Estimates in accounting aren’t new, but they’re having a bigger impact on earnings than ever before, thanks in part to recent updates to standards for credit losses, leases, and revenue recognition, and auditing those estimates is a challenging area, according to Tracy Harding, CPA, Quality Assurance principal at BerryDunn in Bangor, Maine.
As evidence, Harding points to a briefing by the PCAOB that identified estimates as a continuing area of audit issues. This is a global concern: The International Forum of Independent Audit Regulators (IFIAR) found that 29% of all audit findings were related to estimates. According to the IFIAR report, “most findings related to failure to assess the reasonableness of assumptions, including consideration of contrary or inconsistent evidence.”
Harding, who also sits on the AICPA Auditing Standards Board (ASB), discussed these challenges and updates to the standards for auditing estimates during a session Tuesday at AICPA ENGAGE 2019 in Las Vegas. In an interview before the event, Harding described what he considers to be the three biggest challenges with auditing accounting estimates.
The first issue is determining whether the assumptions underlying those estimates are reasonable. “Management makes assumptions that we need to be auditing,” he said. “This really gets to the heart of professional skepticism.”
The second issue relates to internal controls. This issue comes up frequently in publicly traded companies, where the auditor also often needs to audit the company’s internal controls over financial reporting, which includes the review of estimates by management. In a number of cases, the PCAOB has “indicated findings related to understanding what exactly management is doing when they do that review,” said Harding. “How does the auditor gain comfort as to whether those review procedures would provide reasonable assurance of preventing or detecting material misstatements?”
The third issue that Harding sees is understanding the data used to develop the estimate, particularly when a third-party specialist is involved. “Specialists can only work with the information they’re given,” he pointed out. For example, if a client has a defined benefit pension obligation, and the information given to the actuary is incorrect, then the estimate is going to be incorrect. Here, it’s essential that the auditor understands the process of gathering the information and any controls over that process and that the auditor also tests the accuracy and completeness of the data provided to the specialist.
In light of the challenges that estimates pose for auditors, both the PCAOB and the International Auditing and Assurance Standards Board (IAASB) recently released updates to their standards for auditing accounting estimates. With an eye on convergence where possible, the ASB provided input to the IAASB as it drafted the international standard, and also seeks to avoid unnecessary differences with the PCAOB standards. The ASB has a project underway to update AU-C Section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures.
According to Harding, the updates from the PCAOB and the IAASB are not substantially changing the approach to auditing accounting estimates, but “I think what they do is better articulate the importance of a disciplined methodology.” It’s important for auditors to think about management bias, to understand the model used for an estimate, and to decide whether that model makes sense.
The PCAOB and IAASB standards emphasize the need for professional skepticism. Harding noted that even the language auditors use can introduce unconscious bias. “The very word ‘confirmation’ really implies that management is right, and we’re confirming that,” he said. Instead, Harding encouraged auditors to “take a more professionally skeptical look at what could go wrong. How might it be misstated? What are the risks that would cause it to be materially misstated? Let’s point our audit effort at addressing those risks.”
In Harding’s experience, auditors tend to be honest people, so they may “have a harder time envisioning fraud or even management bias,” he said. This points to a need for more research on the psychology of auditing to help auditors “understand what we need to guard against.”
If a specialist is used, the updated standards emphasize the need to evaluate his or her work and qualifications. “You can’t simply take the specialist’s numbers and not do anything with that information,” Harding urged. Is the specialist qualified to do the work? Does this person have a good reputation, and are they objective? Is the model they’re using appropriate for the circumstances? And are the assumptions given them by management reasonable?
Harding hopes that the new standards will better articulate the importance of risk assessment in estimates. “When you’ve got material estimates, you have a higher risk of material misstatement because of the importance of the judgments involved,” he said. “As you think about risk assessment, these estimates should be something that hits your radar and says, ‘What could go wrong?’”
— Liz Farr, CPA, is a freelance writer based in New Mexico. To comment on this article or to suggest an idea for another article, contact Ken Tysiac, the JofA’s editorial director, at Kenneth.Tysiac@aicpa-cima.com.