Armanino Blog

Auditing the Use of Estimates and Specialists

by Patrick Hall
May 09, 2016

Business transactions have grown more complicated in recent years, leading companies to make a significant number of subjective estimates and rely more heavily on outside parties to bring in specialized knowledge. For more than a decade, the Public Company Accounting Oversight Board (PCAOB) has been working on revising its standards for audits of accounting estimates and auditors’ reliance on specialists. Now, it’s pushed back the publication of its proposed guidance from the second quarter to the fourth quarter of 2016.

Use of estimates
Accounting estimates—such as allowances for doubtful accounts, loss and loss adjustment reserves, impairments of long-lived assets, and valuations of financial and nonfinancial assets—involve some level of measurement uncertainty. Some estimates may be easily determinable, but many are inherently subjective or complex. As a result, they may be susceptible to misstatement and require more auditor focus.

In particular, fair value accounting, a type of accounting estimate, has become more widely applied over the past decade. This led the Financial Accounting Standards Board (FASB) to issue updated guidance on fair value measurement (Accounting Standards Codification Topic 820). Auditors sometimes mishandle their examinations of clients’ application of fair value, according to a FASB Staff Consultation Paper, Auditing Accounting Estimates and Fair Value Measurements, which was published in August 2014.

The problem has been significant enough to garner the attention of the Securities and Exchange Commission (SEC), spurring it to pressure the PCAOB to update the auditing standard on the use of estimates.

Reliance on specialists
Increasingly, auditors and managers call on specialists to help them make subjective estimates under U.S. Generally Accepted Accounting Principles. Examples of specialists used to prepare public company financial information include:

  • Actuaries to determine incurred but not reported claim liabilities
  • Engineers to determine obligations regarding environmental remediation,
  • Appraisers to determine the value of intangible assets or real estate,
  • Geologists to estimate mineral deposits or oil reserves for mining and energy companies, and
  • Lawyers to forecast the potential losses from a legal proceeding.

When supervising these specialists, more-specific direction might help minimize the risk of misstatement, especially when specialists aren’t subject to the audit firm’s training, resources and quality control systems.

Updated audit guidance
The auditing standards on the use of estimates are closely linked to the standards on the use of specialists. So, the PCAOB plans to issue proposals on these issues for public comment simultaneously.

Auditing standards generally provide three approaches for substantively testing accounting estimates and fair value measurements. When performing an audit, the auditor selects one or a combination of these approaches:

Testing management’s process. Auditors evaluate the reasonableness and consistency of management’s assumptions, as well as test whether the underlying data is complete, accurate and relevant.

Developing an independent estimate. Using management’s assumptions (or alternative assumptions), auditors come up with an estimate to compare to what’s reported on the internally prepared financial statements.

Reviewing subsequent events or transactions. The reasonableness of estimates can be gauged by looking at events or transactions that happen after the balance sheet date but before the date of the auditor’s report.

For the auditing of accounting estimates, the PCAOB is expected to propose a single standard. The proposed guidance will replace:

  • AU Section 342, Auditing Accounting Estimates
  • AU Section 328, Auditing Fair Value Measurements and Disclosures
  • Some or all requirements of AU Section 332, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities

A potential new standard would strive to promote greater consistency and effectiveness in application and be better aligned with the risk assessment standards.

The PCAOB also plans to update existing audit guidance on the use of specialists. AU Section 336, Using the Work of a Specialist, hasn’t changed much since it was originally published in the 1970s. It deals with auditors’ oversight of third-party specialists, as well as the auditor’s use of the work of a professional hired by an auditing client. In some cases, specialists may help auditors be more alert to financial misstatements.

Existing audit guidance requires auditors to evaluate the relationship of a specialist to the client, including situations that might impair the specialist’s objectivity. But it doesn’t provide specific requirements. The proposal is expected to provide more direction for carrying out that evaluation.

Continued delays
Last fall, the PCAOB announced plans to release these proposals by the second quarter of 2016. During a March meeting of the FASB’s Financial Accounting Standards Advisory Council, however, PCAOB member Jay Hanson said publication of the proposals had slipped to the fourth quarter. He didn’t elaborate on the schedule or the reasons for the later publication date.

These continued delays show how changes to public company auditing standards tend to happen slowly. Changes are subject to extensive reviews by the PCAOB staff and regulators from the SEC, who must approve each PCAOB decision before it can become final. As public companies plan for next year’s audit, they should contact their audit partners for the latest developments on the standards for auditing the use of estimates and specialists to determine what (if anything) has changed.

May 09, 2016

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