[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  

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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

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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

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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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

     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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.''
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \34\ See AS 2110.70-.71.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    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:
---------------------------------------------------------------------------

    \37\ AS 2301.09.
    \38\ See AS 2110.60A, as amended, for examples of specific risk 
factors.
---------------------------------------------------------------------------

     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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \48\ AS 2502.19.
    \49\ See AS 2110.28, as amended.
    \50\ See AS 2810 for requirements related to evaluating bias in 
accounting estimates.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \53\ AS 1105.10.
    \54\ AS 1105.07-.08.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \67\ See AS 2502.40.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \68\ See AS 2502.40.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \69\ See paragraph .08 of the proposed standard.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \71\ See AS 2502.40.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \72\ See Specialists Release, supra note 2.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \73\ Paragraphs 23-25 of ISA 540 Revised describe the auditor's 
further procedures for addressing methods, significant assumptions, 
and data.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \77\ See additional discussion of evaluating audit results 
below.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \82\ See AS 2601.03.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    \83\ See Specialists Release, supra note 2.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \84\ See first note to paragraph .A4 in AS 2501 (Revised).
---------------------------------------------------------------------------

     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.
---------------------------------------------------------------------------

    \85\ See second note to paragraph .A4 in AS 2501 (Revised).
---------------------------------------------------------------------------

     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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \88\ See AS 1105.07.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \89\ The discussion that follows excludes conforming amendments 
that make reference to the new standard.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \90\ See paragraph .01 of AS 3110, Dating of the Independent 
Auditor's Report.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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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 BILLING CODE 8011-01-P
[GRAPHIC] [TIFF OMITTED] TN04AP3.000

 BILLING CODE 8011-01-C

[[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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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