Audit committees should become familiar with two new accounting requirements from the Public Company Accounting Oversight Board (PCAOB) regarding auditing accounting estimates, including fair value measurements, and the work of specialists. Both regulations take effect for audits of fiscal years ending on or after December 15, 2020. This article provides key highlights about each of these new requirements.
Auditing Accounting Estimates
New requirements for auditing accounting estimates will apply to estimates in significant accounts and disclosures, and will replace three PCAOB standards with a single, uniform risk-based approach to auditing estimates, including fair value measurements. Prior to the adoption of this standard, three different standards, each with a common approach for auditing accounting estimates, were adopted between 1988 and 2003. Each varied in the level of detail it provided regarding the auditor’s responsibilities. As a result, there was inconsistency in the auditing of accounting estimates. Further, the three different standards predated the adoption of PCAOB’s risk assessment standards and therefore did not fully integrate requirements related to identifying, assessing, and responding to risks of material misstatement in accounting estimates.
In December 2018, the PCAOB adopted a single standard for auditing accounting estimates. Rather than prescribing detailed procedures, the new standard requires auditors to respond to assessed risks and provides direction for testing estimates based on those risks. It builds on the PCAOB’s existing risk assessment requirements, focusing the auditors’ efforts on those estimates with greater risk of material misstatement. The new standard reminds auditors to take into account relevant audit evidence regardless of whether it corroborates or contradicts the company’s assertions. In other words, it encourages auditors to use professional skepticism and keep in mind the potential risk associated with management bias.
Use of Specialists
More and more, auditors have turned to the work of specialists as accounting estimates have become more prevalent and significant. Auditors typically encounter specialists acting in two capacities:
- Company Specialists are either employed or engaged by the financial statement preparer. Their work is relevant to the development of accounting estimates. Auditors’ may use their information as audit evidence in evaluating management’s estimates.
- Auditor Specialists are either employed or engaged by the auditor. Their work is relevant to assist the auditors’ in evaluating significant accounts and disclosures, including accounting estimates in those accounts and disclosures.
Companies across many industries use various types of specialists, defined as a person or firm possessing special skill or knowledge in a particular field other than accounting or auditing, to assist in developing accounting estimates in their financial statements. Specialists also may be used to interpret laws, regulations, and contracts or to evaluate the characteristics of certain physical assets. Specialists may include actuaries, appraisers, other valuation specialists, legal specialists, environmental engineers, and petroleum engineers.
Specialists are often critical to ensuring high quality financial reporting. Auditors typically use the work of specialists as audit evidence or to assist in their evaluation of significant accounts and disclosures, including accounting estimates in those accounts and disclosures.
Under previous PCAOB standards, an auditor’s use of the work of a company’s specialist and an auditor-engaged specialist were governed by the same requirements, even though their roles were fundamentally different.
In 2018, the PCAOB amended the standards to strengthen the requirements for evaluating the work of a company’s specialist and to enhance the way an auditor uses the work of different types of specialists. The amendments align closely with the PCAOB’s risk assessment standards, so that an auditor’s effort to evaluate the work of a specialist is commensurate with the risk of material misstatement.
The changes direct auditors to give more attention to the work of a company’s specialist and to improve the coordination between an auditor and an auditor’s specialist. The auditor is not required to re-perform the work of any specialists, but the amended standard increases the responsibility of the auditor beyond simply understanding the work of the specialist. Instead, the auditor must uncover the details of the specialist’s work in such areas as examining the methods used, evaluating data including significant assumptions and testing data the company provided to the specialist. These amendments are expected to lead to more uniform practices among audit firms of all sizes, which in turn, should increase audit quality.
Key Intentions for Audit Committees
Whether your audit committee is affected by these changes will depend on the extent to which your company uses specialists. As your audit committee discusses these new requirements with your auditor, keep in mind that the effects of the new requirements also will likely depend on the nature and extent of accounting estimates included in the company’s financial statements.
Under the new requirements, auditors can continue to use the work of the company’s specialist, although they do not require the auditor to use an auditor’s specialist. Typically, the main considerations influencing the auditors’ determination of whether and how to involve specialists in the audit include:
- New or significant unusual transactions,
- The implementation of new accounting standards,
- The subjectivity of certain assumptions in estimates, or
- Increases in the use of company specialists
The new standard and amendments do not change existing requirements for the auditor’s communications with audit committees, including those communications related to critical accounting estimates. Auditors are still required to communicate an overview of their audit strategy, including the use of specialists, the significant risks identified in their risk assessment procedures, and other matters as identified in the standard on audit committee communications.
The new requirements are particularly timely as they take effect just as auditors are responding to the effects of COVID-19. In the current economic environment, it will be important for the auditor to have an understanding of the methods, data, and significant assumptions the company used in developing estimates. This will be especially important in identifying potential risks associated with estimates contained in the company’s financial statements.
