When companies report financial results, they often rely on estimates made by management. Examples include the allowance for doubtful accounts, warranty obligations, costs of pending litigation, goodwill impairment and the fair values of acquired intangible assets. How do auditors evaluate whether amounts reported on the financial statements for these items seem reasonable?
Inquiry and testing
Accounting estimates may be based on subjective or objective information (or both) and involve a level of measurement uncertainty. External auditors evaluate accounting estimates as part of their standard audit procedures.
For instance, they may inquire about the underlying assumptions (or inputs) that were used to make estimates to determine whether the inputs seem complete, accurate and relevant. Estimates based on objective inputs, such as published interest rates or percentages observed in previous reporting periods, are generally less susceptible to bias than those based on speculative, unobservable inputs. This is especially true if management lacks experience making similar estimates in the past.
Whenever possible, auditors try to recreate management’s estimate using the same assumptions (or their own). If an auditor’s estimate differs substantially from what’s reported on the financial statements, the auditor will ask management to explain the discrepancy. In some cases, an independent specialist, such an appraiser or engineer, may be called in to estimate complex items.
Auditors also may compare past estimates to what happened after the financial statement date. The outcome of an estimate is often different from management’s preliminary estimate. Possible explanations include errors, unforeseeable subsequent events and management bias. If management’s estimates are consistently similar to what happened later, it adds credibility to management’s prior estimates. But if significant differences are found, the auditor may be more skeptical of management’s current estimates, necessitating the use of additional audit procedures.
The Public Company Accounting Oversight Board (PCAOB) published revised requirements for auditing accounting estimates and using specialists in audits in December 2018. These changes were published in Release No. 2018-005, Auditing Accounting Estimates, Including Fair Value Measurements, and Release No. 2018-006, Amendments to Auditing Standards for Auditor’s Use of the Work of Specialists. (Note: The work of specialists is often used to support accounting estimates made by management.)
Release No. 2018-005 is a risk-based standard that emphasizes the importance of professional skepticism when auditors evaluate management’s estimates and the need for more attention to potential management bias. Under the updated standard, auditors consider both corroborating and contradictory evidence that’s obtained during the audit. Similarly, Release No. 2018-006 extends the auditor’s responsibility for evaluating specialists beyond simply obtaining an understanding of their work. In short, it requires auditors to perform additional procedures to evaluate the appropriateness of the company’s data, as well as significant assumptions and methods used.
In December 2022, the PCAOB published its post-implementation review on these new-and-improved rules. About one-third of the audit firms surveyed reported that the new requirements on estimates and specialists improved auditing practices, according to Interim Analysis Report: Evidence on the Initial Impact of New Requirements for Auditing Accounting Estimates and the Auditor’s Use of the Work of Specialists. Other firms said that effects were limited and didn’t have major consequences on the audit process or audit fees/hours.
Though the new, more consistent guidance applies specifically to public companies, the effects filter down to audits of private entities that use accounting estimates or rely on the work of specialists.
Gray area in accounting
Accounting estimates and fair value measurements involve a high degree of subjectivity and judgment and may be susceptible to misstatement. In today’s uncertain market conditions, predicting metrics that underlie accounting estimates can be particularly challenging. Therefore, they require more auditor focus today than in more-stable prior accounting periods. Be prepared to provide comprehensive documentation to support your estimates during the upcoming audit season. Contact us with any questions.