When businesses report their finances, they often use accounting estimates determined by management. For example:
- Allowance for doubtful accounts
- Warranty obligations
- Costs of pending litigation
- Goodwill impairment
- Fair values of acquired intangible assets
When auditors evaluate the amounts reported on these financial statements, how do they determine whether those amounts are reasonable?
Methods used to evaluate accounting estimates
As part of their standard audit procedures, external auditors evaluate accounting estimates. These accounting estimates can be based on a combination of subjective and objective information, resulting in measurement uncertainty.
Methods include:
Inquiry
Auditors may inquire about underlying assumptions, or inputs, that were used for making estimates. They will use the information from these inquiries to determine whether the inputs seem complete, accurate, and relevant.
Estimates based on objective inputs (i.e., published interest rates or percentages from previous reporting periods) are typically less susceptible to bias than estimates based on speculative, unobservable inputs—particularly if management does not have prior experience with similar estimates.
Testing
If and when it’s possible, auditors may try to recreate estimates determined by management by using the same inputs, or even their own. If the auditor’s estimate is significantly different from the estimate on the financial statement, they will ask management for an explanation. In cases involving complex items, an independent specialist may also be called in.
Auditors may also compare previous estimates to what occurred after the date of the financial statement, as the outcome of an estimate tends to differ from management’s initial estimate due to errors, unforeseeable circumstances, and/or management bias.
While estimates that are consistently aligned with what happened later add credibility, those with significant differences may cause an auditor to become more skeptical of management’s current estimates, often necessitating additional audits.
Updates to auditing processes
In 2018, the Public Company Accounting Oversight Board (PCAOB) published revisions to the requirements for auditing accounting estimates and using specialists (often to support accounting estimates made by management) in audits.
These revisions were published in:
Release No. 2018-005
Release No. 2018-005, Auditing Accounting Estimates, Including Fair Value Measurements, is a risk-based standard emphasizing the importance of professional skepticism and the attention to potential management bias among auditors when evaluating estimates made by management.
Per the updated standard, auditors should consider both corroborating and contradictory evidence obtained during the audit.
Release No. 2018-006
Release No. 2018-006, Amendments to Auditing Standards for Auditor’s Use of the Work of Specialists, extends the auditor’s responsibility for evaluating specialists, requiring them to do more than simply obtain an understanding of their work. They must also perform procedures assessing the appropriateness of the company’s data, along with the assumptions and methods used.
December 2022 analysis report
The PCAOB published a post-implementation review of these updates in December 2022. 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, approximately 33% of surveyed audit firms reported that the new requirements improved auditing practices. Other firms reported that the effects were limited, with no significant consequences on the audit process fees or hours.
While the newer, more consistent guidance pertains to public companies, these effects filter down to private entity audits that use accounting estimates or depend on specialists.
Accounting gray areas? Smolin can help.
Because they involve a high level of subjectivity and judgment, accounting estimates and fair value measurements may be susceptible to misstatement. It can be particularly challenging to predict metrics that determine these accounting estimates. As a result, more auditor focus is required today than in previous, more stable accounting periods.
It’s critical that you’re prepared to provide comprehensive documentation to support your estimates during the upcoming audit season. Need some assistance? Contact us to work with a knowledgeable accounting professional.