit quality has
been studied in the academic literature with varying empirical
findings. See, e.g., James L. Bierstaker and Arnold Wright, The
Effects of Fee Pressure and Partner Pressure on Audit Planning
Decisions, 18 Advances in Accounting 25 (2001); B. Pierce and B.
Sweeney, Cost-Quality Conflict in Audit Firms: An Empirical
Investigation, 13 European Accounting Review 415 (2004); and Scott
D. Vandervelde, The Importance of Account Relations When Responding
to Interim Audit Testing Results, 23 Contemporary Accounting
Research 789 (2006).
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For the mitigation of this collective action problem and other
potential sources of market failure,\147\ investors generally rely on
auditing standards that are based on investor and public interests.
PCAOB auditing standards establish performance requirements that, if
not implemented, can result in costly penalties to the auditor in the
form of litigation and reputational risk.
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\147\ For a discussion of the concept of market failure, see,
e.g., Francis M. Bator, The Anatomy of Market Failure, 72 The
Quarterly Journal of Economics 351 (1958); and Steven G. Medema, The
Hesitant Hand: Mill, Sidgwick, and the Evolution of the Theory of
Market Failure, 39 History of Political Economy 331 (2007).
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Economic Impacts
Benefits
The new standard should lead to two broad categories of benefits.
The first relates directly to audit quality and the second relates to
fostering an efficient risk-based approach to auditing accounting
estimates, including fair value measurements. The new standard
strengthens auditor responsibilities for auditing accounting estimates,
including fair value measurements, which should increase the likelihood
that auditors detect material misstatements, and more explicitly
integrates the risk assessment standards, which should encourage a
uniform approach to achieve a more efficient and risk-based audit
response. These improvements should enhance audit quality and, in
conjunction with the clarification of the procedures the auditor should
perform, should provide greater confidence in the accuracy of
companies' financial statements.\148\ From a capital market
perspective, an increase in the information quality of companies'
financial statements resulting from improved audit quality can reduce
the non-diversifiable risk to investors and generally should result in
investment decisions by investors that more accurately reflect the
financial position and operating results of each company, increasing
the efficiency of capital allocation decisions.\149\
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\148\ For a discussion on the relationship between audit quality
and financial reporting quality, see DeFond and Zhang, A Review of
Archival Auditing Research 275, 281 (``. . . [A]udit quality is a
component of financial reporting quality, because high audit quality
increases the credibility of the financial reports. This increased
credibility arises through greater assurance that the financial
statements faithfully reflect the [company's] underlying
economics.'').
\149\ See, e.g., Lambert et al., Accounting Information,
Disclosure, and the Cost of Capital, 388 (finding that information
quality directly influences a company's cost of capital and that
improvements in information quality by individual companies
unambiguously affect their non-diversifiable risks.); and Ahsan
Habib, Information Risk and the Cost of Capital: Review of the
Empirical Literature, 25 Journal of Accounting Literature 127, 128
(2006) (``[H]igh quality auditing could provide credible information
in the market regarding the future prospect of the [company] and
hence could reduce the cost of capital in general, and cost of
equity capital in particular.''). See also Jukka Karjalainen, Audit
Quality and Cost of Debt Capital for Private Firms: Evidence from
Finland, 15 International Journal of Auditing 88 (2011).
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The extent of these benefits, which are discussed further below,
will largely depend on the extent to which firms have to change their
practices and methodologies. Benefits will be less in the case of firms
that have already adopted practices and methodologies similar to the
requirements being proposed.
First, the new standard should reduce the problems generated by
moral hazard and potential cognitive biases by strengthening the
performance requirements for auditing accounting estimates and by
emphasizing the importance of addressing potential management bias and
the need to maintain a skeptical mindset while auditing accounting
estimates. Reinforcing the need for professional skepticism should
encourage auditors, for example, to ``refram[e] hypotheses so that
confirmation biases favor [professional skepticism],'' and thereby
mitigate the effect of such biases on auditor judgment.\150\ It should
encourage auditors to be more conscious when weighing audit evidence
and should reduce instances where auditors fail to consider
contradictory evidence. For example, the use of terms such as
``evaluate'' and ``compare'' instead of ``corroborate,'' and greater
emphasis on auditors identifying the significant assumptions in
accounting estimates should promote a more deliberative approach to
auditing estimates, rather than a mechanical process of looking for
evidence to support management's assertions. Academic research also
provides evidence on the effect of framing in the context of auditors'
fair value judgments.\151\ In an experimental
[[Page 13433]]
study, Cohen et al. found that when one group of auditors were
instructed to ``support and oppose'' management's assertions, they
recommended significantly different fair value estimates than another
group of auditors who were instructed to ``support'' management's
assertions.
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\150\ Nelson, A Model and Literature Review of Professional
Skepticism in Auditing 2. In addition, another experimental study
found other factors, such as improved cognitive tools, might be
necessary to enhance the use of professional judgment and critical
thinking skills. See Anthony Bucaro, Enhancing Auditors' Critical
Thinking in Audits of Complex Estimates, Accounting, Organizations
and Society 1, 11 (2018).
\151\ See Jeffrey Cohen, Lisa Gaynor, Norma Montague, and Julie
Wayne, The Effect of Framing on Information Search and Information
Evaluation in Auditors' Fair Value Judgments (Feb. 2016) (working
paper, available in Social Science Research Network).
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Several commenters on the proposal supported the emphasis on
professional skepticism and one commenter agreed that the new
requirements would prompt auditors to devote greater attention to
identifying and addressing management bias. Moreover, some commenters
confirmed that raising awareness of cognitive biases and including
reminders of professional skepticism could help mitigate the effects of
auditors' own biases. In addition, a few commenters supported the
change in terminology and agreed that it would further reinforce the
application of professional skepticism by moving from a corroborative
mindset to an evaluation mindset, while one commenter expressed
skepticism about the impact of terminology on auditor behavior. Some
commenters noted the difficulties and limitations in evaluating and
identifying management bias in accounting estimates due to the
uncertainty and subjectivity involved. Given the subjective assumptions
and inherent measurement uncertainty in many estimates, bias may not be
eliminated entirely. However, the Board believes that a standard that
reinforces the application of professional skepticism and reminds
auditors of risk of management bias and their responsibilities to
evaluate contradictory evidence and to address the effects of bias can
help ameliorate the problems resulting from this bias.
Second, requirements specific to the use of pricing information
from third parties as audit evidence should lead to a more efficient
audit as these new requirements will prompt more tailored audit
procedures (including by performing procedures over groups of similar
instruments, where appropriate) and direct more audit effort toward
pricing information that may be more subject to bias or error.
Third, in addition to achieving these efficiencies, the new
standard should lead to a better allocation of auditing resources more
generally by aligning more closely with the risk assessment standards,
with more hours, effort, and work being dedicated to higher-risk areas.
Essentially, the new standard should lead to increased audit quality
for harder-to-measure estimates (e.g., estimates with high inherent
subjectivity) due to enhanced procedures and should lead to an increase
in efficiency for easier-to-measure and lower-risk estimates.
Fourth, uniformity of the standards should lead to benefits to
auditors and users of financial statements. A single, consistent set of
requirements should lead to more consistent and efficient audits with
greater comparability since there should be no doubt as to what
requirements to apply, and no need to navigate among multiple standards
to make sure that all relevant requirements are met. In turn, assuming
that firms comply with the new requirements, this should increase and
make more uniform the quality of the information presented in the
financial statements. Having a uniform set of requirements might also
enhance the audit committee's understanding of the auditor's
responsibilities and, therefore, potentially facilitate communications
between the audit committee and the auditor. Moreover, a single
standard will facilitate the development of timely guidance for
specific issues when needed.
Finally, establishing more clarity and specificity in requirements
for estimates should lead to efficiency gains by providing auditors
with a better understanding both of their duties and of the Board's
expectations, reducing the risk that auditors would perform unnecessary
or ineffective procedures. Hence, holding audit quality constant,
auditors should gain efficiencies.
Overall, these changes should lead to greater confidence in
financial statements, reducing investors' information asymmetry.
Reinforcing and clarifying auditors' responsibilities should enhance
investors' trust that auditors are obtaining sufficient appropriate
evidence regarding management's accounting estimates, thereby
increasing investors' confidence in companies' financial statements and
the corresponding audit work performed. Also, the new standard may lead
to fewer restatements as a result of increased audit quality for
higher-risk estimates and, hence, increase investor confidence in
financial statements. Increased confidence in companies' financial
statements should ameliorate investors' information asymmetry problem
(adverse selection) and allow for more efficient capital allocation
decisions.
Some commenters on the proposal cautioned against raising investor
expectations about the impact of auditing procedures on the reliability
and accuracy of accounting estimates and expressed skepticism about
potential benefits related to investor confidence and audit quality.
For example, citing the inherent uncertainty and judgment involved in
estimates, some argued that unreasonable bias would be difficult to
detect and a level of bias and uncertainty would remain irrespective of
the level of audit effort. While auditing cannot eliminate the
uncertainty and judgment involved in estimates, it can help identify
material omissions and errors. Furthermore, even if more robust
auditing procedures do not yield more accuracy and precision for each
individual estimate, to the extent that any pattern of bias or error
can be eliminated, this should result in more reliable financial
reporting. The financial statements as a whole may not be fairly
presented if the most optimistic estimates are consistently selected by
the preparer even when each individual estimate is within a reasonable
range. Emphasizing the risk of management bias in accounting estimates
and the auditor's responsibility to apply professional skepticism can
help focus auditors on the effects of management bias on financial
statements.
Costs
The Board recognizes that imposing new requirements may result in
additional costs to auditors and the companies they audit. In addition,
to the extent that auditors pass on any increased costs through an
increase in audit fees, companies and investors could incur an indirect
cost.
Auditors may incur certain fixed costs (costs that are generally
independent of the number of audits performed) related to implementing
the new standard and related amendments. These include costs to update
audit methodologies and tools, prepare training materials, and conduct
training. Larger firms are likely to update methodologies using
internal resources, whereas smaller firms are more likely to purchase
updated methodologies from external vendors.
In addition, auditors may incur certain variable costs (costs that
are generally dependent on the number of audits performed) related to
implementing the new standard. These include costs of implementing the
standard at the audit engagement level (e.g., in the form of additional
time and effort spent on the audit). For example, the new standard
requires, in some instances, performing more procedures related to
assessing risk and testing the company's process, such as evaluating
which of the assumptions used by the company are significant. This
could impose additional costs on auditors and require additional
management time.
Recurring costs (fixed or variable) may also increase if firms
decide to increase their use of specialists in response to the final
auditing
[[Page 13434]]
requirements. If this were to occur, it may in particular affect firms
that do not currently employ or engage specialists and instead rely on
the work of company specialists for some of their audit engagements,
potentially affecting the competitiveness of such firms for such audit
engagements.\152\
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\152\ The PCAOB staff analyzed inspection data to assess the
baseline for auditors' use of the work of specialists and existing
practice in the application of those requirements. The PCAOB
observed that the firms that do not currently employ or engage
auditor's specialists and use the work of company specialists tend
to be smaller audit firms. The PCAOB staff also found that smaller
audit firms generally have comparatively few audit engagements in
which they use the work of company specialists. See the Specialists
Release, supra note 2, for additional discussion.
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To the extent the new standard and related amendments require new
or additional procedures, they may increase costs. For example, the
amendment to AS 2110.52 requires the auditor to include, as part of the
key engagement team members' discussion of the potential for material
misstatement due to fraud, how the financial statements could be
manipulated through management bias in accounting estimates in
significant accounts and disclosures. The new requirement focuses the
auditor's attention on a risk that is particularly relevant to
accounting estimates and further underscores the importance of applying
professional skepticism in this area. The additional requirement could
increase costs.
The new standard's impact on the auditor's fixed and variable costs
will likely vary depending on, among other things, the extent to which
the requirements have already been incorporated in accounting firms'
audit methodologies or applied in practice by individual engagement
teams. For example, the new standard sets minimum requirements when
using pricing information obtained from third-party pricing sources, so
audit firms that are doing less than the minimum requirements will
likely experience higher cost increases. In addition, the standard's
impact could vary based on the size and complexity of an audit. All
else equal, any incremental costs generally are expected to be
scalable: Higher for larger, more complex audits than for smaller, less
complex audits.
The economic impact of the new standard on larger accounting firms
and smaller accounting firms may differ. For example, larger accounting
firms will likely take advantage of economies of scale by distributing
fixed costs (e.g., updating audit methodologies) over a larger number
of audit engagements. Smaller accounting firms will likely distribute
their fixed costs over fewer audit engagements. However, larger
accounting firms will likely incur greater variable costs than smaller
firms, because larger firms more often perform larger audits and it
seems likely that these larger audits will more frequently involve
accounting estimates with complex processes. It is not clear whether
these costs (fixed and variable), as a percentage of total audit costs,
will be greater for larger or for smaller accounting firms. One
commenter on the proposal cautioned that the costs associated with
implementing the new standard might be significant for some smaller
firms; however, this commenter also noted that many of the smaller
firms applying analogous requirements of other standard setters (e.g.,
ISA 540) would already have methodologies in place that addressed many
of the requirements in the new standard. Another commenter asserted
that any new standard would have a disproportionate impact on medium-
sized accounting firms and their clients, as compared with larger firms
and their clients. Additionally, one commenter noted that passing any
incremental costs on to clients might be especially difficult for
smaller firms. The Board believes that the new standard and related
amendments are risk-based and scalable for firms of all sizes, and that
any related cost increases are justified by expected improvements in
audit quality.
In addition to the auditors, companies being audited may incur
costs related to the new standard and related amendments, both directly
and indirectly. Companies could incur direct costs from engaging with
or otherwise supporting the auditor performing the audit. Some
companies could face costs of providing documents and responding to
additional auditor requests for audit evidence, due to a more rigorous
evaluation of the company's assumptions and methods. Companies may also
incur costs if, as a result of the new standard, auditors need to
discuss additional information with audit committees relating to
accounting estimates. In addition, to the extent that auditors are able
to pass on at least part of the increased costs they incur by
increasing audit fees, companies and investors could incur an indirect
cost. Some commenters on the proposal raised concerns that some of the
increased costs, including the costs associated with requests for
additional data and pricing information from third parties, might be
passed through to companies in the form of increased audit fees. One
commenter asserted that the proposal would in effect require some
companies to increase their use of quantitative models that employ
mathematical and statistical techniques producing precise calculations.
The Board acknowledges the possibility of increased costs to companies
related to the new requirements, but believes that it is reasonable to
expect corresponding increases in audit quality, which will benefit
companies and investors as well as auditors, as discussed in the
previous section.
Some commenters argued that the new requirements would likely lead
to significant expansion of audit procedures, documentation, and/or use
of specialists, with limited incremental benefit. In addition, a few
commenters raised concerns that the requirements could result in
increased or duplicative work for issuers with no perceived benefit.
The Board believes that the scalable, risk-based approach of the new
standard allows auditors to tailor their procedures to respond to the
risks. By aligning with the risk assessment standards and setting forth
a framework for testing and evaluating procedures, the new standard is
designed to require more audit effort for accounting estimates with
higher risk of material misstatement, where greater benefits are
expected, and less audit effort for estimates with lower risk of
material misstatement, where lower potential benefits are expected. In
some areas, such as evaluating the relevance and reliability of pricing
information provided by third-party pricing sources, the new standard
may result in decreased audit effort and decreased costs, where
justified by lower risk of material misstatement.
Unintended Consequences
One potential unintended consequence of replacing three existing
standards with one standard might be a perceived loss of some
explanatory language, since the new standard is intended to eliminate
redundancies in the current standards. The Board believes that the new
standard and related amendments, interpreted as described in this
release, should provide adequate direction. However, the PCAOB will
monitor implementation to determine whether additional interpretive
guidance is necessary.
Another possible unintended consequence may result if an auditor
exploits the latitude allowed under the new standard for using
information from the company's third-party pricing source, but does so
inappropriately. The new standard does, however, set forth specific
direction for evaluating the relevance and reliability of such
[[Page 13435]]
information from the third-party pricing source.
One commenter also cautioned that perceived information sharing by
third-party pricing sources beyond contractual agreements could induce
market data originators to stop sharing their confidential market data
with pricing services. The Board does not seek to impose obligations on
auditors to obtain pricing information beyond what is available under
prevailing subscriber arrangements. Clarifications reflected in the
requirements with respect to grouping of financial instruments also
should help alleviate concerns in this area.
Finally, a few commenters on the proposal presented other potential
unintended consequences. For example, one commenter cautioned that
auditors may expand procedures performed unnecessarily, not as a
response to increased risk, but due to fear of inspections. The Board
believes that a single, uniform set of requirements with more clarity
and specificity should provide auditors with a better understanding
both of their duties and of the Board's expectations and reduce the
risk that auditors would perform unnecessary procedures due to fear of
inspections.
Another commenter pointed to the risk of cost spillover to private
company audits, where PCAOB standards are not legally required but may
nevertheless be applied. Pursuant to its statutory mandate under the
Sarbanes-Oxley Act, the Board sets standards for audits of issuers and
SEC-registered brokers and dealers based on considerations of investor
protection and the public interest in the preparation of informative,
accurate, and independent audit reports. The Board does not have
authority either to require or to prohibit application of its standards
in other contexts, and cannot predict or control the extent to which
private companies and their auditors may elect to apply PCAOB
standards.
The Board expects that the overall benefits of the proposed
standard will justify any potential unintended negative effects.
Alternatives Considered, Including Policy Choices
The development of the new standard involved considering a number
of alternative approaches to address the problems described above. This
section explains (1) why standard setting is preferable to other
policy-making alternatives, such as providing interpretive guidance or
enhancing inspection or enforcement efforts; (2) other standard-setting
approaches that were considered; and (3) key policy choices made by the
Board in determining the details of the new standard.
Alternatives to Standard Setting--Why Standard Setting is Preferable to
Other Policy-Making Alternatives
Among the Board's policy tools, an increased focus on inspections,
enforcement of existing standards, or providing additional guidance are
alternatives to revising the standards. The Board considered whether
increasing inspections or enforcement efforts would be effective
corrective mechanisms to address concerns with the audit of estimates,
including fair value measurements, and concluded that inspections or
enforcement actions alone would be less effective in achieving the
Board's objectives than in combination with amending auditing
standards.
Inspection and enforcement actions take place after audits have
occurred (and potential investor harm in the case of insufficient audit
performance). They reinforce future adherence to current auditing
standards. Given the differences in the estimates standards discussed
previously, devoting additional resources to inspections and
enforcement activities without improving the relevant performance
requirements for auditors would increase auditors' compliance with what
the Board and many stakeholders view as standards that could be
improved.
The PCAOB has issued seven Staff Audit Practice Alerts between 2007
and 2014 that address, to varying degrees, auditing accounting
estimates.\153\ The PCAOB has considered issuing additional practice
alerts or other staff guidance specific to the use of third parties
such as pricing services.\154\ The Board believes guidance specific to
the use of third parties would be limited to discussing the auditor's
application of the existing standards and, given the differences in
these standards discussed herein, guidance would be an ineffective tool
and not a long-term solution.
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\153\ See, e.g., Matters Related to Auditing Fair Value
Measurements of Financial Instruments and the Use of Specialists,
Staff Audit Practice Alert No. 2 (Dec. 10, 2007); Auditor
Considerations Regarding Fair Value Measurements, Disclosures, and
Other-Than-Temporary Impairments, Staff Audit Practice Alert No. 4
(Apr. 21, 2009); Assessing and Responding to Risk in the Current
Economic Environment, Staff Audit Practice Alert No. 9 (Dec. 6,
2011); Maintaining and Applying Professional Skepticism in Audits,
Staff Audit Practice Alert No. 10 (Dec. 4, 2012); and Matters
Related to Auditing Revenue in an Audit of Financial Statements,
Staff Audit Practice Alert No. 12 (Sept. 9, 2014).
\154\ Other standard setters have issued guidance relating to
their existing standards. For example, the IAASB issued
International Auditing Practice Note 1000, Special Considerations in
Auditing Financial Instruments (Dec. 16, 2011), to provide guidance
to auditors when auditing fair value measurements of financial
instruments.
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The Board's approach reflects its conclusion that, in these
circumstances, standard setting is needed to fully achieve the benefits
that could result from improvements in the auditing of estimates.
Other Standard-Setting Alternatives Considered
The Board considered certain standard-setting alternatives,
including (1) developing a separate standard on auditing the fair value
of financial instruments or (2) enhancing the estimates standards
through targeted amendments.
Developing a Separate Standard on Auditing the Fair Value of Financial
Instruments
The Board considered developing a separate standard that would
specifically address auditing the fair value of financial instruments.
The Board chose not to pursue this alternative because the addition of
a separate standard could result in confusion and potential
inconsistencies in the application of other standards. Additionally,
the auditing issues pertinent to accounting estimates, including
financial instruments, inherently overlap. Instead, the new standard
includes a special topics appendix, which separately discusses certain
matters relevant to financial instruments without repeating
requirements that relate more broadly to all estimates, such as
evaluating audit evidence.
Enhancing the Estimates Standards Through Targeted Amendments
The Board considered, but determined not to pursue, amending rather
than replacing the three estimates standards. Retaining multiple
standards with similar requirements would not eliminate redundancy and
could result in confusion and potential inconsistencies in the
application of the standards. The approach presented in the new
standard is designed to be clearer and to result in more consistent
application and more effective audits.
Commenters on the proposal were generally supportive of a single,
uniform standard with a consistent set of requirements. One commenter
said that they believed that audit quality would be promoted with a
single framework. On the other hand, one commenter, citing the
differences between fair value measurements and derivatives and hedging
accounting, expressed concerns
[[Page 13436]]
about combining multiple standards into one, but did not specify how
the auditing approach could or should differ. Another commenter
cautioned that a single standard would lead to a one-size-fits-all
audit approach and not allow the tailoring of audit procedures.
However, by aligning with the risk assessment standards and describing
the basic requirements for testing and evaluating estimates, the new
standard is designed to allow the auditors to tailor their procedures
in order to respond to specific risks of material misstatement.
Key Policy Choices
Given a preference for a single, comprehensive standard applicable
to all accounting estimates, including fair value measurements, in
significant accounts and disclosures, the Board considered different
approaches to addressing key policy issues.
Include a Reporting Requirement in the New Standard
Measurement uncertainty cannot be eliminated entirely through audit
procedures. This raises a question of whether reporting of additional
information about such procedures in the auditor's report is necessary.
However, the Board also considered whether requiring communication
in the auditor's report relating to estimates would be duplicative of
the new requirement to communicate critical audit matters (``CAMs'');
any matters arising from the audit of the financial statements that
were communicated or required to be communicated to the audit committee
and that (1) relate to accounts or disclosures that are material to the
financial statements and (2) involved especially challenging,
subjective, or complex auditor judgments.\155\ Under the new auditor's
reporting standard, auditors will identify each CAM, describe the
principal considerations that led them to determine it was a CAM,
briefly describe how the CAM was addressed in the audit, and refer to
the relevant accounts or disclosures in the financial statements.
Because these reporting requirements will apply to financial statement
estimates, including fair value measurements, if they meet the
definition of CAM, AS 2501 (Revised) does not include any additional
reporting requirements.
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\155\ See The Auditor's Report on an Audit of Financial
Statements When the Auditor Expresses an Unqualified Opinion and
Related Amendments to PCAOB Standards, PCAOB Release No. 2017-001
(June 1, 2017).
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Require the Auditor To Develop an Independent Expectation
Given the variety of types of accounting estimates and the ways in
which they are developed, the Board is retaining the three common
approaches from the existing standards for auditing accounting
estimates, including fair value measurements. In addition, the new
standard continues to require the auditor to determine what substantive
procedures are responsive to the assessed risks of material
misstatement.
The Board considered, but determined not to pursue, requiring the
auditor to develop an independent expectation for certain estimates, or
when an estimate gives rise to a significant risk. Some members of the
Board's advisory groups advocated for a requirement for the auditor to
develop an independent expectation in addition to testing management's
process. In addition, some SAG members suggested a requirement for the
auditor to develop an independent expectation rather than test
management's process. Finally, a few commenters on the proposal stated
that auditors should develop independent estimates in addition to
testing management's process. Although requiring an independent
expectation could help reduce the risk of anchoring bias, it may not
always be feasible. For some accounting estimates, the data and
significant assumptions underlying the estimate often depend on
internal company information. Also, developing a customized method or
model for a particular company's estimate may not be practical, and a
more general method or model could be less precise than the company's
own model. In those situations, the auditor may not have a reasonable
alternative to testing the company's process.
Require Additional Audit Procedures When an Accounting Estimate Gives
Rise to Significant Risk
The Board considered including additional requirements when an
accounting estimate gives rise to a significant risk, either more
broadly or specifically when a wide range of measurement uncertainty
exists. Alternatives considered included:
Establishing that certain estimates are presumed to give
rise to a significant risk (e.g., the allowance for loan losses).
Establishing specific procedures that would depend on the
risk determined to be significant (e.g., the use of a complex model
determined to give rise to a significant risk would result in the
auditor being required to perform specific procedures on that model).
Including a requirement, similar to those in AU-C Section
540, Auditing Accounting Estimates, Including Fair Value Accounting
Estimates, And Related Disclosures (``AU-C 540''),\156\ for the auditor
to evaluate how management has considered alternative assumptions or
outcomes and why it has rejected them when significant measurement
uncertainty exists.
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\156\ See paragraph 15a of AU-C 540.
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Including additional requirements when an estimate gives rise to a
significant risk would mandate the auditor to direct additional
attention to that risk. AS 2301, however, already requires an auditor
to perform substantive procedures, including tests of details that are
specifically responsive to the assessed risks of material misstatement.
This includes circumstances when the degree of complexity or judgment
in the recognition or measurement of financial information related to
the risk, especially those measurements involving a wide range of
measurement uncertainty, give rise to a significant risk.\157\ Further,
with respect to critical accounting estimates,\158\ the new standard
and related amendments require the auditor to obtain an understanding
of how management analyzed the sensitivity of its significant
assumptions to change, based on other reasonably likely outcomes that
would have a material effect on its financial condition or operating
performance,\159\ and to take that understanding into account when
evaluating the reasonableness of the significant assumptions and
potential for management bias.
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\157\ See AS 2301.11 and AS 2110.71f.
\158\ See paragraph .A3 of AS 1301, Communications with Audit
Committees.
\159\ See Commission Guidance Regarding Management's Discussion
and Analysis of Financial Condition and Results of Operations,
Release No. 33-8350.
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Thus, requiring specific procedures for accounting estimates that
give rise to significant risks would be duplicative in some ways of the
existing requirement in AS 2301 as well as those set forth by the new
standard, and could result in additional audit effort without
significantly improving audit quality. Additionally, including
prescriptive requirements for significant risks could result in the
auditor performing only the required procedures when more effective
procedures exist, or could provide disincentives for the auditor to
deem a risk significant in order to avoid performing the additional
procedures.
Accordingly, the Board did not adopt these alternatives in favor of
retaining the existing requirement in AS 2301.
[[Page 13437]]
Special Considerations for Audits of Emerging Growth Companies
Pursuant to Section 104 of the Jumpstart Our Business Startups
(``JOBS'') Act, rules adopted by the Board subsequent to April 5, 2012,
generally do not apply to the audits of EGCs unless the SEC
``determines that the application of such additional requirements is
necessary or appropriate in the public interest, after considering the
protection of investors, and whether the action will promote
efficiency, competition, and capital formation.'' \160\ As a result of
the JOBS Act, the rules and related amendments to PCAOB standards the
Board adopts are generally subject to a separate determination by the
SEC regarding their applicability to audits of EGCs.
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\160\ See Public Law 112-106 (Apr. 5, 2012). See Section
103(a)(3)(C) of the Sarbanes-Oxley Act, as added by Section 104 of
the JOBS Act. Section 104 of the JOBS Act also provides that any
rules of the Board requiring (1) mandatory audit firm rotation or
(2) a supplement to the auditor's report in which the auditor would
be required to provide additional information about the audit and
the financial statements of the issuer (auditor discussion and
analysis) shall not apply to an audit of an EGC. The new standard
and related amendments do not fall within either of these two
categories.
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The proposal sought comments on the applicability of the proposed
requirements to the audits of EGCs. Commenters on the issue supported
applying the proposed requirements to audits of EGCs, citing benefits
to the users of EGC financial statements and the risk of confusion and
inconsistency if different methodologies were required for EGC and non-
EGC audits. One commenter suggested ``phasing'' the implementation of
the requirements for audits of EGCs to reduce the compliance burden.
To inform consideration of the application of auditing standards to
audits of EGCs, the staff has also published a white paper that
provides general information about characteristics of EGCs.\161\ As of
the November 15, 2017 measurement date, the PCAOB staff identified
1,946 companies that had identified themselves as EGCs in at least one
SEC filing since 2012 and had filed audited financial statements with
the SEC in the 18 months preceding the measurement date.
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\161\ See PCAOB white paper, Characteristics of Emerging Growth
Companies as of November 15, 2017 (Oct. 11, 2018) (``EGC White
Paper''), available on the Board's website.
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The Board believes that accounting estimates are common in the
financial statements of many EGCs.\162\ The Board also notes that any
new PCAOB standards and amendments to existing standards determined not
to apply to the audits of EGCs would require auditors to address the
differing requirements within their methodologies, which would create
the potential for confusion.\163\ This would run counter to the
objective of improving audit practice by setting forth a more uniform,
risk-based approach to auditing accounting estimates, including fair
value measurements.
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\162\ The five SIC codes with the highest total assets as a
percentage of the total assets for the EGC population are (i) real
estate investment trusts; (ii) state commercial banks; (iii)
national commercial banks; (iv) crude petroleum and natural gas; and
(v) pharmaceutical preparations. Id. at 14-15. The financial
statements of companies operating in these industries would likely
have accounting estimates that include, for example, asset
impairments and allowances for loan losses.
\163\ Approximately 99% of EGCs were audited by accounting firms
that also audit issuers that are not EGCs and 40% of EGC filers were
audited by firms that are required to be inspected on an annual
basis by the PCAOB because they issued audit reports for more than
100 issuers in the year preceding the measurement date. See EGC
White Paper at 3.
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Overall, the above discussion of benefits, costs, and unintended
consequences is generally applicable to audits of EGCs. Since EGCs tend
to be smaller public companies, their accounting estimates may be less
likely to involve complex processes,\164\ although those estimates may
constitute some of the largest accounts in EGCs' financial statements.
Furthermore, EGCs may generally be more subject to information
asymmetry problems associated with accounting estimates than other
issuers. EGCs generally tend to have shorter financial reporting
histories than other exchange-listed companies and as a result, there
is less information available to investors regarding such companies
relative to the broader population of public companies. Although the
degree of information asymmetry between investors and company
management for a particular issuer is unobservable, researchers have
developed a number of proxies that are thought to be correlated with
information asymmetry, including small issuer size, lower analyst
coverage, larger insider holdings, and higher research and development
costs.\165\ To the extent that EGCs exhibit one or more of these
properties, there may be a greater degree of information asymmetry for
EGCs than for the broader population of companies, increasing the
importance of the external audit to investors in enhancing the
credibility of management disclosure.\166\ The new standard and related
amendments, which are intended to enhance audit quality, could increase
the credibility of financial statement disclosures by EGCs.
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\164\ See, e.g., the note to AS 2201.09, which provides that
many smaller companies have less complex operations and that less
complex business processes and financial reporting systems are a
factor indicating less complex operations.
\165\ See, e.g., David Aboody and Baruch Lev, Information
Asymmetry, R&D, and Insider Gains, 55 Journal of Finance 2747
(2000); Michael J. Brennan and Avanidhar Subrahmanyam, Investment
Analysis and Price Formation in Securities Markets, 38 Journal of
Financial Economics 361 (1995); Varadarajan V. Chari, Ravi
Jagannathan, and Aharon R. Ofer, Seasonalities in Security Returns:
The Case of Earnings Announcements, 21 Journal of Financial
Economics 101 (1988); and Raymond Chiang, and P.C. Venkatesh,
Insider Holdings and Perceptions of Information Asymmetry: A Note,
43 Journal of Finance 1041 (1988).
\166\ See, e.g., Molly Mercer, How Do Investors Assess the
Credibility of Management Disclosures?, 18 Accounting Horizons 185,
189 (2004) (``[Academic studies] provide archival evidence that
external assurance from auditors increases disclosure credibility .
. . These archival studies suggest that bankers believe audits
enhance the credibility of financial statements . . .'').
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When confronted with information asymmetry, investors may require a
larger risk premium, and thus increase the cost of capital to
companies.\167\ Reducing information asymmetry, therefore, can lower
the cost of capital to companies, including EGCs, by decreasing the
risk premium required by investors.\168\ Therefore, investors in EGCs
may benefit as much as, if not more than, investors in other types of
issuers as a result of the new standard and related amendments.
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\167\ See, e.g., Lambert et al., Information Asymmetry,
Information Precision, and the Cost of Capital 21.
\168\ For a discussion of how increasing reliable public
information about a company can reduce risk premium, see Easley and
O'Hara, Information and the Cost of Capital 1553.
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PCAOB staff gathered data from 2012-2016 reported inspection
findings for issuer audits that were identified to be EGCs in the
relevant inspection year.\169\ The chart below shows the number of EGC
audits with deficiencies related to the accounting estimates standard
and fair value standard \170\ based on the 2012-2016 reported
inspection findings.\171\ The data help demonstrate
[[Page 13438]]
the high frequency of deficiencies related to the existing estimates
and fair value standards in the audits of EGCs, raising questions about
whether professional skepticism is being appropriately applied and
about overall audit quality in this area. The EGC audits that had
deficiencies related to the existing estimates and fair value standards
as a proportion of total EGC audits that had deficiencies (including
deficiencies in internal control over financial reporting) have
remained relatively high (45%-60%) for the 2012-2016 period.
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\169\ See EGC White Paper for the methodology used to identify
EGCs.
\170\ Deficiencies related to the derivatives standard were
infrequent over the inspection period reviewed, and therefore
considered insignificant for purposes of this analysis.
\171\ The chart identifies the audits of EGCs with deficiencies
reported in the public portion of inspection reports. It shows the
relative frequency of EGC audits with deficiencies citing the
existing accounting estimates standard or the existing fair value
standard compared to the total EGC audits with deficiencies for that
year. It also shows the frequency of inspected EGCs audits that had
a deficiency. For example, in inspection year 2013, 50% of the EGC
audits that were inspected had a deficiency and 60% of the audits
with deficiencies included at least one deficiency citing the
accounting estimates standard or the fair value standard (total 2016
reported inspection findings are based on preliminary results).
[GRAPHIC] [TIFF OMITTED] TN04AP3.001
The Board has provided this analysis to assist the SEC in its
consideration of whether it is ``necessary or appropriate in the public
interest, after considering the protection of investors and whether the
action will promote efficiency, competition, and capital formation,''
to apply the new standard and related amendments to audits of EGCs.
For the reasons explained above, the Board believes that the new
standard and related amendments are in the public interest and, after
considering the protection of investors and the promotion of
efficiency, competition, and capital formation, recommends that the new
standard and related amendments apply to audits of EGCs. Accordingly,
the Board recommends that the Commission determine that it is necessary
or appropriate in the public interest, after considering the protection
of investors and whether the action will promote efficiency,
competition, and capital formation, to apply the new standard and
related amendments to audits of EGCs. The Board stands ready to assist
the Commission in considering any comments the Commission receives on
these matters during the Commission's public comment process.
Applicability to Audits of Brokers and Dealers
The proposal indicated that the proposed standard and amendments
would apply to audits of brokers and dealers, as defined in Sections
110(3)-(4) of the Sarbanes-Oxley Act. The Board solicited comment on
any factors specifically related to audits of brokers and dealers that
may affect the application of the proposed amendments to those audits.
Commenters that addressed the issue agreed that the proposal should
apply to these audits, citing benefits to users of financial statements
of broker and dealers and the risk of confusion and inconsistency if
different methodologies were required under PCAOB standards for audits
of different types of entities.
After considering comments, the Board determined that the new
standard and related amendments, if approved by the SEC, will be
applicable to all audits performed pursuant to PCAOB standards,
including audits of brokers and dealers.
The information asymmetry between the management and the customers
of brokers and dealers about the brokers' and dealers' financial
condition may be significant and of particular interest to customers,
as the brokers or dealers may have custody of customers assets, which
could become inaccessible to the customers in the event of an
insolvency. In addition, unlike the owners of brokers and dealers, who
themselves may be managers and thus may be subject to minimal or no
information asymmetry, customers of brokers and dealers may, in some
instances, be large in number and may not be expert in the management
or operation of brokers and dealers. Such information asymmetry between
the management and the customers of brokers and dealers increases the
role of auditing in enhancing the reliability of financial information,
especially given that the use of estimates, including fair value
measurements, is prevalent among brokers and dealers. The provision to
regulatory agencies of reliable and accurate accounting estimates on
brokers' and dealers' financial statements may enable these agencies to
[[Page 13439]]
more effectively monitor these important market participants. Improved
audits may help prevent accounting fraud that affects brokers' and
dealers' customers and that may be perpetrated, for example, through
manipulated valuations of securities. Therefore, the new standard
should benefit customers and regulatory authorities of brokers and
dealers by increasing confidence that brokers and dealers are able to
meet their obligations to their customers and are in compliance with
regulatory requirements.
Accordingly, the discussion above of the need for the new standard
and related amendments, as well as the costs, benefits, alternatives
considered, and potential unintended consequences to auditors and the
companies they audit, also applies to audits of brokers and dealers. In
addition, with respect to the impact of the new standard on customers
of brokers and dealers, the expected improvements in audit quality
described above would benefit such customers, along with investors,
capital markets and auditors, while the final requirements are not
expected to result in any direct costs or unintended consequences to
customers of brokers and dealers.
III. Date of Effectiveness of the Proposed Rules and Timing for
Commission Action
Pursuant to Section 19(b)(2)(A)(ii) of the Exchange Act, and based
on its determination that an extension of the period set forth in
Section 19(b)(2)(A)(i) of the Exchange Act is appropriate in light of
the PCAOB's request that the Commission, pursuant to Section
103(a)(3)(C) of the Sarbanes-Oxley Act, determine that the proposed
rules apply to the audits of EGCs, the Commission has determined to
extend to July 3, 2019 the date by which the Commission should take
action on the proposed rules.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning the foregoing, including whether the proposed
rules are consistent with the requirements of Title I of the Act.
Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (http://www.sec.gov/rules/pcaob.shtml); or
Send an email to [email protected]. Please include
File Number PCAOB-2019-02 on the subject line.
Paper Comments
Send paper comments in triplicate to Secretary, Securities
and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.
All submissions should refer to File Number PCAOB-2019-02. This file
number should be included on the subject line if email is used. To help
the Commission process and review your comments more efficiently,
please use only one method. The Commission will post all comments on
the Commission's internet website (http://www.sec.gov/rules/pcaob.shtml). Copies of the submission, all subsequent amendments, all
written statements with respect to the proposed rules that are filed
with the Commission, and all written communications relating to the
proposed rules between the Commission and any person, other than those
that may be withheld from the public in accordance with the provisions
of 5 U.S.C. 552, will be available for website viewing and printing in
the Commission's Public Reference Room, on official business days
between the hours of 10:00 a.m. and 3:00 p.m. Copies of such filing
will also be available for inspection and copying at the principal
office of the PCAOB. All comments received will be posted without
charge. Persons submitting comments are cautioned that we do not redact
or edit personal identifying information from comment submissions. You
should submit only information that you wish to make available
publicly. All submissions should refer to File Number PCAOB-2019-02 and
should be submitted on or before April 25, 2019.
For the Commission, by the Office of the Chief Accountant, by
delegated authority.\172\
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\172\ 17 CFR 200.30-11(b)(1) and (3).
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Eduardo A. Aleman,
Deputy Secretary.
[FR Doc. 2019-06426 Filed 4-3-19; 8:45 am]
BILLING CODE 8011-01-P