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, 13396-13439 [2019-06426]
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Federal Register / Vol. 84, No. 65 / Thursday, April 4, 2019 / Notices
SECURITIES AND EXCHANGE
COMMISSION
(‘‘EGCs’’).1 The Board’s request is set
forth in section D.
[Release No. 34–85434; File No. PCAOB–
2019–02]
A. Board’s Statement of the Purpose of,
and Statutory Basis for, the Proposed
Rules
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-accountingestimates-fair-value-measurements.aspx
and at the Commission’s Public
Reference Room.
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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 SarbanesOxley Act, the Commission approve the
proposed rules for application to audits
of emerging growth companies
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(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
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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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.
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.
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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(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-auditingaccounting-estimates-fair-valuemeasurements.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 nonfinancial assets, impairments of longlived 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.
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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
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
• Evaluating the consistency of
management’s assumptions with other
information.9
• 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
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.
8 See generally AS 2501 and AS 2502.26–.39.
9 Id.
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
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
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
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.
11 See
generally AS 2501.13 and AS 2502.41–.42.
generally AS 2502.26–.40.
13 See generally AS 2502.40.
14 See generally AS 2503.28–.34 and .56–.57.
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.
12 See
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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
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
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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liabilities, and obtaining evidence
related to complex transactions).
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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
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
More recently, there are some
indications in PCAOB inspections of
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.
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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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
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 San˜e´ Figueras, and Jose´ Ignacio Alga´s
Ferna´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.
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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
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 thirdparty 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.
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.
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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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
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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-sizefits-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
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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 methods23—
affect the auditor’s risk assessment and
in turn, the required audit effort.
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
22 AS
2301.09.
paragraph AS 2110.60A, as amended, for
examples of specific risk factors.
23 See
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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
24 See Financial Accounting Standards Board
(‘‘FASB’’) Accounting Standards Update No. 2016–
13, Financial Instruments—Credit Losses (Topic
326): Measurement of Credit Losses on Financial
Instruments (June 2016).
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features of management bias), and those
that cannot be addressed (e.g., time
constraints, limits on available
information).
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
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13401
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,
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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
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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:
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• 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.
• 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
25 The requirements in this area focus primarily
on pricing information from pricing services and
brokers or dealers, but also cover pricing
information obtained from other third-party pricing
sources, such as exchanges and publishers of
exchange prices.
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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
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
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
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
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.
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.
28 See PCAOB, Changes in Use of Data and
Technology in the Conduct of Audits, available at
https://pcaobus.org/Standards/research-standardsetting-projects/Pages/technology.aspx.
29 See IAASB Exposure Draft, Proposed ISA 540
(Revised), Auditing Accounting Estimates and
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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.
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
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.
Related Disclosures, (Apr. 20, 2017). In October
2018, the IAASB released the final standard (‘‘ISA
540 Revised’’).
30 Paragraph A59 of ISA 200, Overall Objectives
of the Independent Auditor and the Conduct of an
Audit in Accordance with International Standards
on Auditing, and paragraph .A64 of AU–C Section
200, Overall Objectives of the Independent Auditor
and the Conduct of an Audit in Accordance with
Generally Accepted Auditing Standards, indicate
that the related application and other explanatory
material ‘‘does not in itself impose a requirement’’
but ‘‘is relevant to the proper application of the
requirements’’ of the respective standards.
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13403
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
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.
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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.’’
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.
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
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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
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.
32 See first note to paragraph .05 of the new
standard.
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.
34 See AS 2110.70–.71.
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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.
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
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
35 See
AS 2110.63.
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.
36 ISA
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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
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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,
37 AS
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
38 See AS 2110.60A, as amended, for examples of
specific risk factors.
2301.09.
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measurement uncertainty, or complex
processes or methods 38—would affect
the auditor’s risk assessment and in
turn, the required audit effort. For
example:
• 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.
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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
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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 companyspecific 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
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
39 See
AS 1105.10.
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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
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
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.
AS 1215.06.
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.
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.
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
40 See
41 ISA
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42 The auditor’s responsibilities with respect to
using the work of a company specialist are
presented as Appendix A of AS 1105. See supra
note 2.
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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
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
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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
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
43 The Board’s risk assessment standards address
the auditor’s responsibilities for responding to risks
of material misstatement and obtaining sufficient
appropriate evidence.
44 See AS 2502.15 and .18.
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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
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.
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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.
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
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
46 Additionally, AS 2301.05d requires the auditor
to evaluate whether the company’s selection and
application of significant accounting principles,
particularly those related to subjective
measurements and complex transactions, are
indicative of bias that could lead to material
misstatement of the financial statements.
47 AS 2110.09 and .12–.13.
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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
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
48 AS
2502.19.
AS 2110.28, as amended.
50 See AS 2810 for requirements related to
evaluating bias in accounting estimates.
49 See
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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.
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
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.
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)
51 See also FASB Accounting Standards
Codification Topic 250, Accounting Changes and
Error Corrections.
52 See supra note 45 for additional requirements
related to models.
53 AS 1105.10.
54 AS 1105.07–.08.
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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—
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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
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.
55 See
AS 2502.39.
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Comparison With Standards of Other
Standard Setters
ISA 540 Revised provides that the
auditor’s procedures shall address (a)
whether the 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
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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
56 See
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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.
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.
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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,
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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 forwardlooking information in anticipation of
the new accounting standard on credit
losses.57
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
57 See FASB Accounting Standards Update No.
2016–13, Financial Instruments—Credit Losses
(Topic 326): Measurement of Credit Losses on
Financial Instruments (June 2016).
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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.
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
58 See
59 See
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generally AS 2502.29–.36.
AS 2501.30–.31 (Revised).
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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.
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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
60 For the purposes of this requirement,
significant assumptions identified by the company
may not necessarily include all of those identified
by the auditor as significant.
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significant assumptions and potential
for management bias.
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.
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
61 See Commission Guidance Regarding
Management’s Discussion and Analysis of Financial
Condition and Results of Operations, Release No.
33–8350 (Dec. 19, 2003), 68 FR 75056 (Dec. 29,
2003), at Section V (‘‘Critical Accounting
Estimates’’) for management’s responsibilities
related to critical accounting estimates.
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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
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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
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considered necessary, develop a range
with which to evaluate the
reasonableness of the accounting
estimate.
Company’s Use of a Specialist or ThirdParty 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.
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
62 In a separate proposal, the Board proposed to
amend its standards regarding the auditor’s use of
the work of specialists, including specialists
employed or engaged by the company (‘‘company’s
specialist’’). See Proposed Amendments to Auditing
Standards for the Auditor’s Use of the Work of
Specialists, PCAOB Release No. 2017–003
(‘‘Specialists Proposal’’). The Specialists Proposal
set forth these amendments in Appendix B of AS
1105.
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whether the company has used thirdparty 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.
The new standard retains as proposed
the requirement to evaluate, when thirdparty 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
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.
64 Paragraphs 21–29 of ISA 540 Revised describe
the requirements for obtaining audit evidence from
events occurring up to the date of the auditor’s
report; testing how management made the
accounting estimate; and developing an auditor’s
point estimate or range.
65 ISA 540 Revised provides that in obtaining
audit evidence regarding the risks of material
misstatement relating to accounting estimates,
irrespective of the sources of information to be used
as audit evidence, the auditor shall comply with the
relevant requirements in ISA 500.
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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.
Developing an Independent Expectation
of the Estimate
See Paragraph .21
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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.
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.
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.
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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 developed using:
Auditor responsibility under the new standard:
Assumptions and methods of the auditor ................................................
Data and assumptions obtained from a third party ..................................
Company data, assumptions, or methods ...............................................
Have a reasonable basis for the assumptions and methods.
Evaluate the relevance and reliability of the data and assumptions.
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
66 See
AS 2501.12, AS 2502.40, and AS 2503.40.
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of developing an independent fair value
estimate ‘‘for corroborative purposes.’’ 68
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
67 See
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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
68 See
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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.
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
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
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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.
One commenter suggested that the
Board clarify that when developing an
69 See
paragraph .08 of the proposed standard.
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.
71 See AS 2502.40.
70 Appendix
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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
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
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
72 See
Specialists Release, supra note 2.
23–25 of ISA 540 Revised describe
the auditor’s further procedures for addressing
methods, significant assumptions, and data.
73 Paragraphs
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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
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.
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
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.
75 ED 540, paragraph A134 stated that ‘‘In certain
circumstances, the auditor’s range for an accounting
estimate may be multiples of materiality for the
financial statements as a whole, particularly when
materiality is based on operating results (for
example, pre-tax income) and this measure is
relatively small in relation to assets or other balance
sheet measures. In these circumstances, the
auditor’s evaluation of the reasonableness of the
disclosures about estimation uncertainty becomes
increasingly important. Considerations such as
those included in paragraphs A133, A144, and
A145 may also be appropriate in these
circumstances.’’ Substantially similar guidance
appears in paragraph A125 of ISA 540 Revised.
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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
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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
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
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
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.
77 See additional discussion of evaluating audit
results below.
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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
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subsequent to the measurement date,
such as the cash settlement of shortterm 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
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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
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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
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
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.
78 See discussion of identification of significant
assumptions above.
79 ISA 540 Revised further requires the auditor to
evaluate, based on the audit procedures performed
and audit evidence obtained, whether (a) the
assessments of the risks of material misstatement at
the assertion level remain appropriate, including
when indicators of possible management bias have
been identified; (b) management’s decisions relating
to the recognition, measurement, presentation and
disclosure of these accounting estimates in the
financial statements are in accordance with the
applicable financial reporting framework; and (c)
sufficient appropriate audit evidence has been
obtained.
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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.
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
80 Appendix A focuses primarily on pricing
information from pricing services and brokers or
dealers, but paragraph .A2 also covers pricing
information obtained from other third-party
sources, such as exchanges and publishers of
exchange prices.
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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
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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
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,
81 Additionally, centralized groups may
periodically provide general information within the
firm about a pricing service’s controls and
methodologies or general information on current
market conditions for different types of securities.
Such general information may inform engagement
teams’ risk assessments, to the extent that the
information is reliable and relevant to their
engagements. The activities of centralized groups to
obtain and communicate such general information
are different in nature from the engagement-specific
services provided by the centralized groups, which
are subject to supervision. Thus, it is important for
firm quality control systems to have policies and
procedures related to the accuracy of such general
information from centralized groups.
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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 thirdparty 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.
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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
82 See
AS 2601.03.
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being a service organization under
PCAOB standards have not changed.
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 (companyengaged 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).
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
83 See
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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
84 See first note to paragraph .A4 in AS 2501
(Revised).
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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.
• 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.
• 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.
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
85 See second note to paragraph .A4 in AS 2501
(Revised).
86 See third note to paragraph .A4 in AS 2501
(Revised).
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
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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.
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.
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
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.
88 See AS 1105.07.
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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
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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
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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
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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
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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.
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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
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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
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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
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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/docket043-auditing-accounting-estimates-fairvalue-measurements.aspx and at the
Commission’s Public Reference Room.
Significant amendments are described
below.89
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
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
89 The discussion that follows excludes
conforming amendments that make reference to the
new standard.
90 See paragraph .01 of AS 3110, Dating of the
Independent Auditor’s Report.
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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
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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.
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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
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• 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
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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
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.
91 See the Specialists Release, supra note 2, for a
discussion of auditors’ responsibilities with respect
to specialists.
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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
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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
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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.
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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
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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 reestimation 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
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13425
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
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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.
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
Baseline
Section C above discusses the Board’s
current requirements for auditing
accounting estimates, including fair
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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).
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
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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.
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
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.
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).
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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.
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
100 Id.
at 49–50.
Matthew Glendening, Critical Accounting
Estimate Disclosures and the Predictive Value of
Earnings, 31 (4) Accounting Horizons 1, 12 (2017).
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).
101 See
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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
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
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 YiJing 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).
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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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
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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
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).
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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.
In addition to the potential incentive
problem, cognitive biases, such as
management optimism or
overconfidence, can manifest
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 Holmstro¨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).
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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
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.
Audits are one of the mechanisms for
mitigating the information and incentive
problems arising in the investormanagement relationship.120 Audits are
intended to provide a check of
management’s financial statements, and
thus reduce management’s potential
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).
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.
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).
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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
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
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).
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.
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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
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
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.’’).
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.
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resort to simplifications that might
increase the potential for biases or errors
that have seeped into financial
statements to go undetected.127
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.
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
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).
128 Nelson argues that ‘‘[p]roblem-solving ability,
ethical predisposition, and other traits like selfconfidence 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.
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estimates.132 This can be seen as a
manifestation of findings that auditors
may, at times, experience difficulties
weighting evidence appropriately.133
• 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
• 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
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.
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.
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
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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
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
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
experience and increases client-specific knowledge,
while excessive familiarity impairs audit quality,
resulting in lower earnings quality.
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.
140 See, e.g., Martin et al., Auditing Fair Value
Measurements: A Synthesis of Relevant Research.
141 See, e.g., Brant E. Christensen, Steven M.
Glover, and David A. Wood, Extreme Estimation
Uncertainty in Fair Value Estimates: Implications
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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
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
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.
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to address the effects of bias on the
financial statements.
Fostering a More Efficient Audit
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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
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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 thirdparty 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,
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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.
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
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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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-fitsall 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.
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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
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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distributed, they face a potential
collective action problem that creates
additional barriers to jointly negotiating
with auditors over requirements for
auditing accounting estimates.
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.
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
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).
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,
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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
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 nondiversifiable 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).
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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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.
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
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increase in efficiency for easier-tomeasure 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
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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
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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
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 thirdparty 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
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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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 mediumsized 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
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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
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information from the third-party pricing
source.
One commenter also cautioned that
perceived information sharing by thirdparty 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
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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
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 OtherThan-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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differences in these standards discussed
herein, guidance would be an
ineffective tool and not a long-term
solution.
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
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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.
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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.
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).
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• 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.
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.
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.
156 See
paragraph 15a of AU–C 540.
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.
157 See
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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.
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.
The Board believes that accounting
estimates are common in the financial
statements of many EGCs.162 The Board
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.
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.
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
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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.
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
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.
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.
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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.
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.
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
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 . . .’’).
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.
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).
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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.
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.
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
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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.
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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.
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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)
VerDate Sep<11>2014
18:19 Apr 03, 2019
Jkt 247001
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 (https://www.sec.gov/
rules/pcaob.shtml); or
• Send an email to rule-comments@
sec.gov. 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
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post all comments on the Commission’s
internet website (https://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
Eduardo A. Aleman,
Deputy Secretary.
[FR Doc. 2019–06426 Filed 4–3–19; 8:45 am]
BILLING CODE 8011–01–P
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Agencies
[Federal Register Volume 84, Number 65 (Thursday, April 4, 2019)]
[Notices]
[Pages 13396-13439]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-06426]
[[Page 13395]]
Vol. 84
Thursday,
No. 65
April 4, 2019
Part II
Securities and Exchange Commission
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Public Company Accounting Oversight Board; Notice of Filing of
Proposed Rules on Auditing Accounting Estimates, Including Fair Value
Measurements, and Amendments to PCAOB Auditing Standards; Notice
Federal Register / Vol. 84 , No. 65 / Thursday, April 4, 2019 /
Notices
[[Page 13396]]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-85434; File No. PCAOB-2019-02]
Public Company Accounting Oversight Board; Notice of Filing of
Proposed Rules on Auditing Accounting Estimates, Including Fair Value
Measurements, and Amendments to PCAOB Auditing Standards
March 28, 2019.
Pursuant to Section 107(b) of the Sarbanes-Oxley Act of 2002 (the
``Act'' or ``Sarbanes-Oxley Act''), notice is hereby given that on
March 20, 2019, the Public Company Accounting Oversight Board (the
``Board'' or ``PCAOB'') filed with the Securities and Exchange
Commission (the ``Commission'' or ``SEC'') the proposed rules described
in Items I and II below, which items have been prepared by the Board.
The Commission is publishing this notice to solicit comments on the
proposed rules from interested persons.
I. Board's Statement of the Terms of Substance of the Proposed Rules
On December 20, 2018, the Board adopted a new rule and amendments
to auditing standards (collectively, the ``proposed rules''), under
which the three existing standards related to auditing estimates,
including fair value measurements, will be replaced with a single,
updated standard. The text of the proposed rules appears in Exhibit A
to the SEC Filing Form 19b-4 and is available on the Board's website at
https://pcaobus.org/Rulemaking/Pages/docket-043-auditing-accounting-estimates-fair-value-measurements.aspx and at the Commission's Public
Reference Room.
II. Board's Statement of the Purpose of, and Statutory Basis for, the
Proposed Rules
In its filing with the Commission, the Board included statements
concerning the purpose of, and basis for, the proposed rules and
discussed any comments it received on the proposed rules. The text of
these statements may be examined at the places specified in Item IV
below. The Board has prepared summaries, set forth in sections A, B,
and C below, of the most significant aspects of such statements. In
addition, the Board is requesting that, pursuant to Section
103(a)(3)(C) of the Sarbanes-Oxley Act, the Commission approve the
proposed rules for application to audits of emerging growth companies
(``EGCs'').\1\ The Board's request is set forth in section D.
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\1\ The term ``emerging growth company'' is defined in Section
3(a)(80) of the Securities Exchange Act of 1934 (the ``Exchange
Act'') (15 U.S.C. 78c(a)(80)). See also Inflation Adjustments and
Other Technical Amendments Under Titles I and III of the JOBS Act,
Release No. 33-10332 (Mar. 31, 2017), 82 FR 17545 (Apr. 12, 2017).
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A. Board's Statement of the Purpose of, and Statutory Basis for, the
Proposed Rules
(a) Purpose
Summary
The Board has adopted amendments to its standards for auditing
accounting estimates and fair value measurements, under which three
existing standards will be replaced with a single, updated standard
(``AS 2501 (Revised)'' or the ``new standard''). As discussed in more
detail below, in the Board's view, the new standard and related
amendments will further investor protection by strengthening audit
requirements, applying a more uniform, risk-based approach to an area
of the audit that is of increasing prevalence and significance, and
updating the standards in light of recent developments.
The financial statements of most companies reflect amounts in
accounts and disclosures that require estimation, which may include
fair value measurements or other types of estimates. These estimates
appear in items like revenues from contracts with customers, valuations
of certain financial and non-financial assets, impairments of long-
lived assets, allowances for credit losses, and contingent liabilities.
As financial reporting frameworks evolve toward greater use of
estimates, accounting estimates are becoming more prevalent and more
significant, often having a significant impact on a company's reported
financial position and results of operations.
By their nature, accounting estimates, including fair value
measurements, generally involve subjective assumptions and measurement
uncertainty, making them susceptible to management bias. Some estimates
involve complex processes and methods. As a result, accounting
estimates are often some of the areas of greatest risk in an audit,
requiring additional audit attention and appropriate application of
professional skepticism. The challenges of auditing estimates may be
compounded by cognitive bias, which could lead auditors to anchor on
management's estimates and inappropriately weight confirmatory over
contradictory evidence.
The Board's oversight activities, which have revealed a recurring
pattern of deficiencies in this area, also raise concerns about
auditors' application of professional skepticism, including addressing
potential management bias, in this area of the audit. Over the years,
PCAOB staff has provided guidance for auditors related to auditing
accounting estimates, but this area remains challenging and practices
among firms vary.
Currently, three PCAOB auditing standards primarily relate to
accounting estimates, including fair value measurements. These three
standards, which were originally adopted between 1988 and 2003, include
common approaches for substantive testing but vary in the level of
detail in describing the auditor's responsibilities with respect to
those approaches. In addition, because the three standards predate the
Board's risk assessment standards, they do not fully integrate risk
assessment requirements that relate to identifying, assessing, and
responding to the risks of material misstatement in accounting
estimates.
The new standard builds on the common approaches in the three
existing standards and will strengthen PCAOB auditing standards in the
following respects:
Providing direction to prompt auditors to devote greater
attention to addressing potential management bias in accounting
estimates, as part of applying professional skepticism.
Extending certain key requirements in the existing
standard on auditing fair value measurements, the newest and most
comprehensive of the three existing standards, to other accounting
estimates in significant accounts and disclosures, reflecting a more
uniform approach to substantive testing for estimates.
More explicitly integrating requirements with the Board's
risk assessment standards to focus auditors on estimates with greater
risk of material misstatement.
Making other updates to the requirements for auditing
accounting estimates to provide additional clarity and specificity.
Providing a special topics appendix to address certain
aspects unique to auditing fair values of financial instruments,
including the use of pricing information from third parties such as
pricing services and brokers or dealers.
The Board has adopted the new standard and related amendments after
substantial outreach, including two
[[Page 13397]]
rounds of public comment. Commenters generally supported the Board's
objective of improving the quality of audits involving accounting
estimates, and suggested areas where the proposed requirements could be
modified or clarified. The Board has taken all of these comments, as
well as observations from PCAOB oversight activities and the relevant
academic literature, into account.
In a separate PCAOB release, the Board also adopted amendments to
its standards for using the work of specialists, which are often
involved in developing, or assisting in the evaluation of, accounting
estimates.\2\ Certain provisions of the new standard include references
to AS 1210, Using the Work of an Auditor-Engaged Specialist; AS 1201,
Supervision of the Audit Engagement; and AS 1105, Audit Evidence, as
amended.
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\2\ See Amendments to Auditing Standards for Auditor's Use of
the Work of Specialists, PCAOB Release No. 2018-006 (Dec. 20, 2018)
(``Specialists Release'').
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In its consideration of the new standard and related amendments,
the Board is mindful of the significant advances in technology that
have occurred in recent years, including increased use of data analysis
tools and emerging technologies. An increased use of technology-based
tools, together with future developments in the use of data and
technology, could have a fundamental impact on the audit process. The
Board is actively exploring these potential impacts through ongoing
staff research and outreach.
In the context of this rulemaking, the Board considered how changes
in technology could affect the processes companies use to develop
accounting estimates, including fair value measurements, and the tools
and techniques auditors apply to audit them. The Board believes that
the new standard and related amendments are sufficiently principles-
based and flexible to accommodate continued advances in the use of data
and technology by both companies and auditors. The Board will continue
to monitor advances in this area and any effect they may have on the
application of the new standard.
The new standard and related amendments apply to all audits
conducted under PCAOB standards. Subject to approval by the Commission,
the new standard and related amendments will take effect for audits for
fiscal years ending on or after December 15, 2020.
(b) Statutory Basis
The statutory basis for the proposed rules is Title I of the Act.
B. Board's Statement on Burden on Competition
Not applicable. The Board's consideration of the economic impacts
of the proposed rules is discussed in section D below.
C. Board's Statement on Comments on the Proposed Rules Received From
Members, Participants or Others
The Board released the proposed rules for public comment in
Proposed Auditing Standard--Auditing Accounting Estimates, Including
Fair Value Measurements, and Proposed Amendments to PCAOB Auditing
Standards, PCAOB Release No. 2017-002 (June 1, 2017) (``proposal'' or
``Estimates Proposing Release''). The PCAOB also issued for public
comment a Staff Consultation Paper, Auditing Accounting Estimates and
Fair Value Measurements (Aug. 19, 2014) (``SCP''). Copies of Release
No. 2017-002, the SCP, and the comment letters received in response to
the PCAOB's requests for comment are available on the PCAOB's website
at https:/pcaobus.org/Rulemaking/Pages/docket-043-auditing-accounting-
estimates-fair-value-measurements.aspx. The PCAOB received 81 written
comment letters. The Board's response to the comments received and the
changes made to the rules in response to the comments received are
discussed below.
Background
Accounting estimates are an essential part of financial statements.
Most companies' financial statements reflect accounts or amounts in
disclosures that require estimation. Accounting estimates are pervasive
to financial statements, often substantially affecting a company's
financial position and results of operations. Examples of accounting
estimates include certain revenues from contracts with customers,
valuations of financial and non-financial assets, impairments of long-
lived assets, allowances for credit losses, and contingent liabilities.
The evolution of financial reporting frameworks toward greater use
of estimates includes expanded use of fair value measurements that need
to be estimated. For purposes of this rulemaking, a fair value
measurement is considered a form of accounting estimate because it
generally shares many of the same characteristics with other estimates,
including subjective assumptions and measurement uncertainty.
Rulemaking History
The PCAOB has engaged in extensive outreach to explore the views of
market participants and others on the potential for improvement of the
auditing standards related to accounting estimates. This includes
discussions with the Board's Standing Advisory Group (``SAG'') and the
Pricing Sources Task Force. In addition, in August 2014, the PCAOB
issued the SCP, to solicit comments on various issues, including the
potential need for standard setting and key aspects of a potential new
standard and related requirements.
In June 2017, the Board proposed to replace three auditing
standards that primarily relate to accounting estimates, including fair
value measurements, with a single standard. The proposal included a
special topics appendix addressing certain matters relevant to auditing
the fair value of financial instruments and amendments to several PCAOB
standards to align them with the single standard. A number of
commenters across many affiliations supported the Board's efforts to
strengthen auditing practices and update its standards in this area.
In addition to this outreach, the Board's approach has been
informed by, among other things, observations from PCAOB oversight
activities and SEC enforcement actions and consideration of academic
research, the standard on auditing accounting estimates recently
adopted by the International Auditing and Assurance Standards Board
(``IAASB''), and the extant standard on auditing accounting estimates
of the Auditing Standards Board (``ASB'') of the American Institute of
Certified Public Accountants.
Overview of Existing Requirements
The primary PCAOB standards that apply specifically to auditing
accounting estimates, including fair value measurements are:
AS 2501, Auditing Accounting Estimates (originally issued
in April 1988) (``accounting estimates standard'')--applies to auditing
accounting estimates in general.
AS 2502, Auditing Fair Value Measurements and Disclosures
(originally issued in January 2003) (``fair value standard'')--applies
to auditing the measurement and disclosure of assets, liabilities, and
specific components of equity presented or disclosed at fair value in
financial statements.
AS 2503, Auditing Derivative Instruments, Hedging
Activities, and Investments in Securities (originally issued in
September 2000) (``derivatives
[[Page 13398]]
standard'')--applies to auditing financial statement assertions for
derivative instruments, hedging activities, and investments in
securities. Its scope includes requirements for auditing the valuation
of derivative instruments and securities, including those measured at
fair value.
The accounting estimates standard, fair value standard, and
derivatives standard are referred to collectively as the ``estimates
standards.''
In addition, the Board's risk assessment standards,\3\ which set
forth requirements for the auditor's assessment of and response to risk
in an audit, include requirements that relate to accounting estimates.
These requirements involve procedures regarding identifying and
assessing risks of material misstatement in accounting estimates,\4\
identifying and evaluating misstatements in accounting estimates,\5\
and evaluating potential management bias associated with accounting
estimates.\6\ PCAOB standards also set forth requirements for the
auditor to plan and perform his or her work with due professional care,
which includes the application of professional skepticism.\7\
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\3\ The Board's ``risk assessment standards'' include AS 1101,
Audit Risk; AS 1105; AS 1201; AS 2101, Audit Planning; AS 2105,
Consideration of Materiality in Planning and Performing an Audit; AS
2110, Identifying and Assessing Risks of Material Misstatement; AS
2301, The Auditor's Responses to the Risks of Material Misstatement;
and AS 2810, Evaluating Audit Results.
\4\ See generally AS 2110.13.
\5\ See AS 2810.13.
\6\ See AS 2810.27.
\7\ See generally paragraph .07 of AS 1015, Due Professional
Care in the Performance of Work.
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Both the accounting estimates standard and the fair value standard
provide that the auditor may apply one or a combination of three
approaches to substantively test an accounting estimate:
Testing management's process. This generally involves:
Evaluating the reasonableness of assumptions used by
management that are significant to the estimate, and testing and
evaluating the completeness, accuracy, and relevance of data used; \8\
and
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\8\ See generally AS 2501 and AS 2502.26-.39.
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Evaluating the consistency of management's assumptions
with other information.\9\
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\9\ Id.
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Developing an independent estimate. This generally
involves using management's assumptions, or alternative assumptions, to
develop an independent estimate or an expectation of an estimate.\10\
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\10\ See generally AS 2501.12 and AS 2502.40.
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Reviewing subsequent events or transactions. This
generally involves using events or transactions occurring subsequent to
the balance sheet date, but prior to the date of the auditor's report,
to provide evidence about the reasonableness of the estimate.\11\
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\11\ See generally AS 2501.13 and AS 2502.41-.42.
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In general, the fair value standard, which is the most recent of
the estimates standards, sets forth more detailed procedures for the
common approaches described above. The level of detail within the fair
value standard, however, varies.\12\ For example, the fair value
standard sets forth a number of different requirements for testing
management's process but only a few general requirements for developing
an independent estimate.\13\
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\12\ See generally AS 2502.26-.40.
\13\ See generally AS 2502.40.
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The derivatives standard primarily addresses auditing derivatives.
This standard also includes requirements for auditing the valuation of
derivatives and investment securities, including valuations based on an
investee's financial results, and testing assertions about securities
based on management's intent and ability.\14\
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\14\ See generally AS 2503.28-.34 and .56-.57.
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Existing Practice
The PCAOB's understanding of audit practice at both larger and
smaller audit firms under existing PCAOB standards has been informed
by, among other things, the collective experience of PCAOB staff,
observations from oversight activities of the Board, enforcement
actions of the SEC, comments received on the SCP and proposal, and
discussions with the SAG and audit firms.
Overview of Existing Practice
The PCAOB has observed through its oversight activities that some
audit firms' policies, procedures, and guidance (``methodologies'') use
approaches that apply certain of the basic procedures for auditing fair
value measurements to other accounting estimates (e.g., evaluating the
method used by management to develop estimates).\15\ The PCAOB has also
observed that when testing management's process, some auditors have
developed expectations of certain significant assumptions as an
additional consideration in evaluating the reasonableness of those
assumptions.
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\15\ Notably, most of those firms base their methodologies
largely on the standards of the IAASB or the ASB, both of which have
adopted one standard for auditing both fair value measurements and
other accounting estimates.
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Over the past few years, some audit firms have updated their
methodologies, often in response to identified inspection deficiencies.
For example, in the area of auditing the fair value of financial
instruments, some firms have directed resources to implement more
rigorous procedures to evaluate the process used by third-party pricing
sources to determine the fair value of financial instruments.
The PCAOB has observed diversity in how audit firms use information
obtained from third-party sources in auditing fair value measurements.
Such third-party sources include pricing services and brokers or
dealers, which provide pricing information related to the fair value of
financial instruments.\16\
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\16\ Another type of third-party source--specialists who develop
independent estimates or assist in evaluating a company's estimate
or the work of a company's specialist--is addressed separately in
the Specialists Release. See supra note 2.
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Some larger audit firms have implemented centralized approaches to
developing independent estimates of the fair value of financial
instruments. These firms may use centralized, national-level pricing
desks or groups to assist in performing procedures relating to testing
the fair value of financial instruments. The level of information
provided by these centralized groups to engagement teams varies. In
some cases, the national-level pricing desk obtains pricing information
from pricing services at the request of the engagement team.
Additionally, national-level pricing desks may periodically provide
information about a pricing service's controls and methodologies, and
provide information on current market conditions for different types of
securities to inform an engagement team's risk assessment. In other
cases, the national-level pricing desk itself may develop estimates of
fair value for certain types of securities, assist audit teams with
evaluating the specific methods and assumptions related to a particular
instrument, or evaluate differences between a company's price and price
from a pricing source. Smaller audit firms that do not have a national
pricing group may engage valuation specialists to perform some or all
of these functions. Some smaller firms use a combination of external
valuation specialists and internal pricing groups.
Commenters generally did not disagree with the description of
current practice in the proposal. A few commenters pointed to
additional areas where company and firm size and available resources
can result in diverse audit approaches (e.g., impairment testing,
estimates of environmental
[[Page 13399]]
liabilities, and obtaining evidence related to complex transactions).
Observations From Audit Inspections
Through its oversight activities, the PCAOB has historically
observed numerous deficiencies in auditing accounting estimates. Audit
deficiencies have been observed in both larger and smaller audit
firms.\17\
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\17\ See, e.g., Annual Report on the Interim Inspection Program
Related to Audits of Brokers and Dealers, PCAOB Release No. 2018-003
(Aug. 20, 2018); PCAOB Staff Inspection Brief, Preview of
Observations from 2016 Inspections of Auditors of Issuers (Nov.
2017); and Annual Report on the Interim Inspection Program Related
to Audits of Brokers and Dealers, PCAOB Release No. 2017-004 (Aug.
18, 2017). See also Estimates Proposing Release at 12, footnote 39.
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PCAOB inspections staff has observed audit deficiencies in issuer
audits related to a variety of accounting estimates, including revenue-
related estimates and reserves, the allowance for loan losses, the fair
value of financial instruments, the valuation of assets and liabilities
acquired in a business combination, goodwill and long-lived asset
impairments, inventory valuation allowances, and equity-related
transactions. Examples of such deficiencies include failures to (1)
sufficiently test the accuracy and completeness of company data used in
fair value measurements or other estimates, (2) evaluate the
reasonableness of significant assumptions used by management, and (3)
understand information provided by third-party pricing sources. In
audits of brokers or dealers, deficiencies include failures to (1)
obtain an understanding of the methods and assumptions internally
developed or obtained by third parties that were used by the broker or
dealer to determine fair value of securities, and (2) perform
sufficient procedures to test valuation of securities. The observed
deficiencies are frequently associated with, among other things, a
failure to appropriately apply professional skepticism in auditing the
estimates.\18\
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\18\ Audit deficiencies have also been observed by other
regulators internationally. For example, an International Forum of
Independent Audit Regulators (``IFIAR'') survey released in 2018
reported that accounting estimates was one of the audit areas with
the highest rate and greatest number of findings. The most commonly
observed deficiencies related to failures to assess the
reasonableness of assumptions, including consideration of contrary
or inconsistent evidence where applicable; sufficiently test the
accuracy of data used; perform sufficient risk assessment
procedures; take relevant variables into account; evaluate how
management considered alternative assumptions; and adequately
consider indicators of bias. See IFIAR, Report on 2017 Survey of
Inspection Findings (Mar. 9, 2018), at 10 and B-6.
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More recently, there are some indications in PCAOB inspections of
issuer audits that observed deficiencies in this area are decreasing,
as compared to earlier years. Some audit firms have updated their audit
practices in light of deficiencies identified through inspections. Not
all firms have improved their practices in this area, however, and
PCAOB inspections staff has continued to observe deficiencies similar
to those described above. Inspection observations continue to raise
concerns about auditors' application of professional skepticism,
including addressing potential management bias, in auditing accounting
estimates.
Observations From Enforcement Cases
Over the years, there have been a number of enforcement actions by
the PCAOB and SEC for violations of PCAOB standards in auditing
accounting estimates, demonstrating the importance of this aspect of
the audit. Enforcement actions have been brought against larger and
smaller firms, with domestic and international practices.
PCAOB enforcement cases related to auditing estimates have
generally involved one or more of the following violations (1) failure
to perform any procedures to determine the reasonableness of
significant assumptions; (2) failure to test the relevance,
sufficiency, and reliability of the data supporting the accounting
estimates; (3) failure to perform a retrospective review of a
significant accounting estimate to determine whether management's
judgments and assumptions relating to the estimate indicated a possible
bias; and (4) failure to adequately consider contradictory evidence or
perform procedures to obtain corroboration for management
representations regarding accounting estimates.\19\
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\19\ See, e.g., Deloitte & Touche LLP, PCAOB Release No. 105-
2018-008 (May 23, 2018); Tarvaran Askelson & Company, LLP, Eric
Askelson, and Patrick Tarvaran, PCAOB Release No. 105-2018-001 (Feb.
27, 2018); David M. Burns, CPA, PCAOB Release No. 105-2017-055 (Dec.
19, 2017); Grant Thornton LLP, PCAOB Release No. 105-2017-054 (Dec.
19, 2017); Anthony Kam & Associates Limited, and Anthony KAM Hau
Choi, CPA, PCAOB Release No. 105-2017-043 (Corrected Copy) (Nov. 28,
2017); BDO Auditores, S.L.P., Santiago Sa[ntilde][eacute] Figueras,
and Jos[eacute] Ignacio Alg[aacute]s Fern[aacute]ndez, PCAOB Release
No. 105-2017-039 (Sept. 26, 2017); Kyle L. Tingle, CPA, LLC and Kyle
L. Tingle, CPA, PCAOB Release No. 105-2017-027 (May 24, 2017);
Wander Rodrigues Teles, PCAOB Release No. 105-2017-007 (Mar. 20,
2017); KAP Purwantono, Sungkoro & Surja, Roy Iman Wirahardja, and
James Randall Leali, PCAOB Release No. 105-2017-002 (Feb. 9, 2017);
HJ & Associates, LLC, S. Jeffrey Jones, CPA, Robert M. Jensen, CPA,
and Charles D. Roe, CPA, PCAOB Release No. 105-2017-001 (Jan. 24,
2017); Arshak Davtyan, Inc. and Arshak Davtyan, CPA, PCAOB Release
No. 105-2016-053 (Dec. 20, 2016); David C. Lee, CPA, PCAOB Release
No. 105-2016-052 (Dec. 20, 2016); Arturo Vargas Arellano, CPC, PCAOB
Release No. 105-2016-045 (Dec. 5, 2016); and Goldman Kurland and
Mohidin, LLP and Ahmed Mohidin, CPA, PCAOB Release No. 105-2016-027
(Sept. 13, 2016). See also Estimates Proposing Release at 13,
footnote 41.
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Similarly, the SEC has brought Rule 102(e) proceedings against
auditors for substantive failures in auditing accounting estimates,
including failures to obtain sufficient appropriate audit evidence for
significant accounting estimates in an entity's financial statements
and failures to exercise due professional care, including professional
skepticism, throughout the audit.\20\ In some cases, the auditor (1)
obtained little, if any, reliable or persuasive evidence with respect
to management's adjustments to stale appraised values; (2) failed to
identify and address bias in management's estimates; or (3) failed to
evaluate the results of audit procedures performed, including whether
the evidence obtained supported or contradicted estimates in the
financial statements.\21\
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\20\ See, e.g., Paritz & Company, P.A., Lester S. Albert, CPA,
and Brian A. Serotta, CPA, SEC Accounting and Auditing Enforcement
Release (``AAER'') No. 3899 (Sept. 21, 2017); KPMG LLP and John
Riordan, CPA, SEC AAER No. 3888 (Aug. 15, 2017); William Joseph
Kouser Jr., CPA, and Ryan James Dougherty, CPA, AAER No. 3864 (Apr.
4, 2017); Grassi & Co., CPAs, P.C., SEC AAER No. 3826 (Nov. 21,
2016). See also Estimates Proposing Release at 14, footnote 42.
\21\ See, e.g., Miller Energy Resources, Inc., Paul W. Boyd,
CPA, David M. Hall, and Carlton W. Vogt, III, CPA, SEC AAER Nos.
3780 (June 7, 2016) and 3673 (Aug. 6, 2015); Grant Thornton, LLP,
SEC AAER No. 3718 (Dec. 2, 2015).
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Reasons To Improve Auditing Standards
The Board believes that its standards for auditing accounting
estimates, including fair value measurements, can be improved to
provide better direction to auditors with respect to both the
application of professional skepticism, including addressing potential
management bias, and the use of third-party pricing information.
First, the differences in requirements among the three estimates
standards suggest that revising PCAOB standards to set forth a more
uniform, risk-based approach to auditing estimates can lead to
improvements in auditing practices for responding to the risks of
material misstatement in accounting estimates, whether due to error or
fraud.
Second, because the subjective assumptions and measurement
uncertainty of accounting estimates make them susceptible to management
bias, the Board believes that PCAOB standards related to auditing
accounting estimates will be improved by emphasizing the application of
professional skepticism, including addressing potential management
bias.
[[Page 13400]]
Although the risk assessment standards and certain other PCAOB
standards address professional skepticism and management bias, the
estimates standards provide little or no specific direction on how to
address those topics in the context of auditing accounting estimates.
Third, existing requirements do not provide specific direction
about how to evaluate the relevance and reliability of pricing
information from third parties. PCAOB standards should be improved by
revising the requirements in this area to drive a level of work effort
commensurate with both the risks of material misstatement in the
valuation of financial instruments and the relevance and reliability of
the evidence obtained.
The Board received 38 comment letters on the proposal. A number of
commenters supported the Board's efforts to strengthen auditing
practices and update its standards related to estimates and fair value
measurements. For example, investor groups asserted that the proposal
will strengthen auditor responsibilities, improve audit quality, and
further investor protection. Other commenters pointed to better
integration and alignment with the risk assessment standards, noting,
for example, that a risk-based approach to auditing estimates will help
to resolve the differences in requirements among the current standards.
Some commenters supported combining the three existing standards into a
single standard, for example, because it would make the requirements
easier to navigate and comply with. Some commenters also expressed
support for the incremental direction in the proposal on matters
related to financial instruments, including the use of pricing
information from third parties as audit evidence.
Some commenters on the proposal challenged the relevance of
inspection experience to the Board's consideration of the new standard.
For example, two commenters questioned whether the existence of audit
deficiencies related to estimates warrant revision to the estimates
standards. Another commenter suggested that development of standards
should be based on areas where audit quality can be improved in order
to protect the public interest, not just through areas that have been
identified during the inspection process. In contrast, other commenters
expressed concern over continued audit deficiencies observed in this
area and supported the development of the proposal. Another commenter
argued that a lack of clarity in the estimates standards might be a
contributing factor to the persistence of audit deficiencies associated
with auditing estimates and fair value measurements.
The Board believes that a pattern of deficiencies over time raises
questions about whether professional skepticism is being appropriately
applied and about overall audit quality in this area, and supports the
view that estimates are a challenging area of the audit. More specific
direction should contribute to more consistent, risk-based execution
and improved audit quality.
Some commenters questioned the need for the proposal citing, among
other things, insufficient evidence that existing standards are
deficient and the loss of certain content from the estimates standards
that the commenters considered to be useful. One commenter argued that
the standards for fair value measurements should be differentiated from
the standards for other accounting estimates because the goals of the
standards are fundamentally different.
The Board believes it is appropriate to apply a more uniform
approach to the audit of accounting estimates, including fair value
measurements, including by bringing the requirements together into a
single standard. The estimates standards already reflect common
approaches to substantive testing. While the level of detail varies
across the three standards, these differences do not derive from
differences in the assessed risks of material misstatement. The Board
believes that a single standard will promote auditor performance that
is more consistently responsive to risk. The new standard also includes
an appendix on valuation of financial instruments that provides
specific direction in that area.
Some commenters asserted that the proposal would lead to
unnecessary expansion of procedures and thus increased costs. For
example, one of those commenters contended that the proposed
requirements could affect the ability of smaller accounting firms to
audit certain types of issuers. Another commenter cautioned against a
one-size-fits-all audit approach, expressing concern about expecting
the same level of rigor in developing accounting estimates from both
the largest and smallest public companies. One commenter challenged the
scalability of the proposal, arguing that auditors will assume that all
listed factors and considerations will have to be addressed in every
audit, and that nothing in the proposal directed the auditor to
consider cost-benefit implications or whether further testing and
analysis would meaningfully improve the auditor's ability to assess the
reasonableness of an estimate. Other commenters, however, asserted that
the standard is sufficiently scalable.
The Board believes that the new standard is well-tailored to
address an increasingly significant and challenging area of the audit.
The new standard is designed to be scalable because the necessary audit
evidence depends on the corresponding risks of material misstatement.
The new standard does not prescribe detailed procedures or the extent
of procedures, beyond the requirement to respond to risk, including
significant risk, and direction for applying the primary approaches to
testing. Rather, it builds on the existing requirements of AS 2301
under which the auditor designs procedures that take into account the
types of potential misstatements that could result from the identified
risks and the likelihood and magnitude of potential misstatement.\22\
Specific risk factors associated with the estimates--for example,
subjective assumptions, measurement uncertainty, or complex processes
or methods\23\--affect the auditor's risk assessment and in turn, the
required audit effort.
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\22\ AS 2301.09.
\23\ See paragraph AS 2110.60A, as amended, for examples of
specific risk factors.
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Aligning the new standard and related amendments with the risk
assessment standards directs auditors to focus on estimates with
greater risk of material misstatement. The new standard allows auditors
to tailor their approach to best respond to identified risks and
effectively obtain sufficient appropriate evidence. To the extent the
new standard results in increased audit effort, that effort should be
scaled in relation to the relevant risks, and any associated costs
should be justified in light of the benefits of appropriate audit
attention and the appropriate application of professional skepticism.
Some commenters also challenged the anticipated benefits of the
proposal, arguing that additional audit work would not improve the
quality of financial reporting, given the inherent uncertainty and
subjectivity surrounding estimates.
The new standard and related amendments acknowledge that estimates
have estimation uncertainty and that it affects the risks of material
misstatement. Neither the Board nor auditors are responsible for
placing limits on the range of estimation uncertainty. That uncertainty
is a function of the estimate's measurement requirements under the
applicable financial reporting framework, the economic phenomena
affecting that estimate, and the fact that it involves assessments of
future outcomes. Under
[[Page 13401]]
the new standard and related amendments, the auditor will consider
estimation uncertainty in assessing risk and performing procedures in
response to risk, which involves evaluating whether the accounting
estimates are reasonable in the circumstances and in conformity with
the applicable financial reporting framework, as well as evaluating
potential management bias in accounting estimates, and its effect on
the financial statements. These responsibilities align with the
auditor's overall responsibility for planning and performing financial
statement audits.
Commenters generally acknowledged the Board's efforts to emphasize
professional skepticism, including addressing management bias, in the
proposal and provided varying views on related aspects of the proposal.
Some commenters, for example, indicated that the proposal should place
even more emphasis on the need to challenge management or the
consideration of management bias, noting the existence of overly
optimistic or skewed estimates in financial statements. One commenter
advocated for more discussion within the standard of the various types
of bias that can affect auditing estimates.
In contrast, other commenters asserted that the proposal
overemphasized the need for professional skepticism, or had a negative
tone that assumed a predisposition to management bias. One commenter
pointed out other practices and requirements that, in the commenter's
view, mitigate the risk of management bias, among them CEO and CFO
certification, management reporting and auditor attestation on internal
control over financial reporting, internal audit, and audit committee
oversight. Some of these commenters expressed concern that the emphasis
on professional skepticism would lead to unnecessary expansion of audit
procedures.
A few commenters also argued that management bias is inherent in
accounting estimates and cannot be eliminated. One of the commenters
added that, for those reasons, the proposed requirements addressing
management bias should not apply to estimates made pursuant to the new
accounting standard on credit losses.\24\ Another commenter suggested
that the proposal should differentiate between limitations that an
auditor can address (e.g., analytical ability), those that can be
partially addressed (e.g., some features of management bias), and those
that cannot be addressed (e.g., time constraints, limits on available
information).
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\24\ See Financial Accounting Standards Board (``FASB'')
Accounting Standards Update No. 2016-13, Financial Instruments--
Credit Losses (Topic 326): Measurement of Credit Losses on Financial
Instruments (June 2016).
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The Board acknowledges that given the subjective assumptions and
measurement uncertainty inherent in many estimates, bias cannot be
eliminated entirely. However, a standard that reinforces the importance
of professional skepticism, including addressing the potential for
management bias, when auditing estimates will remind auditors of their
existing responsibilities to evaluate contradictory evidence and to
address the effects of bias on the financial statements.
Some commenters suggested that the standard include guidance on
identifying and testing relevant controls over accounting estimates.
For example, one commenter suggested guidance related to auditor
consideration of management's controls over selection and supervision
of a company specialist. Another commenter suggested additional
guidance on identification and testing of relevant controls, and
identification and response to risks of material misstatement due to
fraud in relation to auditing estimates.
The auditor's responsibilities for testing controls are already
addressed in AS 2110, AS 2301, and AS 2201, An Audit of Internal
Control Over Financial Reporting That Is Integrated with An Audit of
Financial Statements. These requirements apply to controls over
accounting estimates. Those responsibilities are not altered by the new
standard and related amendments. However, after considering the
comments, an amendment was made to provide additional direction on
testing controls related to auditing estimates.
Overview of Final Rules
The Board has adopted a single standard to replace the accounting
estimates standard, the fair value standard, and the derivatives
standard. As described in more detail below, AS 2501 (Revised) includes
a special topics appendix that addresses certain matters relevant to
auditing the fair value of financial instruments. In addition, several
PCAOB auditing standards will be amended to align them with the new
standard on auditing accounting estimates. The new standard and related
amendments will make the following changes to existing requirements:
Provide direction to prompt auditors to devote greater
attention to addressing potential management bias in accounting
estimates, as part of applying professional skepticism. In this regard,
the new standard and related amendments will:
Amend AS 2110 to require a discussion among the key
engagement team members of how the financial statements could be
manipulated through management bias in accounting estimates in
significant accounts and disclosures.
Emphasize certain key requirements to focus auditors on
their obligations, when evaluating audit results, to exercise
professional skepticism, including evaluating whether management bias
exists.
Remind auditors that audit evidence includes both
information that supports and corroborates the company's assertions
regarding the financial statements and information that contradicts
such assertions.
Require the auditor to identify significant assumptions
used by the company and describe matters the auditor should take into
account when identifying those assumptions.
Provide examples of significant assumptions (important to
the recognition or measurement of the accounting estimate), such as
assumptions that are susceptible to manipulation or bias.
Emphasize requirements for the auditor to evaluate whether
the company has a reasonable basis for the significant assumptions used
and, when applicable, for its selection of assumptions from a range of
potential assumptions.
Explicitly require the auditor, when developing an
independent expectation of an accounting estimate, to have a reasonable
basis for the assumptions and method he or she uses.
Require that the auditor obtain an understanding of
management's analysis of critical accounting estimates and take that
understanding into account when evaluating the reasonableness of
significant assumptions and potential management bias.
Recast certain existing requirements using terminology
that encourages maintaining a skeptical mindset, such as ``evaluate''
and ``compare'' instead of ``corroborate.''
Strengthen requirements for evaluating whether data was
appropriately used by a company that build on requirements in the fair
value standard, and include a new requirement for evaluating whether a
company's change in the source of data is appropriate.
Clarify the auditor's responsibilities for evaluating data
that build on the existing requirements in AS 1105.
Amend AS 2401, Consideration of Fraud in a Financial
Statement Audit,
[[Page 13402]]
to clarify the auditor's responsibilities when performing a
retrospective review of accounting estimates and align them with the
requirements in the new standard.
Extend certain key requirements in the fair value standard
to other accounting estimates in significant accounts and disclosures
to reflect a more uniform approach to substantive testing. For
estimates not currently subject to the fair value standard, this will:
Refine the three substantive approaches common to the
accounting estimates standard to include more specificity, similar to
the fair value standard.
Describe the auditor's responsibilities for testing the
individual elements of the company's process used to develop the
estimate (i.e., methods, data, and significant assumptions).
Set forth express requirements for the auditor to evaluate
the company's methods for developing the estimate, including whether
the methods are:
In conformity with the requirements of the applicable
financial reporting framework; and
Appropriate for the nature of the related account or
disclosure, taking into account the auditor's understanding of the
company and its environment.
Require the auditor to take into account certain factors
in determining whether significant assumptions that are based on the
company's intent and ability to carry out a particular course of action
are reasonable.
Further integrate requirements with the risk assessment
standards to focus auditors on estimates with greater risk of material
misstatement. The new standard and related amendments incorporate
specific requirements relating to accounting estimates into AS 2110 and
AS 2301 to inform the necessary procedures for auditing accounting
estimates. Specifically, the new standard and related amendments would:
Amend AS 2110 to include risk factors specific to
identifying significant accounts and disclosures involving accounting
estimates.
Align the scope of the new standard with AS 2110 to apply
to accounting estimates in significant accounts and disclosures.
Amend AS 2110 to set forth requirements for obtaining an
understanding of the company's process for determining accounting
estimates.
Require auditors to respond to significantly differing
risks of material misstatement in the components of accounting
estimates, consistent with AS 2110.
Remind auditors of their responsibility to evaluate
conformity with the applicable financial reporting framework,
reasonableness, and potential management bias and its effect on the
financial statements when responding to the risks of material
misstatement in accounting estimates in significant accounts and
disclosures.
Require the auditor, when identifying significant
assumptions, to take into account the nature of the accounting
estimate, including related risk factors, the applicable financial
reporting framework, and the auditor's understanding of the company's
process for developing the estimate.
Include matters relevant to identifying and assessing
risks of material misstatement related to the fair value of financial
instruments.
Add a note in AS 2301 to emphasize that performing
substantive procedures for the relevant assertions of significant
accounts and disclosures involves testing whether the significant
accounts and disclosures are in conformity with the applicable
financial reporting framework.
Add a note to AS 2301 providing that for certain estimates
involving complex models or processes, it might be impossible to design
effective substantive tests that, by themselves, would provide
sufficient appropriate evidence regarding the assertions.
Make other updates to the requirements for auditing
accounting estimates, including:
Update the description of what constitutes an accounting
estimate to encompass the general characteristics of the variety of
accounting estimates, including fair value measurements, in financial
statements.
Set forth specific requirements for evaluating data and
pricing information used by the company or the auditor that build on
the existing requirements in AS 1105.
Establish more specific requirements for developing an
independent expectation that vary depending on the source of data,
assumptions, or methods used by the auditor and build on AS 2810 to
provide a requirement when developing an independent expectation as a
range.
Relocate requirements in the derivatives standard for
obtaining audit evidence when the valuation of investments is based on
investee results as an appendix to AS 1105.
Provide specific requirements and direction to address
auditing the fair value of financial instruments, including:
Establish requirements to determine whether pricing
information obtained from third parties, such as pricing services and
brokers or dealers, provides sufficient appropriate evidence,
including:
Focus auditors on the relevance and reliability of pricing
information from third-party sources,\25\ regardless of whether the
pricing information was obtained by the company or the auditor.
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\25\ The requirements in this area focus primarily on pricing
information from pricing services and brokers or dealers, but also
cover pricing information obtained from other third-party pricing
sources, such as exchanges and publishers of exchange prices.
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Establish factors that affect relevance and reliability of
pricing information obtained from a pricing service.
Require the auditor to perform additional audit procedures
to evaluate the process used by the pricing service when fair values
are based on transactions of similar financial instruments.
Require the auditor to perform additional procedures on
pricing information obtained from a pricing service when no recent
transactions have occurred for either the financial instrument being
valued or similar financial instruments.
Establish conditions under which less information is
needed about particular methods and inputs of individual pricing
services in circumstances where prices are obtained from multiple
pricing services.
Establish factors that affect the relevance and
reliability of quotes from brokers or dealers.
Require the auditor to understand, if applicable, how
unobservable inputs were determined and evaluate the reasonableness of
unobservable inputs.
The Board seeks to improve the quality of auditing in this area and
believes these changes strengthen and enhance the requirements for
auditing accounting estimates.
Commenters largely supported a single, more uniform standard to
address auditing accounting estimates, including fair value
measurements. For example, one commenter observed that the existence of
three related standards in this area made it difficult for auditors to
navigate to be certain that all requirements were met. A few
commenters, however, asserted that fair value measurements and
derivatives are unique and involve different functions. One of those
commenters also expressed concern about applying audit procedures in
the fair value standard to other accounting estimates. The new standard
takes into account the unique
[[Page 13403]]
aspects of auditing fair value measurements, such as the use of
observable and unobservable inputs. Further, the new standard includes
a separate appendix that addresses auditing the fair value of financial
instruments.
Some commenters requested supplemental or implementation guidance
for various requirements presented in the proposed standard and the
related amendments. Several commenters also advocated for retaining
portions of the derivatives standard that, in their view, provided
helpful guidance. Two commenters suggested that the Board consider
issuing guidance specific to the audits of brokers and dealers.\26\
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\26\ See below for further discussion of the comments received
on specific requirements and additional guidance on the
implementation of the requirements in the new standard.
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A few commenters observed that the proposal did not explicitly
address how advances in technology, including use of data analytics,
could affect audit procedures. In its consideration of the new standard
and related amendments, the Board is mindful of the significant
advances in technology that have occurred in recent years, including
increased use of data analysis tools and emerging technologies. An
increased use of these technology-based tools, together with future
developments in the use of data and technology, could have a
fundamental impact on the audit process. The Board is actively
exploring these potential impacts through ongoing staff research and
outreach.\27\
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\27\ For example, the staff is currently researching the effects
on the audit of, among other things, data analytics, artificial
intelligence, and distributed ledger technology, assisted by a task
force of the SAG. See Data and Technology Task Force overview page,
available on the Board's website.
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In the context of this rulemaking, the Board considered how changes
in technology could affect the approaches to auditing accounting
estimates. The Board believes that the new standard and related
amendments are sufficiently principles-based and flexible to
accommodate continued advances in the use of data and technology by
both companies and auditors. The Board will continue to monitor
advances in this area and any implications related to the standard.\28\
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\28\ See PCAOB, Changes in Use of Data and Technology in the
Conduct of Audits, available at https://pcaobus.org/Standards/research-standard-setting-projects/Pages/technology.aspx.
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Some commenters advocated for greater alignment of the proposal
with the IAASB's exposure draft on International Standard on Auditing
540 (``ISA 540'') \29\ to achieve greater consistency in practice, and
suggested continued coordination of efforts in this area. The Board
considered the IAASB's ISA 540 project while developing the new
standard. While there is some commonality between the new standard and
ISA 540 Revised, the new standard is aligned with the Board's risk
assessment standards and designed for audits of issuers and SEC-
registered brokers and dealers.
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\29\ See IAASB Exposure Draft, Proposed ISA 540 (Revised),
Auditing Accounting Estimates and Related Disclosures, (Apr. 20,
2017). In October 2018, the IAASB released the final standard (``ISA
540 Revised'').
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Following is a discussion of significant comments received on the
proposal along with revisions made by the Board after consideration of
those comments and additional guidance on the implementation of the
requirements of the new standard. The subsections also include a
comparison of the final requirements with the analogous requirements of
the following standards issued by the IAASB and the Auditing Standards
Board (``ASB'') of the American Institute of Certified Public
Accountants:
ISA 540 Revised, adopted by the IAASB; and
AU-C Section 540, Auditing Accounting Estimates, Including
Fair Value Accounting Estimates, and Related Disclosures (``AU-C
Section 540''), adopted by the ASB of the American Institute of
Certified Public Accountants.
The comparison does not necessarily represent the views of the
IAASB or ASB regarding the interpretation of their standards.
Additionally, the information presented in the subsections does not
include the application and explanatory material in the IAASB standards
or ASB standards.\30\
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\30\ Paragraph A59 of ISA 200, Overall Objectives of the
Independent Auditor and the Conduct of an Audit in Accordance with
International Standards on Auditing, and paragraph .A64 of AU-C
Section 200, Overall Objectives of the Independent Auditor and the
Conduct of an Audit in Accordance with Generally Accepted Auditing
Standards, indicate that the related application and other
explanatory material ``does not in itself impose a requirement'' but
``is relevant to the proper application of the requirements'' of the
respective standards.
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AS 2501 (Revised)
Scope of the Standard
See Paragraphs .01-.02
As in the proposal, the new standard applies when auditing
accounting estimates in significant accounts and disclosures.
Commenters on this topic supported the scope set forth in the standard.
Comparison With Standards of Other Standard Setters
The scope and nature of accounting estimates described in ISA 540
Revised, AU-C Section 540, and the new standard share some common
concepts. However, the accounting estimates covered by the new standard
are expressly linked to significant accounts and disclosures.
Objective of the Standard
See Paragraph .03
In the proposal, the standard included a detailed objective
expressly addressing the fundamental aspects of auditing accounting
estimates under the estimates standards: Testing and evaluating whether
accounting estimates (1) are reasonable in the circumstances, (2) have
been accounted for and disclosed in conformity with the applicable
financial reporting framework, and (3) are free from bias that results
in material misstatement.
Commenters asserted that including the phrase ``free from bias that
results in material misstatement'' as a distinct element of the audit
objective was not clear, could imply absolute assurance, or could be
interpreted as a broader obligation than what is required under the
existing standards. Some commenters recommended deleting the reference
to bias from the objective, and others suggested revisions in order to
clarify the intent of including the reference to bias in the objective.
One commenter suggested that the objective should be for auditors to
determine whether accounting estimates and disclosures are reasonable
in the context of the applicable financial reporting framework, which
in the commenter's view would be broader than the proposed objective.
After consideration of comments, the Board has (1) revised the
objective to describe the overall purpose of the procedures required
under the new standard and other relevant procedures under the risk
assessment standards (specifically, to determine whether accounting
estimates in significant accounts and disclosures are properly
accounted for and disclosed in financial statements); \31\ (2)
relocated the description of more specific auditor responsibilities--
evaluating conformity with the applicable financial reporting
framework, reasonableness, and potential management bias--from the
[[Page 13404]]
objective to the requirements; \32\ and (3) provided additional context
in the requirements to enhance clarity, including citing corresponding
requirements in other PCAOB standards. In addition, for conciseness,
the new standard and amendments have been revised to consistently use
the phrase ``sufficient appropriate evidence,'' which has the same
meaning in PCAOB standards as the phrase ``sufficient appropriate audit
evidence.''
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\31\ This approach to formulating an objective is similar to the
approach in other PCAOB standards. See, e.g., paragraph .02 of AS
2410, Related Parties.
\32\ See first note to paragraph .05 of the new standard.
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As discussed in more detail below, the revised objective links more
closely with the requirements of the risk assessment standards \33\ and
continues to focus auditors on their existing obligations to evaluate
potential management bias in the context of auditing accounting
estimates.
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\33\ See supra note 3. The risk assessment standards set forth
requirements relating to the auditor's assessment of, and response
to, the risks of material misstatement in the financial statements.
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Comparison With Standards of Other Standard Setters
The objective of ISA 540 Revised is to obtain sufficient
appropriate audit evidence about whether accounting estimates and
related disclosures in the financial statements are reasonable in the
context of the applicable financial reporting framework. The objective
of AU-C Section 540 is substantially the same but also includes whether
related disclosures in the financial statements are adequate.
Identifying and Assessing Risks of Material Misstatement
See Paragraph .04
The proposed standard discussed how the auditor's responsibilities
regarding the process of identifying and assessing risks of material
misstatement, as set forth in AS 2110 apply to auditing accounting
estimates. The proposed requirement provided that, among other things,
identifying and assessing risks of material misstatement related to
accounting estimates includes determining whether the components of
estimates in significant accounts and disclosures are subject to
significantly differing risks, and which estimates are associated with
significant risks.\34\
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\34\ See AS 2110.70-.71.
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One commenter asserted that the term ``components'' should be
defined and another commenter observed that ``components of estimates''
could be interpreted to mean inputs used to develop the estimate, or
individual accounts that roll up into a financial statement line item.
AS 2501 (Revised) retains paragraph .04 as proposed, including the
reference to components of estimates. This reference is not new and
derives from the concept in the risk assessment standards that
components of a potential significant account or disclosure might be
subject to significantly differing risks \35\ which would need to be
taken into account in designing and performing audit procedures. For
example, a valuation allowance in the company's financial statements
may include a general component and a specific component with differing
risks.
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\35\ See AS 2110.63.
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Comparison With Standards of Other Standard Setters
In identifying and assessing the risks of material misstatement,
ISA 540 Revised requires the auditor to separately assess inherent risk
and control risk. The auditor is required to take into account, in
assessing inherent risk (a) the degree to which the accounting estimate
is subject to estimation uncertainty, and (b) the degree to which (i)
the selection and application of the method, assumptions and data in
making the accounting estimate; or (ii) the selection of management's
point estimate and related disclosures for inclusion in the financial
statements, are affected by complexity, subjectivity, or other inherent
risk factors.\36\
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\36\ ISA 540 Revised and AU-C Section 540 also include
requirements related to identification of significant risks related
to accounting estimates. AS 2110 sets forth requirements for
identifying significant risks under PCAOB standards.
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AU-C Section 540 requires the auditor to evaluate the degree of
estimation uncertainty associated with an accounting estimate in
identifying and assessing the risks of material misstatement.
Responding to the Risks of Material Misstatement
See Paragraphs .05-.07
The proposed standard explained how the basic requirement in AS
2301 to respond to the risks of material misstatement applies when
performing substantive procedures for accounting estimates in
significant accounts and disclosures. Additionally, the proposal
provided that responding to risks of material misstatement in the
context of accounting estimates involves, among other things, (1)
testing whether estimates in significant accounts and disclosures are
in conformity with the applicable financial reporting framework, (2)
responding to significantly differing risks of material misstatement in
the components of an accounting estimate, and (3) applying professional
skepticism in gathering and evaluating audit evidence, particularly
when responding to fraud risks. The proposed standard also reminded
auditors that, as the assessed risk of material misstatement increases,
the evidence that the auditor should obtain also increases. The
evidence provided by substantive procedures depends on the mix of the
nature, timing, and extent of those procedures.
Commenters provided views on various aspects of the proposed
requirements. One commenter asked for clarification on the role of
professional skepticism in relation to fraud risks and management bias.
Another commenter advocated for a framework against which auditor
skepticism can be evaluated. Other commenters suggested including
requirements to evaluate both corroborative and contradictory audit
evidence similar to AS 1105.02. A few commenters also requested
clarification of how substantive procedures related to accounting
estimates can be performed at an interim date.
The new standard retains the discussion of the auditor's
responsibilities for responding to risks associated with estimates
substantially as proposed. The statements in the new standard related
to responding to the risks of material misstatement are rooted in the
Board's risk assessment standards and drew no critical comments.
The new standard reflects two changes from the proposal. As noted
above, the description of more specific auditor responsibilities--
evaluating conformity with the applicable accounting framework,
reasonableness, and potential management bias--has been relocated from
the objective to paragraph .05 to provide additional context for
responding to risks of material misstatement. Specifically, the new
standard states that responding to risks of material misstatement
involves evaluating whether the accounting estimates are in conformity
with the applicable financial reporting framework and reasonable in the
circumstances, as well as evaluating potential management bias in
accounting estimates and its effect on the financial statements.
Notably, the added language regarding potential management bias is
aligned with paragraphs AS 2810.24-.27 to remind auditors of existing
requirements.
Additionally, the new standard now includes a reference to AS
1105.02, as suggested by some commenters, reminding auditors that audit
evidence consists of both information that
[[Page 13405]]
supports and corroborates management's assertions regarding the
financial statements and information that contradicts such assertions.
With respect to the comments regarding guidance on professional
skepticism and performing procedures at interim dates, other PCAOB
standards already address the auditor's responsibilities in those
areas, and the new standard does not change that direction with respect
to auditing estimates. For example, paragraphs .07-.09 of AS 1015, Due
Professional Care in the Performance of Work, paragraph .13 of AS 2401,
and AS 2301.07 address the appropriate application of professional
skepticism, and AS 2301.43-.46 discusses the auditor's responsibilities
when performing substantive procedures at an interim date. Those
standards apply when auditing accounting estimates.
Scalability of the Standard
In response to questions in the proposal, commenters expressed
mixed views on the scalability of the proposed requirements. Some
commenters indicated that the proposed requirements were sufficiently
scalable, while others identified challenges in scaling the auditor's
response to identified risks in accounting estimates and requested
additional guidance. For example, some commenters opined that it was
not clear how auditors would tailor their response to an estimate that
represented a significant risk of material misstatement compared with a
lower risk estimate. One commenter advocated for further guidance to
address situations where an estimate is deemed to have a low inherent
risk. Another commenter indicated that it is important to recognize
that the amount of evidence may not necessarily increase, but the
persuasiveness and sufficiency of the evidence should increase.
The new standard is designed to be scalable because the necessary
audit evidence depends on the corresponding risk of material
misstatement. The standard does not prescribe detailed procedures or
the extent of procedures, beyond the requirement to respond to the
risk, including significant risk, and the direction for applying the
primary approaches for testing. Rather, it builds on the requirements
of AS 2301 to design procedures that take into account the types of
potential misstatements that could result from the identified risks and
the likelihood and magnitude of potential misstatement.\37\ Specific
risk factors associated with the estimates--for example, subjective
assumptions, measurement uncertainty, or complex processes or methods
\38\--would affect the auditor's risk assessment and in turn, the
required audit effort. For example:
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\37\ AS 2301.09.
\38\ See AS 2110.60A, as amended, for examples of specific risk
factors.
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Testing a simple calculation of depreciation expense,
including evaluating remaining useful lives, for a group of assets of
the same type with similar usage and condition would generally require
less audit effort than testing asset retirement obligations that
involve significant assumptions about costs not yet incurred based on
estimation of the probability of future events.
In testing the valuation of assets acquired and
liabilities assumed in a business combination, more audit effort would
need to be directed to assets and liabilities whose valuation involves
more subjective assumptions, such as identifiable intangible assets and
contingent consideration, than to assets with readily determinable
values.
Additionally, the new standard echoes language from AS 2301.37 in
stating that, as the assessed risk of material misstatement increases,
the evidence from substantive procedures that the auditor should obtain
also increases. Consistent with AS 2301, for an individual accounting
estimate, different combinations of the nature, timing, and extent of
testing might provide sufficient appropriate evidence to respond to the
assessed risk of material misstatement for the relevant assertion.
Selection of Approaches
The proposed standard retained the requirement to test accounting
estimates using one or a combination of three basic approaches from the
estimates standards: (1) Testing the company's process, (2) developing
an independent expectation, and (3) evaluating audit evidence from
events or transactions occurring after the measurement date. The
proposed standard also included a note reminding auditors that their
understanding of the process the company used to develop the estimate,
along with results of tests of relevant controls, should inform the
auditor's decisions about the approach he or she takes to auditing an
estimate.
Several commenters expressed support for retaining the three common
approaches, as set forth in the proposal. Other commenters indicated
that the proposal should emphasize that testing the company's process
may not always be the best audit approach; with one commenter noting
that the proposed requirement may lead auditors to test management's
process substantively, regardless of whether another approach will
provide the same or more persuasive audit evidence. Two commenters
stressed the importance of developing an independent expectation and
suggested this approach be selected in addition to testing the
company's process. None of these commenters, however, suggested that
the selection of substantive approaches should be limited.
Some commenters sought further direction on how the auditor would
obtain sufficient evidence when using a combination of approaches, with
some commenters asserting that, for example, the proposed requirement
might result in inconsistent application or auditors unnecessarily
performing all procedures under each approach. One commenter asked the
Board to clarify whether documentation of a specific testing approach
is expected.
Some commenters also requested guidance on the application of
specific testing approaches. For instance, one commenter suggested that
the Board consider directing auditors to always evaluate audit evidence
from events or transactions occurring after the measurement date
related to the accounting estimate, as, in their view, there would be
limited circumstances in which this approach would not provide
appropriate audit evidence to determine whether accounting estimates
are reasonable. Another commenter added that events occurring after the
measurement date may effectively eliminate estimation uncertainty,
which affects risk assessment and the audit response related to
valuation. This commenter suggested the proposal clarify the extent of
additional procedures required, if any, when such events are considered
and tested.
One commenter suggested more guidance be provided about how an
auditor's understanding of management's process affects the auditor's
planned response to assessed risk in accordance with AS 2301. This
commenter also observed that the note to paragraph .07 may be read to
mean that relevant controls are expected to be tested in all audits and
suggested a footnote reference to relevant requirements of AS 2301.
The new standard retains the requirements for testing accounting
estimates substantially as proposed, allowing the auditor to determine
the approach or combination of approaches appropriate for obtaining
sufficient appropriate evidence to support a conclusion about the
particular accounting estimate being audited. The
[[Page 13406]]
new standard takes into account that accounting estimates vary in
nature and in how they are developed. Therefore, mandating a particular
testing approach may not be feasible or practical in the circumstances.
For example, in some cases, data and significant assumptions underlying
the estimate may be largely based on a company's internal information
(e.g., sales projections or employee data), or the estimate may be
generated using a customized company-specific model. In those
situations, the auditor may not have a reasonable alternative to
testing the company's process. Similarly, there may not be any events
or transactions occurring after the measurement date related to certain
estimates (e.g., the outcome of a contingent liability might not be
known for a number of years). Rather than imposing limits on the
selection of approaches, the new standard describes the auditor's
responsibilities for appropriately applying the selected approach, or
combination of approaches, to obtain sufficient appropriate evidence
and performing an appropriate evaluation of the evidence obtained.
As under the estimates standards, the new standard allows for the
auditor to use a combination of approaches to test an estimate. For
example, some estimates consist of multiple components (e.g., valuation
allowances) and the auditor may vary the approaches used for the
individual components. The auditor may also choose to develop an
independent expectation of a significant assumption used by the company
in conjunction with testing the company's process for developing the
estimate. Whether using a combination of approaches or a single
approach, the auditor is required to have a reasonable basis for using
alternative methods or deriving his or her own assumptions, as
discussed in more detail below. Similarly, when using information
produced by the company as audit evidence, the auditor is required to
evaluate whether that information is sufficient and appropriate for the
purposes of the audit, regardless of the approach the auditor uses to
test the estimate.\39\
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\39\ See AS 1105.10.
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The new standard also carries forward the point from the accounting
estimate standard that the auditor's understanding of the company's
process for developing the estimate, and, if relevant controls are
tested, the results of those tests, informs the auditor's decision
about which approach or approaches to take. AS 2301 describes the
auditor's responsibilities for testing controls in a financial
statement audit. The new standard does not change those
responsibilities, including the circumstances under which the auditor
is required to test controls. Rather, the standard emphasizes that the
results of the auditor's tests of controls can affect the nature,
timing and extent of planned substantive procedures. Further, the
auditor's understanding of the company's process related to an estimate
can provide insight into the nature and extent of available audit
evidence, and thus inform the auditor's selection of approaches.
Lastly, the new standard does not set forth requirements for audit
documentation. The auditor's responsibilities with respect to audit
documentation are addressed in AS 1215, Audit Documentation.
Accordingly, audit documentation relevant to selection of approaches
should be evident to an experienced auditor, having no previous
connection with the engagement.\40\
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\40\ See AS 1215.06.
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Comparison With Standards of Other Standard Setters
ISA 540 Revised requires the auditor's procedures to be responsive
to the assessed risks of material misstatement at the assertion level,
considering the reasons for the assessment given to those risks, and
include one or more of the three approaches to substantive testing
(similar to the new standard).\41\
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\41\ ISA 540 Revised also includes requirements for tests of
controls. AS 2301 sets forth requirements for tests of controls in
financial statement audits under PCAOB standards.
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ISA 540 Revised also includes a requirement for the auditor to take
into account that the higher the assessed risk of material
misstatement, the more persuasive the audit evidence needs to be. The
auditor is required to design and perform further audit procedures in a
manner that is not biased towards obtaining audit evidence that may be
corroborative or towards excluding audit evidence that may be
contradictory.
AU-C Section 540 requires the auditor to determine whether
management has appropriately applied the requirements of the applicable
financial reporting framework relevant to the accounting estimate. In
responding to the assessed risks of material misstatement, AU-C Section
540 also requires the auditor to undertake one or more of the three
approaches discussed above, as well as providing an approach to perform
a combination of tests of controls over the estimate along with
substantive procedures.
Testing the Company's Process Used To Develop the Accounting Estimate
See Paragraph .09
The proposed standard included an introductory statement explaining
the purpose of and steps involved in testing the company's process.
Specifically, the standard explained that testing the company's process
involves performing procedures to test and evaluate the methods, data,
and significant assumptions used to develop the company's estimate in
order to form a conclusion about whether the estimate is reasonable in
the circumstances, in conformity with the applicable financial
reporting framework, and free from bias that results in material
misstatement.
Similar to the comments received on the proposed objective, some
commenters expressed concerns about the phrase ``free from bias that
results in material misstatement'' when describing the auditor's
responsibilities in this area. One commenter also asked whether these
requirements would apply to assumptions, models, and data provided by a
company specialist. Another commenter sought clarification on the
meaning of the terms ``test,'' ``data,'' and ``assumptions.''
As with the objective of the standard, paragraph .09 of the new
standard was revised to describe an overarching concept for testing the
company's process--that is, to form a conclusion about whether the
estimate is properly accounted for and disclosed in financial
statements. These revisions are responsive to comments and link the
auditor's responsibilities more closely to the requirements of the
Board's risk assessment standards.
As discussed in more detail below, the new standard directs the
auditor to look to the requirements in Appendix A of AS 1105 \42\ for
the auditor's responsibilities with respect to using the work of a
company's specialist in the audit. This direction has been modified
from the proposal to align with changes to the Specialists Release.
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\42\ The auditor's responsibilities with respect to using the
work of a company specialist are presented as Appendix A of AS 1105.
See supra note 2.
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Finally, the meaning of the terms ``test,'' ``data,'' and
``assumptions'' in the new standard is consistent with the meaning of
these terms used in the estimates standards and other PCAOB standards.
Comparison With Standards of Other Standard Setters
ISA 540 Revised provides that, as part of testing how management
made the accounting estimate, the auditor is
[[Page 13407]]
required to perform procedures to obtain sufficient appropriate audit
evidence regarding the risks of material misstatement relating to (a)
selection and application of the methods, significant assumptions and
the data used by management in making the accounting estimate, and (b)
how management selected the point estimate and developed related
disclosures about estimation uncertainty.\43\
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\43\ The Board's risk assessment standards address the auditor's
responsibilities for responding to risks of material misstatement
and obtaining sufficient appropriate evidence.
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AU-C Section 540 provides that as part of testing how management
made the accounting estimate and the data on which it is based, the
auditor should evaluate whether the method of measurement used is
appropriate in the circumstances, the assumptions used by management
are reasonable in light of the measurement objectives of the applicable
financial reporting framework, and the data on which the estimate is
based is sufficiently reliable for the auditor's purposes.
Evaluating the Company's Methods
See Paragraphs .10-.11
The proposed standard provided that the auditor should evaluate
whether the methods used by the company are (1) in conformity with the
applicable financial reporting framework, including evaluating whether
the data and significant assumptions are appropriately applied; and (2)
appropriate for the nature of the related account or disclosure and the
company's business, industry, and environment. The proposed
requirements were similar to certain requirements of the fair value
standard.\44\
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\44\ See AS 2502.15 and .18.
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A number of commenters expressed concerns about the requirement to
evaluate whether the company's methods are appropriate for the
company's ``business, industry, and environment'' because in their
view, the requirement seemed to suggest all companies within a
particular industry use, or should use, the same method. Two commenters
also suggested adding specific requirements--to evaluate models used by
the company and test the mathematical accuracy of the calculations used
by the company to translate its assumptions into the accounting
estimate. One commenter sought clarification on the intent of the
requirement to evaluate whether the data and significant assumptions
are appropriately applied under the applicable financial reporting
framework.
The new standard retains substantially as proposed the requirement
to evaluate whether the methods used by the company are in conformity
with the applicable financial reporting framework, including evaluating
whether the data is appropriately used and significant assumptions are
appropriately applied under the framework. The applicable financial
reporting framework may prescribe a specific method to develop an
estimate or allow for alternative methods, or provide guidance on how
to apply the method, including guidance on the selection or use of
assumptions or data. Evaluating whether the company's method is in
conformity with the financial reporting framework involves evaluating
whether the data is appropriately used and significant assumptions are
appropriately applied by the method, which, if applicable, would
include testing the mathematical accuracy of the calculations under the
method.
The methods used by the company may involve the use of a model
(e.g., expected future cash flows). The new standard does not prescribe
specific procedures for testing models, as suggested by one
commenter.\45\ The Board believes that requirements specific to models
are not necessary because evaluating the method, as discussed above,
includes consideration of models to the extent necessary to reach a
conclusion on the appropriateness of the method. Under the new
standard, the necessary audit procedures to evaluate the method used by
the company (which, as appropriate, include models involved in the
method) are commensurate with the assessed risks associated with the
estimate. For example, the risks associated with a method that uses a
commercially available valuation model may relate to whether the model
is appropriate for the related estimate under the applicable financial
reporting framework, whereas the risks associated with a method that
uses an internally-developed company model may include additional risks
associated with how the model was developed. In this example, the
internally-developed model scenario would require greater audit effort
to respond to the broader range of risks, as compared to the
commercially available model scenario. In either case, the auditor
would evaluate whether the method was used appropriately, including
whether adjustments, if any, to the output of the model were
appropriate.
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\45\ This commenter advocated for the approach taken by the
IAASB regarding models. ISA 540 Revised requires that, when
management's application of the method involves complex modeling,
the auditor's procedures address whether judgments have been applied
consistently and, when applicable, whether (1) the design of the
model meets the measurement objective of framework, is appropriate
in the circumstances, and changes from the prior period's model are
appropriate in the circumstances; and (2) adjustments to the output
of the model are consistent with the measurement objective and are
appropriate in circumstances.
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After consideration of comments, the requirement regarding
evaluating the appropriateness of the method was revised to remove the
reference to the company's business and industry. Under the new
standard, the auditor is required to evaluate whether the company's
method is appropriate for the nature of the related account or
disclosure, taking into account the auditor's understanding of the
company and its environment. This revised requirement is consistent
with the risk assessment standards because the auditor's evaluation of
the method (a substantive procedure) is informed by the auditor's
understanding of the company and its environment (obtained through the
auditor's risk assessment procedures).\46\ Notably, part of the
auditor's procedures for obtaining an understanding of the company and
its environment include obtaining an understanding of relevant
industry, regulatory, and other external factors, and evaluating the
company's selection and application of accounting principles.\47\
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\46\ Additionally, AS 2301.05d requires the auditor to evaluate
whether the company's selection and application of significant
accounting principles, particularly those related to subjective
measurements and complex transactions, are indicative of bias that
could lead to material misstatement of the financial statements.
\47\ AS 2110.09 and .12-.13.
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The proposed standard also addressed circumstances in which a
company has changed its method for developing an accounting estimate by
requiring the auditor to determine the reasons for and evaluate the
appropriateness of such change.
One commenter asserted that it would be more appropriate to require
the auditor to evaluate whether the company's reasons for making the
change are appropriate. This commenter also sought clarification on
what constitutes a change in method and on the auditor's responsibility
when the company has not made a determination about whether different
methods result in significantly different estimates. Another commenter
expressed concern that, because of a lack of clarity about the
definition of ``method'' and what
[[Page 13408]]
constitutes a change, the proposed requirement could result in
potentially onerous documentation necessary to support changes to
methods. Finally, one commenter suggested adding a requirement for the
auditor to evaluate whether the company failed to revise its method to
recognize changes in facts and circumstances.
The new standard retains as proposed the requirements for the
auditor to (1) determine the reasons for changes to the method used by
the company and evaluate the appropriateness of such change, and (2)
evaluate the appropriateness of methods selected by the company in
circumstances where the company has determined that different methods
could result in significantly different estimates. The requirements in
the new standard are similar to those in the fair value standard \48\
and consistent with the auditor's responsibilities to obtain an
understanding of the company's process used to develop the estimate,
including the methods used.\49\ These requirements also take into
account that, in some cases, more than one method may be used to
develop a particular estimate. It is important for the auditor to
understand the basis for the company's change to its method, as changes
that are not based on new information or other changes in the company's
circumstances could be indicative of management bias (e.g., changing
the method to achieve a favorable financial result).\50\
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\48\ AS 2502.19.
\49\ See AS 2110.28, as amended.
\50\ See AS 2810 for requirements related to evaluating bias in
accounting estimates.
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With respect to other comments raised above, a separate requirement
to evaluate whether the company failed to revise its method to
recognize changes in facts and circumstances is unnecessary as auditors
would make this determination when evaluating appropriateness of the
method for the nature of the account or disclosure, taking into account
the auditor's understanding of the company and its environment. That
understanding should inform the auditor about conditions which might
indicate that a change in method is needed. For example, the use of a
discounted cash flow method to value a financial instrument may no
longer be appropriate once an active market is introduced for the
instrument. Moreover, changes to the method could result in a change to
the corresponding estimate and affect the consistency of the financial
statements (as discussed in AS 2820, Evaluating Consistency of
Financial Statements).\51\ In addition, contrary to the views of one
commenter, the new standard does not impose any new documentation
requirements to the existing provisions of AS 1215.
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\51\ See also FASB Accounting Standards Codification Topic 250,
Accounting Changes and Error Corrections.
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Comparison With Standards of Other Standard Setters
ISA 540 Revised provides that the auditor's procedures shall
address (a) whether the method selected is appropriate in the context
of the applicable financial reporting framework, and, if applicable,
whether changes from the method used in prior periods are appropriate;
(b) whether judgments made in selecting the method give rise to
indicators of possible management bias; (c) whether the calculations
are applied in accordance with the method and are mathematically
accurate; and (d) whether the integrity of the significant assumptions
and the data has been maintained in applying the method.\52\
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\52\ See supra note 45 for additional requirements related to
models.
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AU-C Section 540 requires the auditor to determine whether the
methods for making the accounting estimate are appropriate and have
been applied consistently, and whether changes, if any, in accounting
estimates or in the method for making them from the prior period are
appropriate in the circumstances. Further, AU-C Section 540 provides
that as part of testing how management made the accounting estimate,
and the data on which it is based, the auditor evaluates whether the
method of measurement used is appropriate in the circumstance.
Testing Data Used
See Paragraphs .12-.14
The proposed standard discussed the auditor's responsibilities for
testing and evaluating both internal and external data. This included
(1) reiterating existing requirements in AS 1105 to test the accuracy
and completeness of information produced by the company, or to test the
controls over the accuracy and completeness of that information; \53\
and (2) requiring the auditor to evaluate the relevance and reliability
\54\ of data from external sources.
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\53\ AS 1105.10.
\54\ AS 1105.07-.08.
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The proposed standard also provided that the auditor should
evaluate whether the data is used appropriately by the company,
including whether (1) the data is relevant to the measurement objective
for the accounting estimate; (2) the data is internally consistent with
its use by the company in other estimates tested; and (3) the source of
the company's data has changed from the prior year and, if so, whether
the change is appropriate.
A few commenters called for clarification of various aspects of the
proposed requirements pertaining to data. For example, one commenter
suggested the requirements clarify that company data supplied to a
third party or company specialist is not considered to be data from an
external source. This commenter also asked for a framework for
evaluating whether the source of the company's data has changed from
the prior year and, if so, whether the change is appropriate. Another
commenter sought more clarity on whether the requirement applies to all
data or may be limited to significant data.
Some commenters also suggested additional requirements in this
area. For example, one commenter asserted that the existing
requirements related to completeness and accuracy of data in AS 1105 do
not themselves constitute a procedure that addresses risks of material
misstatement and instead, suggested an express requirement to evaluate
whether the data used in the estimate is accurate and complete. Another
commenter pointed to the existence of data analytics tools as an
alternative to sampling, and advocated for some acknowledgement in the
requirements of the importance of the integrity of these tools and the
controls over their development. One commenter suggested a requirement
to assess whether management has appropriately understood or
interpreted significant data.
The new standard retains the requirements for testing and
evaluating data substantially as proposed, including requirements to
evaluate whether the data is relevant to the measurement objective,
internally consistent, and whether the source of the company's data has
changed from the prior year and if so, whether the change is
appropriate. The new standard builds on the auditor's responsibilities
established by AS 1105, including requirements to test the accuracy and
completeness of information produced by the company. Contrary to the
views of one commenter, AS 1105 currently includes an obligation for
the auditor to test company-produced data. Accordingly, an additional
requirement to evaluate whether the data used in the estimate is
accurate and complete is not necessary. Furthermore, the determination
of the data to be tested--and the nature, timing, and extent of that
testing--
[[Page 13409]]
should be based on and responsive to the assessed risks of material
misstatement.
Consistent with the proposed standard, AS 2501 (Revised) makes a
distinction between procedures to be performed regarding internal data
and procedures regarding data from external sources used by the company
to develop accounting estimates. Examples of internal data include the
company's historical warranty claims and historical losses on defaulted
loans. Examples of external data include economic, market, or industry
data. Company data supplied by the company to a third party or company
specialist is not data from an external source. The new standard also
points auditors to Appendix B of AS 1105 for situations in which the
valuation of an investment is based on the investee's financial
results.
The new standard also retains substantially as proposed
requirements to evaluate whether the data was used appropriately by the
company. Evaluating the manner in which data was used by the company
necessarily builds on the auditor's understanding of the company's
process used to develop the estimate. This includes evaluating whether
the company's selection and use of data is in conformity with the
requirements of the financial reporting framework. Further, devoting
audit attention to changes in the data source might reveal potential
contradictory evidence and help the auditor identify potential
management bias. For example, while a new source of data might result
in an estimate that better reflects a company's specific circumstances,
a change in data source could also be used by a company to achieve a
desired financial result. The new standard has been modified to clarify
that evaluating whether the data is used appropriately includes
evaluating whether the data is internally consistent with its use by
the company in other significant accounts and disclosures based on
similar example procedures in the fair value standard.\55\
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\55\ See AS 2502.39.
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As noted by one commenter, significant advances in technology have
occurred in recent years, including increased use of data analysis
tools. The Board considered how changes in technology could affect the
approaches to auditing accounting estimates and believes that the new
standard and related amendments are sufficiently principles-based and
flexible to accommodate continued advances in the use of data and
technology by both companies and auditors.
Comparison With Standards of Other Standard Setters
ISA 540 Revised provides that the auditor's procedures shall
address (a) whether the data is appropriate in the context of the
applicable financial reporting framework, and, if applicable, changes
from prior periods are appropriate; (b) whether judgments made in
selecting the data give rise to indicators of possible management bias;
(c) whether the data is relevant and reliable in the circumstances; and
(d) whether the data has been appropriately understood or interpreted
by management, including with respect to contractual terms.
AU-C Section 540 provides that in testing how management made the
accounting estimate, and the data on which it is based, the auditor
should evaluate whether the data on which the estimate is based is
sufficiently reliable for the auditor's purposes.
Identification of Significant Assumptions
See Paragraph .15
The proposed standard provided that the auditor should identify
which of the assumptions used by the company are significant
assumptions to the estimate and provided criteria to assist the auditor
in making this determination. Furthermore, the proposed standard
provided that, if the company has identified significant assumptions
used in an estimate, the auditor's identification of significant
assumptions should also include those assumptions.
Some commenters expressed concern about one of the factors to be
considered in identifying significant assumptions--whether an
assumption relates to an identified and assessed risk of material
misstatement. The commenters opined that the factor was too broad and
could result in an excessive number of assumptions being identified as
significant. Some of those commenters suggested adding a note to
describe how all of the factors set forth in the proposal work
together. A few commenters made other suggestions with respect to this
requirement including (1) incorporating the requirement to identify
assumptions used by the company which are important to the recognition
or measurement of the accounting estimate in the financial statements
into AS 2110.28e, as amended; (2) adding a qualifying phrase, such as
``as applicable,'' to the factors because some factors may not always
be relevant or may vary in significance; and (3) incorporating the
concept described in AS 2502.33 that significant assumptions cover
matters that materially affect the estimate.
Some commenters also voiced concerns that the proposed requirement
to include as significant those assumptions that the company has
identified as significant may not be appropriate because (1) management
is not required to designate assumptions as significant, and (2)
auditors and company management may reach different conclusions about
which assumptions are significant. One commenter expressed the view
that the omission of a requirement to identify assumptions beyond what
management identified may be inconsistent with the requirements of AS
2110, and suggested the Board clarify the auditor's responsibilities
when, for example, management has not considered a specific assumption
needed to correctly apply the applicable accounting framework. Another
commenter suggested that assumptions identified by the company as
significant should be reflected as an additional factor relevant to
identifying significant assumptions rather than a requirement.
After consideration of comments received, the requirement was
revised. Specifically, the factor regarding whether an assumption
relates to an identified and assessed risk of material misstatement was
removed. Instead, the new standard requires the auditor to take into
account the nature of the accounting estimate, including related risk
factors,\56\ the requirements of the applicable financial reporting
framework, and the auditor's understanding of the company's process for
developing the estimate when identifying significant assumptions.
Further, the remaining factors from the proposal--sensitivity to
variation, susceptibility to manipulation and bias, unobservable data
or adjustments, and dependence on the company's intent and ability to
carry out specific courses of action--have been reframed in the new
standard as examples of assumptions that would ordinarily be
significant. The examples provided are not intended to be an exhaustive
list of significant assumptions or a substitute for taking into account
the auditor's understanding of the nature of the estimate, including
risk factors, the requirements of the applicable financial reporting
framework, and his or her understanding of the company's process for
developing the estimate. Rather, the examples are provided to
illustrate how the concepts in the new standard can be applied to
identify significant assumptions that are important to the
[[Page 13410]]
recognition or measurement of an accounting estimate. The revised
formulation provides better context for the application of the
requirement, as suggested by some commenters, and prompts auditors to
consider those assumptions that drive or are associated with identified
risks of material misstatement.
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\56\ See AS 2110.60-.60A, as amended.
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The auditor is not expected to document a detailed comparison of
each assumption used in the estimate to each factor or example
described above. Instead, consistent with AS 1215, the auditor should
document the significant assumptions identified and the auditor's
rationale for that determination.
In addition, the proposed note--requiring auditors to include as
significant those assumptions that the company has identified as
significant assumptions--was not included in the new standard. As
discussed above, the new standard requires the auditor, in identifying
significant assumptions, to take into account the auditor's
understanding of the company's process for developing the estimate,
which would include understanding the assumptions used by the company
in that estimate (whether expressly identified or implicit in the
nature of the estimate or method used). This approach addresses
commenter concerns about whether the Board was imposing a
responsibility on management to identify significant assumptions.
The intent of the proposed requirement to include significant
assumptions identified by the company was to provide the auditor with a
starting point for the auditor's evaluation (consistent with the fair
value standard). However, since the revised requirement already focuses
the auditor on understanding the assumptions used by the company to
develop the estimate and the associated risk factors, the new standard
does not include a new factor for assumptions identified as significant
by management, as suggested by a commenter.
Lastly, the requirement to identify significant assumptions was not
relocated to AS 2110.28, as suggested by one commenter, because
identifying significant assumptions is an inherent part of testing the
company's process for developing estimates.
Evaluation of Significant Assumptions
See Paragraphs .16-.18
The proposed standard set forth requirements to evaluate the
reasonableness of significant assumptions used by the company, both
individually and in combination, including evaluating whether (1) the
company has a reasonable basis for those assumptions and, when
applicable, the company's selection of assumptions from a range of
potential assumptions; and (2) significant assumptions are consistent
with, among other things, the company's objectives, historical data,
the economic environment, and market information. In circumstances when
the auditor develops an expectation of an assumption to evaluate its
reasonableness, the proposed standard also provided that the auditor
should have a reasonable basis for that expectation.
Some commenters asked for clarification of certain aspects of the
requirement. For example, a few commenters asked for clarification on
the requirement to assess whether management has a reasonable basis for
its assumptions. Another commenter asked for an explanation of what
``reasonable'' is intended to mean in the context of accounting
estimates. One commenter sought clarification on how to evaluate
differences between management's assumption and the auditor's
expectation in circumstances where the auditor develops an expectation
of an assumption to evaluate its reasonableness. Another commenter
requested that the requirement address factors relevant to evaluating
reasonableness of forward-looking information in anticipation of the
new accounting standard on credit losses.\57\
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\57\ See FASB Accounting Standards Update No. 2016-13, Financial
Instruments--Credit Losses (Topic 326): Measurement of Credit Losses
on Financial Instruments (June 2016).
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With respect to evaluating consistency with baseline information
described in the standard, one commenter asked for clarification of how
the requirement to evaluate factors in paragraph .16 works with the
requirement to ``test'' in paragraph .09. This commenter also asked for
clarification of the extent of the procedures to be performed when
evaluating the consistency of significant assumptions with the
contextual information set forth in the standard, where relevant,
asserting that the requirement may be difficult to apply in practice.
Another commenter suggested that the auditor be required to consider
whether the assumptions are consistent with the information provided in
order to better align the provision with language used by the IAASB.
One commenter suggested inclusion of a specific requirement to
assess significant assumptions for management bias.
The new standard retains the requirements for evaluating
reasonableness of significant assumptions substantially as proposed.
The requirements recognize that estimates are generally developed using
a variety of assumptions and focus the auditor on how the company
selects its assumptions.
The auditor's assessment of whether the company has a reasonable
basis for a significant assumption (including an assumption based on
forward-looking information) relates to whether the assumption used by
the company is based on an analysis of relevant information, or
determined arbitrarily, with little or no such analysis. The auditor's
assessment also involves considering whether the company considered
relevant evidence, regardless of whether it corroborates or contradicts
the company's assumption.
Under the new standard, the auditor should evaluate whether the
significant assumptions are consistent with relevant information such
as the company's objectives; historical experience (e.g., prior years'
assumptions and past practices), taking into account changes in
conditions affecting the company; and other significant assumptions in
other estimates tested (e.g., assumptions are consistent with each
other and other information obtained). This requirement is consistent
with requirements in the fair value standard.\58\ In making this
evaluation, the auditor uses his or her understanding of the company
and its environment, the assessed risks of material misstatement, and
his or her understanding of the process used to develop the estimates.
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\58\ See generally AS 2502.29-.36.
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In circumstances where the auditor develops an expectation of an
assumption to evaluate reasonableness, the auditor is required to have
a reasonable basis for that expectation (consistent with the
requirements regarding developing independent expectations), taking
into account relevant information, including the information set forth
in the requirement. The new standard does not prescribe specific
follow-up procedures when there are differences between the auditor's
expectation and the company's significant assumptions. The nature and
extent of procedures would depend on relevant factors such as the
reason for the difference and the potential effect of the difference on
the accounting estimate.\59\
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\59\ See AS 2501.30-.31 (Revised).
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[[Page 13411]]
With respect to the comment regarding management bias, the new
standard was revised to provide that responding to risks of material
misstatement involves, among other things, evaluating potential
management bias in accounting estimates, and its effect on the
financial statements (in paragraph .05). Furthermore, the requirements
in paragraphs .30-.31 of the new standard, as well as AS 2810.27
address the evaluation of bias in accounting estimates. Therefore, an
explicit requirement to evaluate bias as part of evaluating
reasonableness of significant assumptions is not necessary.
Intent and Ability
As part of evaluating the reasonableness of significant
assumptions, the proposed standard provided that the auditor take into
account factors (e.g., company's past history of carrying out stated
intentions, written plans or other documentation, stated reasons for
course of action, and the company's ability to carry out action based
on financial resources, legal restrictions, etc.) that affect the
company's intent and ability to carry out a particular course of action
when such action is relevant to the significant assumption.
One commenter asserted that compliance with the proposed
requirements would not be possible when information described in
factors does not exist and suggested adding the phrase ``as
applicable'' to the requirement.
The new standard retains, as proposed, the requirement to take into
account specific factors in evaluating the reasonableness of
significant assumptions when the significant assumption is based on the
company's intent and ability to carry out a particular course of
action. As in other PCAOB standards, the auditor takes factors into
account to the extent they are relevant.
Critical Accounting Estimates
With respect to critical accounting estimates, the proposed
standard provided that the auditor should obtain an understanding of
how management analyzed the sensitivity of its significant assumptions
\60\ to change, based on other reasonably likely outcomes that would
have a material effect, and to take that understanding into account
when evaluating the reasonableness of the significant assumptions and
potential for management bias.
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\60\ For the purposes of this requirement, significant
assumptions identified by the company may not necessarily include
all of those identified by the auditor as significant.
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Some commenters expressed concern that the proposed requirement may
place undue emphasis on, or create an inappropriate linkage with, a
company's management discussion and analysis (``MD&A'') disclosure. One
commenter also suggested that the requirement may not always apply (if,
for example, management were unable to perform a sensitivity analysis),
and suggested clarification that the intent was for the auditor to
understand whether, and if so, how, management analyzed the sensitivity
of significant assumptions to change.
Some commenters suggested the proposed requirement be recast or
aligned as a risk assessment procedure. For example, one commenter
observed that the auditor's and management's judgment can differ with
respect to critical accounting estimates. That commenter also stated
that it was unclear whether the auditor should obtain this
understanding if choosing a substantive-only testing strategy. One
commenter suggested limiting the proposed requirement to critical
accounting estimates with significant risks. Another commenter sought
clarification that the requirement does not alter the auditor's
responsibilities under AS 2710, Other Information in Documents
Containing Audited Financial Statements.
The new standard retains the requirement substantially as proposed.
In consideration of comments, the requirement was clarified to better
align with the SEC's requirement for critical accounting estimates \61\
by describing that the sensitivity of management's significant
assumptions to change is based on other reasonably likely outcomes that
would have a material effect on the company's financial condition or
operating performance.
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\61\ See Commission Guidance Regarding Management's Discussion
and Analysis of Financial Condition and Results of Operations,
Release No. 33-8350 (Dec. 19, 2003), 68 FR 75056 (Dec. 29, 2003), at
Section V (``Critical Accounting Estimates'') for management's
responsibilities related to critical accounting estimates.
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Under the new standard, the auditor is not expected to evaluate the
company's compliance with the SEC's MD&A requirements, but rather to
obtain an understanding of management's analysis of critical accounting
estimates and to use this understanding in evaluating the
reasonableness of the significant assumptions and potential for
management bias in accordance with AS 2810.27. In the Board's view, the
sensitivity analysis used by the company in developing the critical
accounting estimates disclosures for the year under audit can provide
important information about the significant assumptions underlying
those estimates.
The Board considered recasting the requirement to obtain an
understanding of management's analysis of its critical accounting
estimates as a risk assessment procedure, as suggested by some
commenters. However, this understanding is a necessary part of
evaluating the reasonableness of significant assumptions and the
potential for management bias in critical accounting estimates, which
is a substantive procedure. Moreover, MD&A disclosures regarding
critical accounting estimates might not be available until late in the
audit, and therefore could affect the timing of related audit
procedures.
The requirements in the new standard with respect to critical
accounting estimates would not change the auditor's responsibilities
under AS 2710 regarding other information in documents containing
audited financial statements.
Although there may be significant overlap between estimates with
significant risks identified by the auditor and the critical accounting
estimates identified by management, the requirements for auditors under
paragraph .18 of the new standard are not limited to estimates with
significant risks as suggested by one commenter. Rather, the paragraph
is consistent with the requirements to evaluate the reasonableness of
assumptions in significant accounts and disclosures. The MD&A
disclosures regarding critical accounting estimates can provide
relevant information to inform the auditor's evaluation of the
reasonableness of the significant assumptions and potential for
management bias.
Comparison With Standards of Other Standard Setters
ISA 540 Revised provides that the auditor's procedures shall
address (a) whether the significant assumptions are appropriate in the
context of the applicable financial reporting framework, and, if
applicable, changes from prior periods are appropriate; (b) whether
judgments made in selecting the significant assumptions give rise to
indicators of management bias; (c) whether the significant assumptions
are consistent with each other and with those used in other accounting
estimates, or with related assumptions used in other areas of the
entity's business activities, based on the auditor's knowledge obtained
in the
[[Page 13412]]
audit; and (d) when applicable, whether management has the intent to
carry out specific courses of action and has the ability to do so.
ISA 540 Revised also requires the auditor to address whether, in
the context of the applicable financial reporting framework, management
has taken appropriate steps to (a) understand estimation uncertainty;
and (b) address estimation uncertainty by selecting an appropriate
point estimate and by developing related disclosures about estimation
uncertainty. When, in the auditor's judgment based on the audit
evidence obtained, management has not taken appropriate steps to
understand or address estimation uncertainty, ISA 540 Revised requires
the auditor to, among other things, request management to perform
additional procedures to understand estimation uncertainty or to
address it by reconsidering the selection of management's point
estimate or considering providing additional disclosures relating to
the estimation uncertainty, and evaluate management's response. If the
auditor determines that management's response to the auditor's request
does not sufficiently address estimation uncertainty, to the extent
practicable, the auditor is required to develop an auditor's point
estimate or range.
AU-C Section 540 provides that as part of testing how management
made the accounting estimate, and the data on which it is based, the
auditor shall evaluate whether the assumptions used by management are
reasonable in light of the measurement objectives of the applicable
financial reporting framework. Further, for accounting estimates that
give rise to significant risks, AU-C Section 540 requires the auditor
to evaluate: (a) How management considered alternative assumptions or
outcomes and why it rejected them, or how management has otherwise
addressed estimation uncertainty in making accounting estimates; (b)
whether the significant assumptions used by management are reasonable;
and (c) where relevant to the reasonableness of the significant
assumptions used by management or the appropriate application of the
applicable financial reporting framework, management's intent to carry
out specific courses of action and its ability to do so.
AU-C Section 540 further provides that if, in the auditor's
professional judgment, management has not addressed adequately the
effects of estimation uncertainty on the accounting estimates that give
rise to significant risks, the auditor should, if considered necessary,
develop a range with which to evaluate the reasonableness of the
accounting estimate.
Company's Use of a Specialist or Third-Party Pricing Information
See Paragraphs .19-.20
The proposed standard would have required the auditor to also take
into account the work of a company's specialist used in developing an
accounting estimate when determining the evidence needed in testing the
company's process. The proposed standard also referenced Appendix B of
AS 1105 \62\ for testing and evaluating the work of a company's
specialist when that work is used to support a conclusion regarding a
relevant assertion, such as a relevant assertion related to an
accounting estimate.
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\62\ In a separate proposal, the Board proposed to amend its
standards regarding the auditor's use of the work of specialists,
including specialists employed or engaged by the company
(``company's specialist''). See Proposed Amendments to Auditing
Standards for the Auditor's Use of the Work of Specialists, PCAOB
Release No. 2017-003 (``Specialists Proposal''). The Specialists
Proposal set forth these amendments in Appendix B of AS 1105.
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In addition, when third-party pricing information used by the
company is significant to the valuation of financial instruments, the
proposed standard required the auditor to evaluate whether the company
has used that information appropriately and whether it provides
sufficient appropriate evidence.
One commenter expressed concern that the proposed requirement would
result in practical challenges as it would require the auditor to test
the methods, data, and significant assumptions used or developed by a
company specialist in the same manner that the auditor would if the
accounting estimate was developed without the assistance of a company
specialist. Another commenter advocated for closer alignment with the
proposed requirements of Appendix B of AS 1105, citing, for example,
requirements for testing the accuracy and completeness of company-
produced data used by the specialists and evaluating the relevance and
reliability of data obtained from external sources.
One commenter advocated for requiring auditors to consider whether
company specialists possess specific credentials as part of auditing
estimates under the proposed standard.
With respect to circumstances when third-party pricing information
used by the company is significant to the valuation of financial
instruments, one commenter requested additional guidance or criteria
for evaluating whether the company has used third-party pricing
information ``appropriately'' when assessing whether the information
provides sufficient appropriate evidence.
In consideration of comments (including those received on the
Specialists Proposal), the new standard requires the auditor to look to
the requirements of Appendix A of AS 1105 that discuss the auditor's
responsibilities for using the work of company specialists.\63\
Appendix A of AS 1105 sets forth, among other things, procedures to be
performed in evaluating the data, assumptions, and methods used by a
company's specialist. Further, rather than addressing specific
credentials of the specialist, Appendix A of AS 1105 requires the
auditor to assess the knowledge, skill, and ability of the company's
specialist.
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\63\ The auditor's responsibilities with respect to using the
work of a company's specialist are presented as Appendix A of AS
1105. See Specialists Release, supra note 2. The analogous proposed
requirements were originally presented as Appendix B of AS 1105 in
the Specialists Proposal.
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The new standard retains as proposed the requirement to evaluate,
when third-party pricing information used by the company is significant
to the valuation of financial instruments, whether the company has used
third-party pricing information appropriately and whether it provides
sufficient appropriate evidence. The auditor's determination as to
whether third-party pricing information was used appropriately by the
company includes whether the information is in conformity with the
applicable financial reporting framework.
Comparison With Standards of Other Standard Setters
ISA 540 Revised provides that when using the work of a management's
expert, the requirements in paragraphs 21-29 of ISA 540 Revised \64\
may assist the auditor in evaluating the appropriateness of the
expert's work as audit evidence for a relevant assertion in accordance
with paragraph 8(c) of ISA 500, Audit Evidence.\65\ In evaluating the
work of the management's expert, the nature, timing, and extent of the
further audit procedures are affected by the auditor's
[[Page 13413]]
evaluation of the expert's competence, capabilities and objectivity,
the auditor's understanding of the nature of the work performed by the
expert, and the auditor's familiarity with the expert's field of
expertise.
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\64\ Paragraphs 21-29 of ISA 540 Revised describe the
requirements for obtaining audit evidence from events occurring up
to the date of the auditor's report; testing how management made the
accounting estimate; and developing an auditor's point estimate or
range.
\65\ ISA 540 Revised provides that in obtaining audit evidence
regarding the risks of material misstatement relating to accounting
estimates, irrespective of the sources of information to be used as
audit evidence, the auditor shall comply with the relevant
requirements in ISA 500.
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Developing an Independent Expectation of the Estimate
See Paragraph .21
The proposal sought to retain the general approach in the estimates
standards for developing an independent expectation,\66\ and more
explicitly tailored the requirements to the different sources of the
methods, data, and assumptions used by the auditor. Those sources
include (1) independent assumptions and methods of the auditor, (2)
data and assumptions obtained from a third party, and (3) the company's
data, assumptions, or methods.
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\66\ See AS 2501.12, AS 2502.40, and AS 2503.40.
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Additionally, while seeking to retain the requirement under the
fair value standard for an auditor to understand management's
assumptions to ensure that his or her independent estimate takes into
consideration all significant variables,\67\ the proposal expressly
required the auditor to take into account the requirements of the
applicable financial reporting framework.
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\67\ See AS 2502.40.
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The proposal also replaced certain terms used in the estimates
standards to describe audit procedures with more neutral language (such
as replacing ``corroborate'' with ``compare'') to reduce the risk of
confirmation bias or anchoring bias when auditing accounting estimates.
Commenters on this topic were generally supportive of the proposed
requirement for developing an independent expectation, indicating that
the requirement is clear and sufficient. One commenter asked the Board
to clarify situations where developing an independent expectation of
the estimate would be appropriate. Another commenter indicated that
using the phrase ``developing an independent expectation'' implies that
the auditor would reach this expectation independently, without
reference to management's methods, data, and assumptions, and
recommended that the Board consider changing this phrasing to
developing a ``comparative estimate'' or a ``point estimate'' to better
reflect the procedures described.
After consideration of these comments, the requirement is adopted
substantially as proposed. The determination of when to use an approach
or a combination of approaches is at the auditor's discretion based on
the relevant facts and circumstances. In addition, the use of the
phrase ``developing an independent expectation of the estimate'' is
consistent with the concept in the estimates standards. The intention
of the requirement is not to imply that the auditor could (or should)
develop an expectation of the estimate without reference to the
company's methods, data, and assumptions, but rather to more explicitly
acknowledge that, in developing an independent expectation of the
estimate, an auditor could use methods, data, and assumptions obtained
from different sources.
Consistent with the proposal, the new standard tailors the
requirements to develop an independent expectation to the different
sources of the methods, data, and assumptions used by the auditor as
set forth in the table below and discussed further in the sections that
follow.
------------------------------------------------------------------------
Auditor's independent expectation Auditor responsibility under
developed using: the new standard:
------------------------------------------------------------------------
Assumptions and methods of the auditor. Have a reasonable basis for the
assumptions and methods.
Data and assumptions obtained from a Evaluate the relevance and
third party. reliability of the data and
assumptions.
Company data, assumptions, or methods.. Test and evaluate in the same
manner as when testing the
company's process.
------------------------------------------------------------------------
This approach provides more direction to auditors in light of the
various ways in which auditors develop an independent expectation of
accounting estimates.
The new standard also expressly prompts the auditor to take into
account the requirements of the applicable financial reporting
framework when developing an independent expectation. By taking into
account the requirements of applicable financial reporting framework,
the auditor might identify additional considerations relevant to the
estimate that the company did not take into account in its own process
for developing the estimate. As with the proposal, the new standard
also uses more neutral terms, such as ``evaluate'' and ``compare'' to
mitigate the risk of confirmation bias or anchoring bias when auditing
accounting estimates. For example, the new standard requires the
auditor to compare the auditor's independent expectation to the
company's accounting estimate instead of developing an independent fair
value estimate ``for corroborative purposes.'' \68\
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\68\ See AS 2502.40.
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Independent Assumptions and Methods of the Auditor
See Paragraph .22
The proposal recognized that, when developing an independent
expectation of an estimate, the auditor can independently derive
assumptions or use a method that differs from the company's method. In
those situations, the auditor should have a reasonable basis for his or
her assumptions and methods used.
Commenters on this topic were generally supportive of the proposed
requirement that the auditor have a reasonable basis for the
assumptions and methods used when developing an independent expectation
of the estimate. The requirement is adopted as proposed.
Under the new requirement, the auditor is required to have a
reasonable basis for the assumptions and methods used to develop an
independent expectation. Having a reasonable basis would reflect
consideration of, among other things, the nature of the estimate;
relevant requirements of the applicable financial reporting framework;
the auditor's understanding of the company, its environment, and the
company's process for developing the estimate; and other relevant audit
evidence, regardless of whether the evidence corroborates or
contradicts the company's assumptions.
Data and Assumptions Obtained From a Third Party
See Paragraph .23
The proposal directed the auditor to the existing requirements in
AS 1105 when evaluating the relevance and reliability of data or
assumptions obtained from a third party. This approach is consistent
with the requirements for evaluating data from external sources as
described above.
The proposal also directed the auditor to comply with the
requirements of proposed AS 1210 when the third party
[[Page 13414]]
is a specialist engaged by the auditor.\69\ The proposal did not set
forth specific requirements related to methods obtained from a third
party that is not a specialist.
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\69\ See paragraph .08 of the proposed standard.
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One commenter expressed concern that the proposed requirements were
too restrictive and somewhat impractical and that it may not be
possible or necessary to obtain data and assumptions from a third party
and to create assumptions independent of those of the company. The
commenter recommended that the Board retain the extant direction
allowing the auditor to use management's assumptions when developing
independent expectations.
After consideration of the comment, the requirement is adopted as
proposed. As described below, consistent with the estimates standards
and the proposal, the new requirement continues to allow the use of
company data, assumptions, or methods while also allowing the auditor
to use other sources.\70\
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\70\ Appendix A of AS 2501 (Revised) applies when the auditor
develops an independent expectation of the fair value of financial
instruments using pricing information from a third party. These
requirements are discussed further below.
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Also consistent with the proposal, the new standard does not set
forth specific requirements related to methods obtained from a third
party, as the Board understands that auditors typically use either the
company's methods or their own (which may include specialists' methods)
in developing an independent expectation.
Use of Company Data, Assumptions, or Methods
See Paragraph .24
The proposal sought to retain the existing requirements for the
auditor to test data from the company and evaluate the company's
significant assumptions for reasonableness, when used by the auditor to
develop an independent estimate.\71\ The proposal also required the
auditor to evaluate the company's method, if the auditor uses that
method to develop an independent expectation. The proposal recognized
that auditors may use a portion or a combination of data, assumptions,
and method provided by the company in developing their expectations. If
the company's data, assumptions, or methods are those of a company's
specialist, the proposal also directed the auditor to comply with the
requirements in proposed Appendix B of AS 1105 for using the work of a
company specialist as audit evidence.
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\71\ See AS 2502.40.
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One commenter suggested that the Board clarify that when developing
an independent expectation of an estimate, the auditor's testing of
management's process is limited to those areas on which the auditor
intends to rely for purposes of developing the expectation.
This provision is adopted substantially as proposed. Under the new
standard, when an auditor chooses to develop an independent expectation
using certain of the company's data, significant assumptions, or
methods, the auditor is required to test such data or evaluate such
assumptions or methods, using the corresponding procedures that apply
when the auditor tests the company's process. In response to comments,
the text was revised from the proposal to clarify the scope of the
obligation to test. The new standard also includes a note referring the
auditor to look to the requirements in Appendix A of AS 1105 in
situations where the company's data, assumptions or methods were those
of a company's specialist.\72\
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\72\ See Specialists Release, supra note 2.
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Comparison With Standards of Other Standard Setters
When the auditor develops a point estimate or a range to evaluate
management's point estimate and related disclosures about estimation
uncertainty, ISA 540 Revised provides that the auditor's further audit
procedures include procedures to evaluate whether the methods,
assumptions or data used are appropriate in the context of the
applicable financial reporting framework. ISA 540 Revised also provides
that regardless of whether the auditor uses management's or the
auditor's own methods, assumptions or data, further audit procedures be
designed and performed to address the matters in paragraphs 23-25 of
ISA 540 Revised.\73\
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\73\ Paragraphs 23-25 of ISA 540 Revised describe the auditor's
further procedures for addressing methods, significant assumptions,
and data.
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AU-C Section 540 provides that if the auditor uses assumptions or
methods that differ from management's, the auditor shall obtain an
understanding of management's assumptions or methods sufficient to
establish that the auditor's point estimate or range takes into account
relevant variables and to evaluate any significant differences from
management's point estimate.
Developing an Independent Expectation as a Range
See Paragraph .25
The proposal provided that, if the auditor's independent
expectation consisted of a range rather than a point estimate, the
auditor should determine that the range was appropriate for identifying
a misstatement of the company's accounting estimate and was supported
by sufficient appropriate audit evidence.\74\
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\74\ The estimates standards provide for the development of an
independent point estimate as one approach for testing accounting
estimates, but these standards do not discuss developing an
independent expectation as a range of estimates. AS 2810 provides
for developing a range of possible estimates for purposes of the
auditor's evaluation of misstatements relating to accounting
estimates.
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Some commenters asked for clarification or guidance on how to
determine that a range is appropriate for identifying a misstatement.
Some commenters stated that the proposed requirement implied a level of
precision within a range that may not be feasible. Some commenters
suggested expressly acknowledging situations where the range is greater
than the materiality threshold by including, for example, language
similar to IAASB's Exposure Draft, Proposed ISA 540 (Revised) (``ED
540''), paragraph A134.\75\ One of these commenters argued that for
certain highly judgmental estimates, additional audit work cannot
reduce the size of the range below the materiality threshold, and that
the proposed requirement could lead to excessive work. Another
commenter suggested that the proposed standard did not sufficiently
address estimation uncertainty, including what constitutes a reasonable
range of estimation uncertainty and how auditors are to address and
disclose such uncertainty.
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\75\ ED 540, paragraph A134 stated that ``In certain
circumstances, the auditor's range for an accounting estimate may be
multiples of materiality for the financial statements as a whole,
particularly when materiality is based on operating results (for
example, pre-tax income) and this measure is relatively small in
relation to assets or other balance sheet measures. In these
circumstances, the auditor's evaluation of the reasonableness of the
disclosures about estimation uncertainty becomes increasingly
important. Considerations such as those included in paragraphs A133,
A144, and A145 may also be appropriate in these circumstances.''
Substantially similar guidance appears in paragraph A125 of ISA 540
Revised.
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After considering the comments, the requirement has been revised to
clarify that, when establishing an independent expectation as a range,
the auditor should determine that the range encompasses only reasonable
outcomes, in conformity with applicable financial reporting framework,
and is supported by sufficient appropriate evidence.
Also, a footnote has been added to paragraph .26 of the new
standard reminding auditors that, under AS 2810.13, if a range of
reasonable estimates is supported by sufficient appropriate evidence
and the recorded estimate is outside of the range of
[[Page 13415]]
reasonable estimates, the auditor should treat the difference between
the recorded accounting estimate and the closest reasonable estimate as
a misstatement.
The requirement that the range should be supported by sufficient
appropriate evidence is consistent with the principle in the new
standard that the auditor should have a reasonable basis for the data,
assumptions, and methods used in developing an independent expectation.
The sufficiency and appropriateness of the evidence needed will depend
on the relevant circumstances, including the nature of the accounting
estimate, the requirements of the applicable financial reporting
framework, and the number and nature of significant assumptions and
data used in the independent expectation.
Notably, the new standard does not restrict the size of the
auditor's range to the level of materiality for the financial
statements as a whole determined under AS 2105 (``financial statement
materiality''). An appropriate range in accordance with paragraph .25
of the new standard might be very large, even exceeding financial
statement materiality. For example, under certain market conditions,
comparable transactions for some assets, even after appropriate
adjustment, might indicate a wide range of fair value measurements. As
another example, some accounting estimates are highly sensitive to one
or more assumptions, such that a small change in an assumption can
result in a large change in the value of the estimate. In those
situations, the auditor's responsibility is to determine an appropriate
range based on the criteria set forth in the new standard.
The Board considered the comments asking for a statement in the
standard acknowledging that an independent expectation as a range could
exceed the materiality level determined under AS 2105. However, such a
statement was not added because it would not have changed the auditor's
responsibility under the new standard.
Finally, with respect to estimation uncertainty, the new standard
and related amendments acknowledge that estimates have estimation
uncertainty, which affects the risks of material misstatement. Neither
the Board nor auditors are responsible for placing limits on the range
of estimation uncertainty. That uncertainty is a function of the
estimate's measurement requirements under the applicable financial
reporting framework, the economic phenomena affecting that estimate,
and the fact that estimates involve assessments of future outcomes.
Under the new standard, the auditor's responsibility is to consider
estimation uncertainty in assessing risk and performing procedures in
response to risk, which involves evaluating whether the accounting
estimates are reasonable in the circumstances and in conformity with
the applicable financial reporting framework, as well as evaluating
management bias in accounting estimates, and its effect on the
financial statements. These responsibilities are better aligned with
the auditor's overall responsibility for planning and performing
financial audits.\76\
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\76\ Auditors may also have disclosure and reporting
responsibilities in relation to these matters. See AS 3101, The
Auditor's Report on an Audit of Financial Statements When the
Auditor Expresses an Unqualified Opinion, and AS 1301,
Communications with Audit Committees.
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Comparison With Standards of Other Standard Setters
ISA 540 Revised provides that if the auditor develops an auditor's
range, the auditor shall (a) determine that the range includes only
amounts that are supported by sufficient appropriate audit evidence and
have been evaluated by the auditor to be reasonable in the context of
the measurement objectives and other requirements of the applicable
financial reporting framework; and (b) design and perform further audit
procedures to obtain sufficient appropriate audit evidence regarding
the assessed risks of material misstatement relating to the disclosures
in the financial statements that describe the estimation uncertainty.
AU-C Section 540 provides that if the auditor concludes that it is
appropriate to use a range, the auditor should narrow the range, based
on audit evidence available, until all outcomes within the range are
considered reasonable.
Comparing the Auditor's Independent Expectation to the Company's
Accounting Estimate
See Paragraph .26
The proposal set forth the requirement for the auditor to compare
the auditor's independent expectation to the company's estimate and
evaluate the differences in accordance with AS 2810.13.\77\
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\77\ See additional discussion of evaluating audit results
below.
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No comments were received on this topic. The requirement is adopted
substantially as proposed, with an expanded footnote reminding auditors
that under AS 2810.13, if a range of reasonable estimates is supported
by sufficient appropriate evidence and the recorded estimate is outside
of the range of reasonable estimates, the auditor should treat the
difference between the recorded accounting estimate and the closest
reasonable estimate as a misstatement.
Evaluating Audit Evidence From Events or Transactions Occurring After
the Measurement Date
See Paragraphs .27-.29
The proposal noted that events and transactions that occur after
the measurement date can provide relevant evidence to the extent they
reflect conditions at the measurement date. The proposal provided that
the auditor should evaluate whether the audit evidence from events or
transactions occurring after the measurement date is sufficient,
reliable, and relevant to the company's accounting estimate and whether
the evidence supports or contradicts the company's estimate.
Commenters were generally supportive of the proposed requirements,
indicating they were clear and sufficient. Two commenters requested
additional clarity regarding the assessment of whether the audit
evidence is sufficient, reliable, and relevant to the company's
accounting estimate, one in the context of subsequent events and one
more generally. Another commenter suggested including cautionary
language with respect to fair value estimates indicating that fair
value measurements are derived from information that would be known or
knowable to a market participant at the measurement date.
The Board considered these comments and determined that the
requirements in the proposal are sufficiently clear and has adopted the
requirements as proposed.
The new standard, as with the proposal, requires the auditor to
evaluate whether audit evidence from events or transactions occurring
after the measurement date is sufficient, reliable, and relevant to the
company's accounting estimate and whether the evidence supports or
contradicts the company's estimate. This would include evaluating
pertinent information that is known or knowable at the measurement
date. For example, the sale of a bond shortly after the balance-sheet
date (which in this case is also the measurement date) may provide
relevant evidence regarding the company's fair value measurement of the
bond as of the balance sheet date if the intervening market conditions
remain the same. As another example, when a business combination
occurred during the year, events occurring
[[Page 13416]]
subsequent to the measurement date, such as the cash settlement of
short-term receivables, may provide relevant evidence about the
accounting estimate as of the measurement date if they reflect
conditions at the measurement date. In those situations, the audit
procedures would be focused on evaluating the relevance and reliability
of the evidence provided by the subsequent event, including the extent
to which the subsequent event reflects conditions existing at the
measurement date.
Additionally, the new standard requires the auditor to take into
account changes in the company's circumstances and other relevant
conditions between the event or transaction date and the measurement
date. It also notes that as the length of time from the measurement
date increases, the likelihood that events and conditions have changed
during the intervening period also increases.
Comparison With Standards of Other Standard Setters
The corresponding ISA 540 Revised requirement provides that when
the auditor's further audit procedures include obtaining audit evidence
from events occurring up to the date of the auditor's report, the
auditor shall evaluate whether such audit evidence is sufficient and
appropriate to address the risks of material misstatement relating to
the accounting estimate, taking into account that changes in
circumstances and other relevant conditions between the event and the
measurement date may affect the relevance of such audit evidence in the
context of the applicable financial reporting framework.
AU-C Section 540 provides that the auditor should determine whether
events occurring up to the date of the auditor's report provide audit
evidence regarding the accounting estimate.
Evaluating Audit Results
See Paragraphs .30-.31
The proposed standard incorporated existing requirements of AS 2810
for evaluating the results of audit procedures performed on accounting
estimates, including evaluating bias in accounting estimates (both
individually and in the aggregate).
One commenter noted that the requirements could be interpreted as a
presumption that bias always exists in accounting estimates or a
requirement to determine whether actual bias exists, and suggested that
the standard include the word ``potential'' when referencing bias,
similar to the requirements of AS 2810. Another commenter sought
clarification as to whether the proposed standard required the auditor
to evaluate bias in individual assumptions.
The new standard retains paragraphs .30 and .31 regarding
evaluating audit results substantially as proposed. In consideration of
comments, paragraphs .30 and .31 were revised to include a reference to
potential bias, consistent with AS 2810.24-.27. The requirements in the
new standard are intended to remind auditors of their existing
responsibilities to evaluate potential bias in accounting estimates
(both individually and in the aggregate) and its effect on the
financial statements. For example, indicators of management bias may
affect the assessed risk of material misstatement and the auditor's
conclusions about whether accounting estimates are reasonable in the
circumstances. As discussed above, individual assumptions that are
susceptible to manipulation or bias are ordinarily considered
significant and evaluated for reasonableness.\78\
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\78\ See discussion of identification of significant assumptions
above.
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Comparison With Standards of Other Standard Setters
ISA 540 Revised requires the auditor to evaluate whether judgments
and decisions made by management in making the accounting estimates
included in the financial statements, even if they are individually
reasonable, are indicators of possible management bias. When indicators
of possible management bias are identified, the auditor shall evaluate
the implications for the audit. Where there is intention to mislead,
management bias is fraudulent in nature.\79\
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\79\ ISA 540 Revised further requires the auditor to evaluate,
based on the audit procedures performed and audit evidence obtained,
whether (a) the assessments of the risks of material misstatement at
the assertion level remain appropriate, including when indicators of
possible management bias have been identified; (b) management's
decisions relating to the recognition, measurement, presentation and
disclosure of these accounting estimates in the financial statements
are in accordance with the applicable financial reporting framework;
and (c) sufficient appropriate audit evidence has been obtained.
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AU-C Section 540 requires the auditor to review the judgments and
decisions made by management in the making of accounting estimates to
identify whether indicators of possible management bias exist.
Both ISA 540 Revised and AU-C Section 540 provide that the auditor
should determine whether the accounting estimates and related
disclosures are reasonable in the context of the applicable financial
reporting framework, or are misstated.
Appendix A--Special Topics
Introduction
Appendix A of the proposed standard set forth requirements for the
auditor to perform specific procedures when auditing the fair value of
financial instruments, focusing on the use of pricing information from
third parties such as pricing services and brokers or dealers. The
proposal also incorporated and built on topics discussed in the
derivatives standard, including certain procedures for auditing the
valuation of derivatives and securities measured at fair value. The
proposed requirements were informed by outreach, including the Pricing
Sources Task Force, and publications of other standard setters.
Paragraph .A1 of Appendix A prompts the auditor to obtain an
understanding of the nature of the financial instruments being valued
in order to identify and assess risks of material misstatement related
to the fair value of those instruments. Paragraph .A2 provides the
general framework, specifically, the auditor's responsibility to
determine whether the pricing information from a third party \80\
provides sufficient appropriate evidence to respond to the risks of
material misstatement.
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\80\ Appendix A focuses primarily on pricing information from
pricing services and brokers or dealers, but paragraph .A2 also
covers pricing information obtained from other third-party sources,
such as exchanges and publishers of exchange prices.
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Paragraphs .A3-.A9 provide more specific direction for cases where
pricing information from pricing services and brokers or dealers are
used. Paragraph .A10 sets forth factors for the auditor to take into
account when obtaining an understanding of how unobservable inputs were
determined and evaluating the reasonableness of unobservable inputs
when the unobservable inputs are significant to the valuation of
financial instruments.
A number of commenters expressed general support for the proposed
Appendix A but commented on specific aspects of the proposed
requirements. These comments are addressed below in a section-by-
section discussion of the proposal and the new standard. In addition,
there were two areas of comment that relate to several aspects of the
proposed Appendix: (1) The extent to which audit procedures could be
performed over groups or classes of financial instruments, rather than
individual instruments; and (2) the role played by centralized groups
within an accounting firm, such as a pricing desk, in performing
procedures related to
[[Page 13417]]
testing the fair value of financial instruments.
On the first area of comment, commenters asked for clarification on
whether all of the required procedures in Appendix A were to be applied
to financial instruments individually; expressing concerns that doing
so would lead to excessive work. Some commenters suggested clarifying
changes to the proposed Appendix, such as inserting ``type of'' or
``types of'' before the term ``financial instrument'' in various
requirements in the appendix. One commenter suggested adding a note
indicating that the procedures in paragraphs .A4-.A8 of the proposal
were not required to be applied to each individual financial
instrument. Another commenter suggested that auditors be allowed to
understand and evaluate the methods and inputs used by pricing services
at the level of the asset class for financial instruments with lower
estimation uncertainty.
The Board did not intend that all required procedures in Appendix A
be applied to individual financial instruments in all cases. Rather,
the Board intended that financial instruments with similar
characteristics and risks of material misstatement could be grouped for
purposes of applying substantive procedures. In some circumstances,
however, it may not be appropriate to group financial instruments (for
example, where financial instruments are dissimilar, or where the
auditor does not have a reasonable basis upon which to base the
grouping). As discussed in greater detail below, Appendix A of the new
standard has been revised to clarify areas where it may be appropriate
for procedures to be performed over groups of financial instruments
rather than individual financial instruments.
On the second area, commenters asked for additional guidance about
the role of centralized groups that the largest accounting firms often
use to assist in performing procedures related to testing the fair
value of financial instruments. The specific services performed and the
nature and level of detail of information provided by centralized
groups to engagement teams can vary. Some commenters suggested that the
proposal further address how the requirements apply when a centralized
pricing desk is used and raised specific issues regarding the use of
centralized groups under the proposed requirements. One commenter
advocated for more precise requirements about the degree to which
procedures may be executed by a centralized group. The new standard
does not prescribe the role or responsibilities of centralized pricing
groups in audits, and Appendix A does not provide specific direction in
that regard. Instead, the new standard allows engagement teams to
continue seeking assistance from centralized groups when performing the
procedures required under the new standard. This approach gives audit
firms the flexibility to determine the most appropriate way to use
their centralized pricing groups on an audit to satisfy the requirement
of the new standard.
As under the proposal, centralized groups within the firm that
assist engagement teams with evaluating the specific methods and
assumptions related to a particular instrument, identifying and
assessing risks of material misstatement, or evaluating differences
between a company's price and a pricing service's price generally would
be subject to the supervision requirements of AS 1201.\81\
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\81\ Additionally, centralized groups may periodically provide
general information within the firm about a pricing service's
controls and methodologies or general information on current market
conditions for different types of securities. Such general
information may inform engagement teams' risk assessments, to the
extent that the information is reliable and relevant to their
engagements. The activities of centralized groups to obtain and
communicate such general information are different in nature from
the engagement-specific services provided by the centralized groups,
which are subject to supervision. Thus, it is important for firm
quality control systems to have policies and procedures related to
the accuracy of such general information from centralized groups.
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Identifying and Assessing Risks of Material Misstatement Related to the
Fair Value of Financial Instruments
See Paragraph .A1
Under the proposal, the auditor was to obtain an understanding of
the nature of the financial instruments being valued to identify and
assess the risks of material misstatement related to their fair value,
taking into account specified matters.
Commenters were generally supportive of the proposed requirement.
One commenter suggested that the auditor should be permitted to
stratify financial instruments into groups as part of identifying and
assessing risks of material misstatement, and suggested reframing one
of the required procedures to refer to the type of financial
instruments. Paragraph .A1 is not intended to require auditors to
obtain an understanding of each financial instrument one-by-one. The
language has been revised to refer to financial instruments (plural) or
type of financial instruments to make this clear. The new standard
allows auditors, where appropriate, to stratify financial instruments
into groups with similar characteristics for purposes of performing
procedures to evaluate pricing information for financial instruments.
In those situations, the auditor's stratification is to be based on his
or her understanding of the nature of the financial instruments
obtained under paragraph .A1.
Use of Pricing Information From Third Parties as Audit Evidence
See Paragraphs .A2-.A3
The proposal addressed pricing information from organizations that
routinely provide uniform pricing information to users, generally on a
subscription basis (pricing services), and brokers or dealers. The
proposal provided that when the auditor uses pricing information from a
third party to develop an independent expectation or tests pricing
information provided by a third party used by management, the auditor
should perform procedures to determine whether the pricing information
provides sufficient appropriate audit evidence to respond to the risks
of material misstatement.
Commenters on this topic were generally supportive of the proposed
requirement. One commenter questioned whether the use of the word
``tests'' is appropriate in relation to pricing information provided by
a third party used by management, because it might be inconsistent with
other requirements in the proposed standard. The commenter requested
clarification as to whether the use of the word ``tests'' in paragraph
.A2 is intended to set out a different work effort than what AS 1105
would require to evaluate information from external sources.
Another commenter questioned whether receiving prices from a third-
party service, in and of itself, amounts to using a service
organization. The commenter claimed that, based solely on the criteria
in paragraph .03 of AS 2601, Consideration of an Entity's Use of a
Service Organization, without the context provided by AS 2503.11-.14,
it is likely that third-party pricing services would often be
considered service organizations, and that this outcome is not
warranted given the relatively low risks involved. The same commenter
asked about how paragraph .A3 would be applied to situations in which
pricing services prepare pricing information upon client request, but
follow uniform procedures that cause the preparer of the specific
information to be unaware of the identity of the user, such that bias
of the user would not be introduced.
[[Page 13418]]
Paragraphs .A2 and .A3 of the standard are adopted as proposed,
except for the revision discussed below. Under the new standard, as
with the proposal, when the auditor uses pricing information from a
third party to develop an independent expectation or evaluates pricing
information provided by a third party that is used by the company, the
auditor is required to perform procedures to determine whether the
pricing information provides sufficient appropriate evidence to respond
to the risks of material misstatement. This approach focuses auditors
on assessing the relevance and reliability of the pricing information
regardless of whether it is obtained by the company or the auditor,
which should lead to more consistency in practice. The new standard
also includes a reminder that under AS 2301.09, the auditor should
design audit procedures to obtain more persuasive audit evidence the
higher the auditor's assessment of risk. This added reminder reinforces
the principle that the required procedures are scalable based on the
assessed risks of material misstatement. In general, fair values of
financial instruments based on trades of identical financial
instruments in an active market have a lower risk of material
misstatement than fair values derived from observable trades of similar
financial instruments or unobservable inputs. Thus, the necessary audit
response would also differ. For example, for exchange-traded securities
in active markets, quoted prices obtained from a stock exchange may
provide sufficient appropriate evidence.
After consideration of comments, the word ``tests'' has been
replaced with ``evaluates'' to clarify that the requirement is
consistent with the work effort ordinarily required by AS 1105 when
evaluating information from external sources.
As is the case under existing PCAOB standards, a pricing service
would continue to be a service organization if the services it provides
to a subscriber are part of the subscriber's information system over
financial reporting.\82\ In those instances, the auditor would apply
the requirements of the new standard when performing substantive
testing and look to the requirements of AS 2601 regarding his or her
responsibilities for understanding and evaluating controls of the
pricing service. The Board does not intend that the new standard would
change practice in this area, given that the criteria for being a
service organization under PCAOB standards have not changed.
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\82\ See AS 2601.03.
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The applicability of either Appendix A or the requirements for
using the work of specialists to pricing services depends on the nature
of the service provided and the characteristics of the instrument being
valued. Appendix A applies when the auditor uses uniform pricing
information from pricing services that is routinely provided to their
users, generally on a subscription basis. This pricing information may
be generated at various points in time and is available to all
subscribers including both companies and audit firms. In general,
financial instruments covered by these services tend to be those with
more direct or indirect observable inputs.
As with the proposal, the new standard includes a footnote
providing that, when a pricing service is engaged by a company or
auditor to individually develop a price for a specific financial
instrument not routinely priced for subscribers, the requirements in
Appendix A of AS 1105 (company-engaged specialists) or AS 1210
(auditor-engaged specialists) apply, depending on who engaged the
pricing service.\83\ In general, financial instruments covered by these
services have few direct or indirect observable market inputs (for
example, because of an issuer's default, a delisting, or a major change
in liquidity of the related asset class).
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\83\ See Specialists Release, supra note 2.
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Using Pricing Information From Pricing Services
See Paragraph .A4
The proposal set forth a number of factors that affect the
reliability of pricing information provided by a pricing service. These
factors built on existing requirements for evaluating the reliability
of audit evidence under AS 1105.
Some commenters suggested changes to or asked for clarification of
the proposed factors for assessing the reliability of pricing
information from pricing services. For example, some commenters asked
for clarification or guidance regarding the required work effort to
evaluate the pricing service, such as the nature and extent of
procedures to evaluate the expertise and experience of the pricing
service and whether the required procedures were to be applied
separately for each financial instrument. Also, one commenter made
specific suggestions regarding factors to be considered in evaluating
the reliability and relevance of third-party pricing information. One
commenter argued that the requirements of paragraphs .A4b, .A5c, and
.A7 are unrealistic in some cases because auditors will not have access
to the details of pricing service methodology, data, and assumptions.
According to the commenter, requiring auditors to perform additional
procedures in such cases without further guidance on procedures to be
performed is unhelpful to the smaller companies who, in the commenter's
view, are most likely to be unable to obtain an independent valuation,
and to smaller audit firms without a pricing desk.
Additionally, some commenters requested guidance on how the auditor
should determine that the pricing service, broker or dealer does not
have a relationship with the company that could directly or indirectly
or significantly influence the pricing service or broker or dealer.
Other commenters suggested that auditors consider the results of their
procedures regarding related parties under AS 2410 when considering the
relationship of a pricing service or broker or dealer to the issuer.
Other commenters suggested clarifying that a price challenge by
management based on substantive information that causes the pricing
service to change its price should not generally be deemed significant
influence by management.
After consideration of the comments received, the new standard has
been revised as follows:
The requirements have been revised to clarify that the
procedures in this paragraph are not required to be applied separately
for each instrument (e.g., through the use of phrases such as ``types
of financial instruments'').
The new standard includes a note \84\ clarifying that
procedures performed under AS 2410 should be taken into account in
determining whether the pricing service has a relationship with the
company by which company management has the ability to directly or
indirectly control or significantly influence the pricing service as
described in paragraph .A4c. The Board believes that pricing
information from parties not considered to be related parties would
ordinarily be more reliable than pricing information from sources
determined to be related parties. The results of procedures performed
under AS 2410 would provide information about whether the pricing
service is a related party and, if so, the nature of relationships
between the company and the pricing service. The
[[Page 13419]]
nature and extent of further procedures that might be needed depend on
the relevant circumstances. For example, if the results of AS 2410
procedures identified relationships between the company and pricing
service, the auditor would need to evaluate whether the relationships
gave company management the ability to directly or indirectly control
or significantly influence the pricing service. Also, additional
procedures might be needed to ascertain whether the pricing service was
economically dependent on the company's business, if the pricing
service was a smaller entity with few subscribers.
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\84\ See first note to paragraph .A4 in AS 2501 (Revised).
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The new standard also includes a note \85\ clarifying that
the existence of a process by which subscribers can challenge a pricing
service's pricing information does not, by itself, mean that company
management has the ability to directly or indirectly control or
significantly influence that pricing service. The Board agrees with
commenters that the existence of such a price challenge process
ordinarily would not, on its own, suggest significant influence over
the pricing service.
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\85\ See second note to paragraph .A4 in AS 2501 (Revised).
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The new standard also includes a note \86\ indicating that
if the auditor performs procedures to assess the reliability of pricing
information provided by a pricing service at an interim date, the
auditor should evaluate whether the pricing service has changed its
valuation process relative to the types of financial instruments being
valued, and, if so, the effect of such changes on the pricing
information provided at period end. The Board understands that firms
may perform procedures at various times during the year with respect to
the methodology used by pricing service. The note reminds auditors that
if the pricing service changes its process, e.g., because of changes in
market conditions, it is important for the auditor to evaluate the
effect of such changes on the pricing information provided at period
end to determine whether the pricing service continues to provide
relevant evidence at that date.
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\86\ See third note to paragraph .A4 in AS 2501 (Revised).
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As with the proposal, the new standard recognizes that pricing
information that is routinely provided by a pricing service with
experience and expertise relative to the type of financial instrument
being valued is generally more reliable than a price developed by a
pricing service that has limited or no experience. The Board agrees
with the commenters that the number and financial industry experience
levels of evaluators employed by the pricing service, the extent of
informational resources that the pricing service provides to assist
users in understanding its data and evaluation methodologies, and the
pricing service's evaluation quality controls and price challenge
processes, among other things, are relevant considerations when
evaluating experience and expertise. However, the absence of lengthy
experience pricing a particular instrument does not necessarily mean
that the pricing service is incapable of providing relevant audit
evidence. The evaluation of experience and expertise should be based on
the relevant facts and circumstances including the need to obtain more
persuasive audit evidence as the assessed risk of material misstatement
increases.
Similar to the proposal, the new standard contemplates that pricing
services use different methodologies to determine fair value. The Board
understands, based on observation from oversight activities and
outreach that many pricing services provide information to their
subscribers about their methodology, which can be assessed to determine
whether that methodology is in conformity with the applicable financial
reporting framework. Under the new standard, the evaluation of pricing
service methodology can be performed for groups of financial
instruments, provided that certain conditions set forth in the Appendix
are met. When an auditor is unable to obtain information about the
methodology used by the pricing service to determine fair values of the
types of financial instruments being valued, additional or alternative
procedures to obtain the necessary evidence may include, for example,
obtaining and evaluating pricing information from a different pricing
source, obtaining evidence about the inputs used from public data about
similar trades, or developing an independent expectation.
The new standard, as with the proposal, also provides that the
procedures in Appendix A apply to pricing information obtained from
pricing sources used by the company in their estimation process as well
as from those obtained by the auditor for the purpose of developing an
independent expectation.\87\ This approach focuses on assessing the
relevance and reliability of the pricing information obtained, rather
than of the third party itself, and is better aligned with the assessed
risks of material misstatement.
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\87\ An auditor's ability to use sampling methodologies and
pricing information obtained from pricing sources used by the
company may differ under other requirements, such as interpretive
releases issued by the SEC. See, e.g., SEC, Codification of
Financial Reporting Policies Section 404.03, Accounting, Valuation
and Disclosure of Investment Securities, Accounting Series Release
No. 118 (Dec. 23, 1970), which provides requirements for audits of
SEC-registered investment companies.
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See Paragraph .A5
The proposal set forth certain factors that are important to the
auditor's assessment of the relevance of pricing information provided
by a pricing service.
Two commenters suggested that the description of the factors seemed
to indicate that auditors need to understand how each financial
instrument in the portfolio is valued individually, whereas in their
view, auditors should be able to assess these factors based on the
asset class and other characteristics.
The Board did not intend to require auditors to assess the factors
set forth in this paragraph individually for each financial instrument
in all cases, but rather, where applicable, to allow auditors to
consider the factors for groups of financial instruments with similar
characteristics and risks of material misstatement. Accordingly, the
new standard has been revised to use the plural term ``financial
instruments'' to clarify where a broader application is intended.
Like the proposal, the new standard provides direction on
evaluating the relevance of pricing information provided by a pricing
service, building on the requirements related to the relevance of audit
evidence under AS 1105.\88\ Under the new standard, the procedures to
be performed generally depend on whether there is available information
about trades in the same or similar securities.
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\88\ See AS 1105.07.
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Fair values based on quoted prices in active markets for identical
financial instruments. The relevance of pricing information depends on
the extent to which the information reflects market data as of the
measurement date. Recent trades of identical financial instruments
generally provide relevant audit evidence.
Fair values based on transactions of similar financial instruments.
Only a fraction of the population of financial instruments is traded
actively. For many financial instruments, the available audit evidence
consists of market data for trades of similar financial
[[Page 13420]]
instruments or trades of the identical instruments in an inactive
market. This is the context in which the Board thinks it is most likely
that procedures would be performed for groups of financial instruments
of a similar nature (taking into account the matters in paragraph .A1)
that are priced by the pricing service using the same process.
How a pricing service identifies and considers transactions
comparable to the financial instrument being valued affects the
relevance of the pricing information provided as audit evidence. When
fair values are based on transactions of similar instruments, the new
standard requires the auditor to perform additional audit procedures to
evaluate the process used by the pricing service, including evaluating
how transactions are identified, considered comparable, and used to
value the types of financial instruments selected for testing, as
discussed below.
No recent transactions have occurred for the same or similar
financial instruments. When no recent transactions have occurred for
either the financial instrument being valued or similar financial
instruments, pricing services may develop prices using broker quotes or
models. How a pricing service develops prices for these financial
instruments, including whether the inputs used represent the
assumptions that market participants would use when pricing the
financial instruments, affects the relevance of the pricing information
provided as audit evidence.
When pricing information from a pricing service indicates no recent
trades for the financial instrument being valued or similar
instruments, the new standard requires the auditor to perform
additional audit procedures, including evaluating the appropriateness
of the valuation method and the reasonableness of the observable and
unobservable inputs used by the pricing service, as discussed below.
These types of financial instruments would generally be valued
individually.
See Paragraph .A6
The proposal provided that when the fair values are based on
transactions of similar financial instruments, the auditor should
perform additional audit procedures to evaluate the process used by the
pricing service.
Some commenters requested clarification or guidance on the
additional procedures to be performed when evaluating the process used
by a pricing service, and guidance for situations in which the auditor
is unable to perform the procedures. Another commenter asked for
clarification regarding firm-level due diligence over pricing services,
arguing that the standard as proposed would preclude the use of
centralized pricing desks or firm-level due diligence procedures in
evaluating a pricing service's process.
After consideration of comments received, this paragraph in the new
standard has been revised in two respects. First, a phrase was added to
clarify that the additional procedures to be performed relate to how
transactions of similar instruments are identified, considered
comparable, and used to value the types of financial instruments
selected for testing.
Second, in light of previously discussed comments requesting
clarification about the unit of testing, a note was added to paragraph
.A6 of the new standard providing that that when a pricing service uses
the same process to price a group of financial instruments, the audit
procedures to evaluate the process can be performed for those financial
instruments as a group, rather than for each instrument individually,
if the financial instruments are similar in nature (taking into account
the matters in paragraph .A1 of the new standard). The note was
included with this paragraph because, as previously noted, these are
the situations in which the Board believes auditors would be most
likely to perform procedures at a group level. To address the use of
group-level procedures in other contexts, a footnote was added to the
note indicating that other procedures required by the Appendix may also
be performed at a group level, provided that the conditions described
in the note are met.
The new standard does not prescribe detailed procedures because the
necessary audit procedures will vary in nature and extent depending on
a number of factors, including the relevant risks and the process used
by the pricing service (e.g., matrix pricing, algorithm, or cash flow
projections). For example, evaluating the reasonableness of a fair
value based on the estimated cash flows from a pool of securitized
mortgage loans would differ from evaluating an input derived from
adjusted observable data. Procedures may include for example,
evaluating how comparable transactions are selected and monitored or
how matrix pricing is developed.
Additionally, the new standard does not prescribe who is to perform
the procedures with respect to pricing services. It is the Board's
understanding of current practice that, in large firms, firm-level due
diligence over pricing services is typically performed centrally by a
national-level pricing desk and not undertaken by each engagement team.
The determination of whether the due diligence procedures over a
pricing service should be performed by an engagement team or by the
national office centralized group is at the discretion of the auditor,
based on the relevant facts and circumstances. The Board does not
intend that the new standard would give rise to a change in current
practice in this area.
See Paragraph .A7
The proposal provided that when there are no recent transactions
either for the financial instrument being valued or for similar
financial instruments, the auditor should perform additional audit
procedures, including evaluating the appropriateness of the valuation
method and the reasonableness of observable and unobservable inputs
used by the pricing service.
One commenter requested clarification or guidance on the additional
procedures to be performed in circumstances when no recent transactions
have occurred for either the financial instrument or similar financial
instruments, expressing concern about smaller firms' ability to comply
with the proposed requirement.
The requirement has been adopted substantially as proposed. Given
the diverse nature of financial instruments that fall into this
category, prescribing detailed procedures is impractical. The necessary
audit procedures to evaluate the valuation methods and inputs will vary
based on the relevant risks, type of inputs, and valuation methods
involved.
Additionally, when an auditor is unable to obtain information from
a pricing service about the method or inputs used to develop the fair
value of a financial instrument when no recent transactions have
occurred for either the financial instrument being valued or for
similar financial instruments, the auditor is required under the new
standard to perform additional procedures, such as obtaining and
evaluating pricing information from a different pricing source,
obtaining evidence about the inputs used from public data about similar
trades, or developing an independent expectation.
Using Pricing Information From Multiple Pricing Services
See Paragraph .A8
The proposal provided direction for using pricing information from
multiple pricing services to assess the valuation of financial
instruments. Specifically, the proposal set forth certain conditions
[[Page 13421]]
under which less information is needed about the particular methods and
inputs used by the individual pricing services when pricing information
is obtained from multiple pricing services. In general, these factors
relate to situations in which there is reasonably consistent pricing
information available from several sources with ample observable
inputs.
Commenters on this paragraph generally supported the underlying
principle that less evidence may be needed when pricing information is
obtained from multiple pricing services. Some commenters questioned one
of the conditions set forth in the proposal, related to the methods
used to value the financial instruments. Those commenters suggested
that requiring the auditor to understand the valuation methods used was
inconsistent with the concept of obtaining less information. One
commenter suggested that sufficient appropriate audit evidence could be
obtained solely on the basis of two of the conditions: That the
instruments are routinely priced by several pricing services, and the
prices obtained are reasonably consistent. Some commenters asked for
clarification on whether the conditions can be applied on a group basis
or would be required to be applied to individual financial instruments,
expressing concern that the latter approach would lead to excessive
work.
Other commenters sought clarification or offered suggestions
regarding the wording of some of the conditions set forth in the
proposal. One commenter suggested consistently using the terms
``multiple'' and ``several'' in relation to pricing services. Another
commenter asked for clarification of the meaning of the phrase
``reasonably consistent between or among the pricing services from
which pricing information is obtained,'' specifically, whether the
phrase referred to consistent over a period of time or as of a point in
time.
Another commenter suggested a different set of conditions for when
less evidence may be needed. In that commenter's view, the auditor
would have obtained sufficient appropriate audit evidence with respect
to the valuation of a financial instrument if: (i) The auditor assesses
the financial instrument to have ``lower estimation uncertainty''
(e.g., based on the asset class and other characteristics of the
financial instrument), (ii) the auditor obtains multiple prices from
pricing services for the financial instrument, (iii) those pricing
services routinely price that type of financial instrument, (iv) the
prices obtained are reasonably consistent, and (v) the auditor has
obtained an understanding of the pricing services' methodologies at an
asset class level of the financial instrument.
Another commenter suggested that the standard should require taking
the average of a reasonable number of available prices, excluding
outliers, and that procedures such as those outlined in paragraph .A4
should be performed for at least one pricing source. The same commenter
also requested clarification of whether and how pricing sources like
Google and Yahoo Finance may be used.
After consideration of the comments received, paragraph .A8 in the
new standard has been revised to remove the reference to valuation
methods and to make other wording changes that, along with the footnote
to paragraph .A6, clarify that procedures under this paragraph can be
performed at a group level, provided that the conditions described in
the note to paragraph .A6 are met.
Regarding the comment on usage of the terms ``multiple'' and
``several'' in Paragraph .A8, the term ``multiple'' refers to more than
one pricing service. The term ``several'' is used to clarify that,
under the condition in paragraph .A8, pricing information is to be
obtained from more than two pricing services, all of which routinely
price the instruments.
The new standard includes the condition that prices obtained are
reasonably consistent across pricing services (as of a relevant point
in time), taking into account the nature and characteristics of the
financial instruments being valued and market conditions. For example,
the range of prices that would be reasonably consistent would be
narrower for a type of financial instrument with a number of observable
market inputs, such as recent trades of identical or substantially
similar instruments, than for a type of instrument with relatively few
observable market inputs.
The suggestion to compute averages of prices from different sources
was not included in the new standard because averages could obscure a
wide range of price variation and no consideration would be given to
whether certain prices are more indicative of the fair value of the
instrument than others. The Board considered the other factors
suggested by commenters and determined that those factors generally
were similar in nature to requirements in Appendix A. For example, the
suggested factor based on lower estimation uncertainty is, in the
Board's view, subsumed in the other listed factors.
Websites that publish, for the general public, prices for exchange-
traded securities in active markets are not pricing services as
described in the new standard, and the auditor's responsibility for
information from those sources is set forth in paragraph .A2 of the new
standard. Evaluating whether securities prices from these websites
provide sufficient appropriate evidence includes evaluating whether the
websites obtain the prices directly from original sources (e.g., stock
exchanges).
Using Pricing Information From a Broker or Dealer
See Paragraph .A9
The proposal set forth certain factors that affect the relevance
and reliability of the evidence provided by a quote from a broker or
dealer. In addition, the proposal included an amendment to AS 1105.08
to more broadly address restrictions, limitations, and disclaimers in
audit evidence from third parties.
Some commenters asked for guidance on the proposed requirement to
evaluate the relationship of the source of the pricing information with
the company, including the factors to be evaluated. Another commenter
suggested that the standard state that the list of factors affecting
relevance and reliability is not all inclusive, although the commenter
did not suggest additional factors to be included. One commenter
asserted that the proposal would result in a significant change in
practice, and suggested that the Board should consider whether there
were lower risk circumstances for which a broker quote may be
sufficient appropriate audit evidence without meeting all criteria.
Another commenter noted that the first sentence of the paragraph reads
as though it applies only when the auditor tests the company's price
based on a quote from a broker or dealer. The commenter suggested that
the proposal should clarify whether the requirement would also apply
when the auditor develops an independent expectation using a broker
quote.
The new standard has been revised to include a note providing that
auditors should take into account the results of the procedures
performed under AS 2410, Related Parties, when determining whether the
broker or dealer has a relationship with the company by which company
management has the ability to directly or indirectly control or
significantly influence the broker or dealer. Otherwise, the
requirements in the new standard have been adopted substantially as
proposed. The Board believes that the factors set forth in the
[[Page 13422]]
standard provide sufficient direction to the auditor to evaluate the
relevance and reliability of the evidence provided by the quote, in
order to determine whether the quote provides sufficient appropriate
evidence in light of the risks of material misstatement.
The requirements in the proposal were framed in terms of when the
company's fair value measurement is based on a quote from a broker or
dealer because the Board understands that this is the situation
typically encountered in practice. However, the factors set forth in
the standard relate to the relevance and reliability of audit evidence
from those quotes, and thus are equally applicable to those less common
situations when the auditor uses a broker quote to develop an
independent expectation. The requirement in the new standard has been
revised to remove the reference to the ``company's'' measurement.
If the broker quote does not provide sufficient appropriate
evidence, the auditor would be required to perform procedures to obtain
relevant and reliable pricing information from another source (for
example, obtaining a quote from a different broker or dealer, obtaining
pricing information from a pricing service, or developing an
independent expectation).
Unobservable Inputs
See Paragraph .A10
The proposal set forth a requirement for the auditor to obtain an
understanding of how unobservable inputs were determined and to
evaluate the reasonableness of those inputs. This understanding would
involve, among other things, taking into account the assumptions that
market participants would use when pricing the financial instrument,
including assumptions about risk, and how the company determined its
fair value measurement, including whether it appropriately considered
available information. For example, if management adjusts interest
rates, credit spread, or yield curves used to develop a fair value
measurement, the auditor would be required to evaluate whether the
adjustments reflect the assumptions that market participants would
ordinarily use when pricing that type of financial instrument.
The two commenters on this paragraph expressed opposing views. One
commenter supported the requirement while the other commenter suggested
deleting the paragraph.
The requirement is adopted as proposed. By providing factors that
the auditor takes into account, the new standard provides additional
direction in an area that is inherently subjective and judgmental in
nature and therefore poses a higher risk of material misstatement.
Additional Amendments to PCAOB Auditing Standards
The Board has also adopted amendments to several of its existing
auditing standards to conform to the new standard, as reflected in
Exhibit A to the SEC Filing Form 19b-4, available on the Board's
website at https://pcaobus.org/Rulemaking/Pages/docket-043-auditing-accounting-estimates-fair-value-measurements.aspx and at the
Commission's Public Reference Room. Significant amendments are
described below.\89\
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\89\ The discussion that follows excludes conforming amendments
that make reference to the new standard.
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Amendments to AS 1015, Due Professional Care in the Performance of Work
The proposed amendments to AS 1015.11 included two changes to the
discussion of reasonable assurance when auditing accounting estimates
(1) clarifying that many (although not all) accounting presentations
contain accounting estimates, the measurement of which is inherently
uncertain and depends on the outcome of future events; and (2)
providing that, in auditing accounting estimates, the auditor considers
information through the date of the auditor's report, which under PCAOB
standards is a date no earlier than the date on which the auditor has
obtained sufficient appropriate evidence.\90\
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\90\ See paragraph .01 of AS 3110, Dating of the Independent
Auditor's Report.
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One commenter advocated for including language in AS 1015 that
explains inherent limitations that an auditor may face with regard to
identifying and evaluating management bias in accounting estimates. In
this commenter's view, financial reporting frameworks do not
distinguish between reasonable judgment latitude, subconscious
management bias, and willful biased manipulation.
The amendments are adopted substantially as proposed. The Board
acknowledges that various circumstances can give rise to management
bias and that, given the subjective assumptions and uncertainty
inherent in many estimates, bias cannot be eliminated entirely. The new
standard, as well as other PCAOB standards, address the auditor's
responsibilities for evaluating potential management bias in accounting
estimates and its effect on financial statements.
Amendments to AS 1105, Audit Evidence
The proposed amendment to AS 1105.08 would require the auditor to
evaluate the effect of any restrictions, limitations, or disclaimers
imposed by a third party on the reliability of evidence provided by
that party.
A few commenters sought guidance on how to apply the requirement,
including how the auditor would determine if the evidence was
sufficiently reliable.
The amendment to AS 1105.08 is adopted as proposed. Third-party
information often contains restrictions, limitations, or disclaimers as
to the use of such information and its conformity with the applicable
financial reporting framework. The nature of the restriction,
limitation, or disclaimer and how the information provided is being
used would inform the auditor's assessment of whether the evidence
provided by the third-party information is sufficiently reliable, or
whether additional procedures need to be performed (and, if so, the
nature and extent of such procedures). For example, language in a
business valuation disclaiming responsibility for company-provided data
used to prepare the valuation may not affect the reliability of that
valuation as long as the auditor performs audit procedures to test
company-provided data used.
Appendix B, Audit Evidence Regarding Valuation of Investments Based on
Investee Financial Results
The proposal set forth amendments to add Appendix A, Audit Evidence
Regarding Valuation of Investments Based on Investee Financial
Condition or Operating Results, to AS 1105. The proposed amendments
would have retained and updated certain requirements from the
derivatives standard for situations in which the valuation of an
investment selected for testing is based on the investee's financial
condition or operating results, including certain investments accounted
for by the equity method and investments accounted for by the cost
method for which there is a risk of material misstatement regarding
impairment.
Commenters expressed concerns that the updated requirements in the
proposal were written in a manner that was overly prescriptive,
impracticable, burdensome, or inconsistent with the application of a
risk-based approach. For example, commenters asserted that certain
procedures involving interaction
[[Page 13423]]
with investee management or the investee auditor were not practicable
because the investor company's auditor might not have access to those
parties. Commenters also sought clarification on the intent and
application of several procedures set forth in the appendix.
After consideration of comments, the Board has decided to retain
the existing requirements from the derivatives standard, with only
limited conforming changes. The requirements are set forth as Appendix
B, Audit Evidence Regarding Valuation of Investments Based on Investee
Financial Results, to AS 1105. The intent of updating the requirements
from the derivatives standard was to better align the required
procedures with the risk assessment standards, not to substantively
change audit practice in this area. Retaining the language of the
existing requirements is consistent with the intention not to change
audit practice. The requirements of the risk assessment standards
continue to be applicable to investments audited under Appendix B of AS
1105.
Amendment to AS 1205, Part of the Audit Performed by Other Independent
Auditors
AS 1205.14 discusses the applicability of that standard to
situations where the company being audited has an investment accounted
for under the equity method or the cost method and the investee is
audited by another auditor. In consideration of comments on the
appendix to AS 1105 discussed above, the Board is also amending AS 1205
to help auditors determine the appropriate standard to apply in those
situations. Specifically, the amendment provides that the auditor
should look to the requirements of Appendix B of AS 1105 for situations
in which the valuation of an investment selected for testing is based
on the investee's financial results and neither AS 1201 nor AS 1205
applies. The amendment clarifies that Appendix B of AS 1105 applies
when AS 1205, by its terms, does not apply and the investee auditor is
not supervised under AS 1201.
Amendments to AS 2110, Identifying and Assessing Risks of Material
Misstatement
The proposal included a number of amendments to AS 2110 related to:
Obtaining an understanding of the processes used to
develop accounting estimates and evaluating the use of service
organizations that are part of a company's information system;
Discussing how the financial statements could be
manipulated through management bias; and
Assessing additional risk factors specifically for
accounts and disclosures involving accounting estimates.
One commenter suggested that requirements related to identifying
and assessing risks of material misstatements in accounting estimates
should be in one standard (i.e., new standard) rather than amending the
various risk assessment standards. In contrast, another commenter
expressed support for amending other PCAOB standards as a result of a
new standard on accounting estimates.
The amendments to AS 2110, described in more detail below, are
adopted substantially as proposed.
Information and Communication
The proposed amendment to AS 2110.28 would require the auditor, as
part of obtaining an understanding of a company's information system
and related business processes, to obtain an understanding of the
processes used to develop accounting estimates, including (1) the
methods used, which may include models; (2) the data and assumptions
used, including the source from which they are derived; and (3) the
extent to which the company uses specialists or other third parties,
including the nature of the service provided and the extent to which
the third parties use company data and assumptions.
The proposed amendment also included a note emphasizing that the
requirements in AS 2601 with respect to the auditor's responsibilities
for obtaining an understanding of controls at a service organization
would apply when the company uses a service organization that is part
of the company's information system over financial reporting. In
addition, for critical accounting estimates, the proposed amendment
referenced a requirement in the proposed standard for the auditor to
obtain an understanding of how management analyzed the sensitivity of
its significant assumptions to change, based on other reasonably likely
outcomes that would have a material effect.
One commenter suggested a requirement for the auditor to obtain an
understanding of how management identifies and addresses the risk of
management bias. Another commenter suggested adding language similar to
the existing note on evaluation of risk and controls within the
information system to clarify that a service organization is part of
the evaluation, not a separate consideration.
In light of related amendments to AS 2110 in the Board's rulemaking
on the auditor's use of specialists, the amendment to AS 2110.28 was
revised to clarify that the auditor's understanding of the processes
used to develop accounting estimates includes the extent to which the
company uses third parties other than specialists.\91\
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\91\ See the Specialists Release, supra note 2, for a discussion
of auditors' responsibilities with respect to specialists.
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The amendment emphasizes elements of assessing the risks of
material misstatement that are specifically relevant to accounting
estimates, recognizing that the methods, data and assumptions used by
the company in its process to develop accounting estimates, including
how they are selected and applied, drive the risk associated with the
estimate. In addition, as part of obtaining an understanding the
information system, the amendment reminds the auditor to consider
whether the requirements of AS 2601 are applicable to the third party
used by the company in developing an accounting estimate.
A separate requirement for the auditor to obtain an understanding
of how management identifies and addresses the risk of management bias
was not necessary as the new standard requires the auditor to evaluate
management bias and its effect on financial statements as part of
responding to risks of material misstatements in accounting estimates.
Comparison With Standards of Other Standard Setters
Similar to this amendment, ISA 540 Revised sets forth requirements
to obtain an understanding of how management identifies the relevant
methods, assumptions or sources of data, and the need for changes in
them, that are appropriate in the context of the applicable financial
reporting framework, including how management (a) selects or designs,
and applies, the methods used, including the use of models; (b) selects
the assumptions to be used, including consideration of alternatives,
and identifies significant assumptions; and (c) selects the data to be
used.
Discussion of the Potential for Material Misstatement Due to Fraud
AS 2110.52 requires the key engagement team members to discuss the
potential for material misstatement due to fraud. The proposed
amendment to AS 2110.52 would require the auditor to include, as part
of this discussion, how the financial statements could be manipulated
through management bias in accounting estimates in significant accounts
and disclosures.
[[Page 13424]]
Commenters that addressed this topic were generally supportive of
the amendment but provided some suggestions for refinements. One
commenter suggested that the standard include discussion of different
types of bias. Another commenter also indicated that, in their view,
the consideration of bias may be better placed in paragraphs .49-.51 of
AS 2110 as part of the overall discussion of the susceptibility of the
financial statements to material misstatement. Further, in one
commenter's view, the requirement implied that the auditor should seek
out bias in every accounting estimate. This commenter suggested the
language be revised to focus on estimates that are ``more susceptible''
to material misstatement from management bias or where management bias
is ``more likely to'' result in a material misstatement.
The amendment to AS 2110.52 is adopted as proposed. Contrary to the
view of one commenter, the requirement does not direct the auditor to
seek out bias in each estimate. Rather, by including the potential for
management bias (regardless of type) as part of the engagement team's
overall brainstorming discussion, the requirement focuses the auditor's
attention on a risk that is particularly relevant to accounting
estimates in significant accounts and disclosures. In addition,
including the requirement as part of paragraph .52 provides additional
context as to the nature of the discussion about susceptibility of the
company's financial statements to material misstatement due to fraud.
Identifying Significant Accounts and Disclosures and Their Relevant
Assertions
AS 2110.60 provides risk factors relevant to the identification of
significant accounts and disclosures and their relevant assertions. The
proposed amendment to AS 2110.60 provided the auditor with additional
risk factors that are relevant to identifying significant accounts and
disclosures involving accounting estimates, including (1) the degree of
uncertainty associated with the future occurrence or outcome of events
and conditions underlying the assumptions; (2) the complexity of the
process for developing the accounting estimate; (3) the number and
complexity of significant assumptions associated with the process; (4)
the degree of subjectivity associated with significant assumptions (for
example, because of significant changes in the related events and
conditions or a lack of available observable inputs); and (5) if
forecasts are important to the estimate, the length of the forecast
period and degree of uncertainty regarding trends affecting the
forecast.
One commenter suggested including additional factors such as (1)
the extent to which the process involves specialized skills or
knowledge; (2) the complexity of the data used for developing the
accounting estimate, including the difficulty, if any, in obtaining
relevant and reliable data and maintaining the integrity of the data;
and (3) the potential for management bias. Another commenter questioned
whether the Board intends management bias to extend beyond a fraud
risk, suggesting the requirement highlight management bias as a
specific risk factor. A different commenter asked for clarification on
how instances of high measurement uncertainty are contemplated.
One commenter sought clarity on whether the above risk factors are
intended to be considered when identifying and assessing the risks of
material misstatement related to accounting estimates (in addition to
identifying significant accounts and disclosures).
The amendment to AS 2110.60 is adopted as proposed. The additional
risk factors included in the amendment describe those characteristics
and conditions that are associated with accounting estimates and that
can affect the auditor's determination of the likely sources of
potential misstatement. While the factors assist the auditor in
identifying significant accounts and disclosures and their relevant
assertions, these factors also prompt auditors to appropriately assess
the associated risks in the related accounts and disclosures and
develop appropriate audit responses. As discussed above, AS 2810
requires the auditor to evaluate management bias and its effect on the
financial statements. In circumstances where management bias gives rise
to a fraud risk, the auditor looks to the requirements of AS 2301 to
respond to those risks.
The factors were not expanded to include extent of specialized
skills used, potential for management bias, or complexity of the data
used, as suggested by one commenter. These characteristics are already
captured within the factors presented in the amendment or elsewhere in
the risk assessment standards. For example, assessing the complexity of
the process for developing an accounting estimate would necessarily
include understanding the data and assumptions that are used within the
process. Further, as discussed above, the new standard and related
amendments recognize that the degree of uncertainty associated with
some estimates affect the assessed risks and direct auditors to plan
and perform audit procedures to respond to those risks.
Amendments to AS 2301, the Auditor's Responses to the Risks of Material
Misstatement
The proposal included a note to AS 2301.36 emphasizing that
performing substantive procedures for the relevant assertions of
significant accounts and disclosures involves testing whether the
significant accounts and disclosures are in conformity with the
applicable financial reporting framework.
Commenters did not express concerns with the proposed amendment.
However, some commenters called for additional guidance on identifying
and testing relevant controls over accounting estimates. For example,
one commenter suggested guidance related to auditor consideration of
management controls over selection and supervision of a company
specialist. Another commenter suggested additional guidance on
identification and testing of relevant controls, and identification and
response to risks of material misstatement due to fraud in relation to
auditing estimates. This commenter expressed the view that testing the
operating effectiveness of controls, including controls over complex
models or methods used, can be critical in auditing accounting
estimates and, in some circumstances, may be required (e.g., in
situations in which substantive procedures alone do not provide
sufficient appropriate evidence).
The auditor's responsibilities for testing controls are addressed
in AS 2110, AS 2301, and AS 2201, An Audit of Internal Control Over
Financial Reporting That Is Integrated with An Audit of Financial
Statements. These requirements would apply to controls over accounting
estimates. Nonetheless, in the Board's view, providing additional
direction on the need to test controls related to accounting estimates
could help promote an appropriate audit response in cases where only a
financial statement audit is performed. Accordingly, after
consideration of comments, the Board is amending AS 2301.17 to include
a note reminding auditors that for certain accounting estimates
involving complex models or processes, it might be impossible to design
effective substantive tests that, by themselves, would provide
sufficient appropriate evidence regarding relevant assertions.
The amendment to AS 2301.36 is also adopted as proposed.
[[Page 13425]]
Amendments to AS 2401, Consideration of Fraud in a Financial Statement
Audit
To better align requirements with the scope of the proposed
standard, the proposed amendment to AS 2401.64 would have deleted
reference to ``significant accounting estimates reflected in the
financial statements'' and clarified that, when an auditor performs a
retrospective review, the review should be performed for accounting
estimates in significant accounts and disclosures. The proposed
amendment would also have clarified that the retrospective review
involves a comparison of the prior year's estimates to actual results,
if any, to determine whether management's judgments and assumptions
relating to the estimates indicate a possible bias on the part of
management.
Some commenters expressed concern that the proposed amendment would
expand the population of accounting estimates subject to retrospective
review, resulting in excessive work. Other commenters suggested either
including the requirement to perform a retrospective review within the
proposed standard, or providing a clearer linkage between the proposed
standard and the requirements for retrospective review in AS 2401. One
commenter suggested a requirement to evaluate the accuracy of
management's prior estimates going back a minimum of three years.
After consideration of comments, the amendment to AS 2401.64 was
revised to further clarify that the accounting estimates selected for
testing should be those for which there is an assessed fraud risk. The
scope of the retrospective review, as amended, is better aligned with
the new standard and focuses the auditor on accounting estimates
already identified through the risk assessment process as being
susceptible to material misstatement due to fraud.
A separate requirement for performing a retrospective review is not
necessary in the new standard as the requirement in AS 2401 would
achieve the same objective. Further, for some estimates, the outcome of
the estimate may not be known within a reporting period to facilitate
such a review. Similarly, requiring a review over multi-year period
would not be feasible for some estimates. Obtaining an understanding of
the company's process for developing an estimate would necessarily
provide information about the company's ability to make the estimate.
In addition, the new standard requires the auditor to evaluate whether
the company has a reasonable basis for significant assumptions used in
accounting estimates.
Comparison With Standards of Other Standard Setters
ISA 540 Revised requires the auditor to review the outcome of
previous accounting estimates, or, where applicable, their subsequent
re-estimation to assist in identifying and assessing the risks of
material misstatement in the current period. The auditor shall take
into account the characteristics of the accounting estimates in
determining the nature and extent of that review. The review is not
intended to call into question judgments about previous period
accounting estimates that were appropriate based on the information
available at the time they were made.
AU-C Section 540 includes a similar requirement.
Amendment to AS 2805, Management Representations
The proposed amendment to AS 2805.06 would require the auditor to
obtain specific representations related to accounting estimates in
connection with an audit of financial statements presented in
conformity with generally accepted accounting principles. Consistent
with the fair value standard, the auditor would obtain representations
about the appropriateness of the methods, the consistency in
application, the accuracy and completeness of data, and the
reasonableness of significant assumptions used by the company in
developing accounting estimates. Commenters did not address the
requirement and the Board has adopted this amendment as proposed.
Amendment To Rescind AI 16, Auditing Accounting Estimates: Auditing
Interpretations of AS 2501
As discussed in the proposal, the Board is rescinding AI 16. That
interpretation addresses performance and reporting guidance related to
fair value disclosures, primarily voluntary disclosures including fair
value balance sheets. Fair value disclosure requirements in the
accounting standards have changed since the issuance of this
interpretation, and fair value balance sheets covered by the
interpretation are rarely included in issuer financial statements.
Accordingly, this interpretation is unnecessary. Commenters did not
object to rescinding this interpretation.
Effective Date
The Board determined that AS 2501 (Revised) and related amendments
will take effect, subject to approval by the SEC, for audits of
financial statements for fiscal years ending on or after December 15,
2020.
The Board sought comment on the amount of time auditors would need
before the proposed standard and amendments would become effective, if
adopted by the Board and approved by the SEC. A number of commenters
recommended that the Board provide an effective date two years after
SEC approval, which they asserted would give firms the necessary time
to update firm methodologies, develop and implement training, and
ensure effective quality control process to support implementation.
Some commenters supported an earlier effective date, with one commenter
indicating that the proposed standard should be effective
contemporaneously with the implementation of the new accounting
standard on credit losses. One commenter also suggested a phased in
approach for EGCs. Two commenters noted that the proposal should be
effective at the same time as any amendments related to the auditor's
use of the work of specialists.
While recognizing other implementation efforts, the effective date
determined by the Board is designed to provide auditors with a
reasonable period of time to implement the new standard and related
amendments, without unduly delaying the intended benefits resulting
from these improvements to PCAOB standards. The effective date is also
aligned with the effective date of the amendments being adopted in the
Specialists Release.
D. Economic Considerations and Application to Audits of Emerging Growth
Companies
The Board is mindful of the economic impacts of its standard
setting. The economic analysis describes the baseline for evaluating
the economic impacts of the new standard, analyzes the need for the
changes adopted by the Board, and discusses potential economic impacts
of the new standard and related amendments, including the potential
benefits, costs, and unintended consequences. The analysis also
discusses the alternatives considered. There are limited data and
research findings available to estimate quantitatively the economic
impacts of discrete changes to auditing standards in this area, and
furthermore, no additional data was identified by commenters that would
allow the Board to generally quantify the expected economic impacts
(including expected incremental costs related to the
[[Page 13426]]
proposal) on audit firms or companies. Accordingly, the Board's
discussion of the economic impact is qualitative in nature.
The Board sought information relevant to economic consequences over
the course of the rulemaking. The Board has considered all the comments
received and has developed an economic analysis that evaluates the
potential benefits and costs of the final requirements and facilitates
comparison to alternative actions considered.
Commenters who discussed the economic analysis in the Board's
proposal provided a range of views. A number of commenters agreed with
the economic analysis relating to the need for the proposal. Some
commenters agreed with the potential benefits outlined in the proposal,
including an increase in investor confidence and consistency in the
application of requirements. At the same time, other commenters
cautioned against raising expectations among investors about the impact
of the proposal on audit quality by noting various inherent limitations
that the auditor faces in auditing estimates. A number of commenters
suggested that additional audit work required by the new standard would
increase cost without necessarily improving audit quality related to
auditing estimates. In addition, some commenters expressed concern that
some of the increase in cost might be passed through to companies in
the form of increased audit fees.
Baseline
Section C above discusses the Board's current requirements for
auditing accounting estimates, including fair value measurements, and
current practices in the application of those requirements. This
section expands on the current practices of the profession and
currently observed patterns.
As discussed in Section C, the PCAOB has historically observed
numerous deficiencies in auditing accounting estimates. PCAOB staff
gathered data from reported inspection findings related to issuer
audits between 2008 and 2016 for the eight accounting firms that have
been inspected every year since the PCAOB's inspection program
began.\92\ The chart below shows the number of audits with deficiencies
related to the accounting estimates standard and fair value standard
based on the 2008-2016 reported inspection findings \93\ for those
eight firms.\94\
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\92\ The eight accounting firms are BDO USA, LLP; Crowe Horwath
LLP; Deloitte & Touche LLP; Ernst & Young LLP; Grant Thornton LLP;
KPMG LLP; PricewaterhouseCoopers, LLP; and RSM US LLP (formerly
McGladrey, LLP).
\93\ Deficiencies related to the derivatives standard were
infrequent over the inspection period reviewed, and therefore
considered insignificant for purposes of this analysis.
\94\ The chart identifies the audits with deficiencies reported
in the public portion of inspection reports. It shows the relative
frequency of audits with deficiencies citing the existing accounting
estimates standard or the existing fair value standard compared to
the total audits with deficiencies for that year. For example, in
inspection year 2010, 66% of all audits with deficiencies had at
least one deficiency related to the accounting estimates standard or
the fair value standard (total 2016 reported inspection findings are
based on preliminary results).
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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).
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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\
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\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.
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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\
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\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\
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\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\
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\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.
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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\
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\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.
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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\
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\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.
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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\
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\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.
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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.
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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\
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\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.
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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 (https://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 (https://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