Three Ways Companies Can Prepare for the New PCAOB Standard on Auditing Estimates and Using Specialists
Accounting estimates are a critical component of financial reporting and represent an area of higher risk for material misstatement. This risk is due to the impact accounting estimates have on the financial statements and the inherent level of subjectivity and complexity that accompanies many of the estimates. Given the importance and impact of accounting estimates on financial statements, auditors and regulators are increasing their scrutiny over the process used to develop the estimate, the reasonableness of the assumptions and judgments used in the estimate, and the competence of third-party specialists engaged to produce the estimate. To this end, the PCAOB recently adopted significant new guidance on how auditors should assess accounting estimates and the use of specialists (third parties) in developing those estimates. The new and revised guidelines will be effective for all audits of financial statements conducted under PCAOB standards for fiscal years ending on or after December 15, 2020.
Accounting estimates are time- and labor-intensive for management and auditors, often requiring significant resources to properly develop and assess the estimates. While the recent PCAOB guidance is specifically directed to auditors, it will likely impact management teams as they are ultimately responsible for the accounting estimates.
Here are three ways companies can prepare for the impact of the new guidance.
1. Understand valuation and estimation alternatives and document accordingly.
The new guidelines require auditors to focus on addressing potential management bias in accounting estimates. This requirement means that companies must understand alternatives to inputs and techniques used in valuation and estimation models and be able to explain why the chosen methodology is most appropriate. For example, when management evaluates long-lived assets for potential impairment, the value of those assets could be calculated using a discounted cash flow model. Management must be able to document and support the discount rates and earnings projections compared to a range of acceptable alternatives and support how the terminal value was determined. Management should know each alternative that was considered and why the valuation technique was selected over the potential alternatives. Tracking results compared to initial estimates will be important to evaluate whether the chosen methodology and assumptions continue to be appropriate on a prospective basis.
2. Consider engaging third-party support.
Given the time required to develop certain estimates that rely on intricate valuation models and other complex techniques, some companies engage third-party specialists. Companies should consider two main factors when choosing a specialist. First, companies should appreciate the increased focus on the auditor requirement to assess the ability of the specialist as well as its relationship with the company. As part of this process, companies should engage nationally accredited and reputable firms with whom they have no personal relationships, which could lead to concerns regarding competence and objectivity. Second, engaging a third-party specialist does not obviate management from its responsibility for the accounting estimate. Management is still required to understand, review, and approve the model, calculations, assumptions, and conclusions reached. As a result, management should keep thorough records of email correspondence and review comments in draft documents to demonstrate a comprehensive review process, which may also involve conducting regular meetings with specialists. Allowing auditors to attend some of these meetings can ensure that controls surrounding this key estimate are performed appropriately.
3. Know the population of significant estimates that impact your financial statements.
The increased audit requirements will result in increased documentation during quarterly reviews, walkthroughs, and tests of controls. Identifying all of the significant assumptions and estimates that impact the financial statements and will be subject to the increased scrutiny will help companies avoid surprises and be adequately prepared. Examples of transactions and accounting areas that often include significant estimates and will likely require additional effort and documentation include asset acquisitions, business combinations, long-lived asset impairmentand goodwill impairments, revenue recognition, allowances for credit losses, derivatives, reserve estimates, asset retirement obligations, and debt instruments.