New PCAOB Guidance on Estimates, Specialists

Heads up, audit professionals: the PCAOB has released fresh guidance on how to audit accounting estimates and how to use specialists in complex audit work — two issues that are the subject of new audit standards going into effect in 2021.

Each subject has two pieces of staff guidance, so that’s four PDFs for you to download in total. 

“Accounting estimates and using the work of specialists are both prevalent areas of the audit,” PCAOB chairman William Duhnke said in a typically dry prepared statement. “As auditors begin to plan and perform work on audits subject to new requirements in these areas, we are committed to proactively providing resources to them and supporting effective implementation.”

Still, kudos to the PCAOB for drawing up this guidance, because corporate financial statements increasingly do rely on accounting estimates, which are a time-honored way for crooks and incompetents to screw up financial statements. We’ve written about fraud cases involving estimates at least three times this year (most recently Conn’s and its low-balling of bad debt reserves). Even where fraud isn’t in the picture, estimates around issues such as goodwill, allowances for doubtful accounts, the useful life of assets, and similar items can have enormous import for the balance sheet. 

Likewise, specialists play an increasingly important role because business strategies and revenue streams are increasingly more esoteric. Somebody has to figure out what all those synthetic derivatives are worth, or where that sky-high valuation for a tech startup with no product and no revenue came from. Supervising such specialists, understanding their assumptions, and evaluating their expertise and independence is not easy. Hence the guidance. 

A full analysis of all the guidance will come next week or after Labor Day. For now, here’s a summary of each one.

Auditing Accounting Estimates

This first piece of guidance is meant to help auditors with the new Audit Standard 2501: Auditing Accounting Estimates, Including Fair Value Measurements, which goes into effect for audits of financial statements ending on or after Dec. 15, 2020. 

Ten pages long, this one first explores how to identify and assess the risks in accounting estimates. A lot of that is about understanding the methods that companies use to arrive at estimates, including models, data, and even outside advice provided by company-paid specialists. (More on those company specialists further down.) I especially like the “required ‘brainstorming’ discussion” where the audit team considers various ways management might commit fraud via estimates. 

Then comes material on how to test the company’s methods for finding estimates, testing the data that the company might use, and evaluating the reasonableness of key assumptions the company might use to develop an estimate. 

The guidance also includes a few tables comparing audit requirements under current standards, versus the requirements under new standards coming into effect in 2021. 

Auditing Fair Value of Financial Instruments

This guidance (nine pages) is specifically for financial instruments companies carry on the balance sheet, and the fair value thereof. The new AS 2501 will apply to financial instruments too. The guidance here is along similar lines to the guidance above: how to identify and assess the risks around material misstatement, and understanding the types of information you need to make those determinations. 

Most of those questions hinge on how to determine the price of a financial instrument. For lots of instruments that can be difficult, if they’re thinly traded and auditors can’t rely on prices to determine value. (Compared to, say, cash or widely held stocks, where the value is obvious.)

So the guidance talks about the reliability of pricing data, how to handle “pricing services” that try to provide such information, and how to approach “unobservable inputs” that a company might invent from thin air use to value instruments with no market pricing at all.

Supervising or Using Work of Auditor’s Specialist

Six pages long, this guidance examines how an auditor should supervise a specialist engaged by the audit firm (as opposed to a specialist working for the client company). 

The single largest segment discusses how to evaluate the knowledge, skills, and ability of a specialist. That includes reviewing a specialist’s credentials and reputation, whether you get that intel by independent due diligence or from questionnaires you give to the specialist to assess his or her “KSA.” The guidance, of course, suggests that you consider both.

The rest of this guidance looks at how to assess a specialist’s independence and objectivity. The guidance does stress: “The existence of a relationship between the company and the auditor-engaged specialist does not prevent the auditor from using the work of the auditor engaged specialist.” Such relationship, however, would influence how you evaluate the specialist’s work. 

Using Work of a Company’s Specialist

Yes, an auditor can use a client company’s own employees or business partners as specialists under certain circumstances. This piece of guidance, 10 pages long, offers a few examples of when that might happen: an environmental expert discussing stranded assets and remediation contingency funds; or lawyers interpreting the details of contracts; or operations folks who understand the useful life of physical assets.

The crucial questions for an auditor would be how to evaluate the knowledge and ability of the company’s specialist; and how to evaluate the relationship between company and specialist to understand all possible conflicts — “specifically, whether circumstances exist that give the company the ability to significantly affect the specialist’s judgments,” as the guidance says. It offers a litany of points to ponder.

Then comes a section on how to evaluate the actual work of the specialist, from evaluating that person’s assumptions to understanding how all that work affects the evidence you want to use in your own audit. The guidance also includes three examples from financial services, oil and gas, and manufacturing.

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