A company’s preparation of financial statements in accordance with US GAAP can be very complex due to the required estimates management must make, and auditing these estimates can be even more challenging. In order to strengthen auditors’ review of a company’s accounting estimates and of the work of the specialists who often help companies make those estimates—while promoting consistency in practice—the Public Company Accounting Oversight Board adopted a new standard and amended existing rules. Though adopted in 2018, they just took effect at the end of 2020 and are now being applied by auditors for the first time to all year-end audits conducted under PCAOB standards.
What Prompted the New Rules?
By definition, the areas where estimates are needed tend to be the most uncertain parts of the financial statements, subject to management’s judgments and bias. Auditors often struggle validating the estimates and, as such, the PCAOB noted auditors continue to have deficiencies in auditing companies’ estimates. Auditing estimates is especially important right now because of COVID-19, as the pandemic’s changes and uncertainties are forcing many companies to rely even more on estimates in their financial statements.
As for specialists, they often help a company develop its estimates. For example, appraisal specialists might help a company value its assets or geologists might help a company determine the extent of mineral deposits it owns. The PCAOB wants to ensure the work of specialists is properly scrutinized, and any problems are identified.
Due to the new rules, companies should expect auditors to ask more questions about the estimates being used, how those estimates were determined, and who helped with the formulation. Companies should be checking how and where they’re using estimates and specialists and making certain those uses are justified and documented.
Here are some of the specifics of the new rules. [This post is a summary and does not cover every detail. If you have specific questions, please contact MorganFranklin’s Technical Accounting Solution Center (TASC)].
The Estimates Rule
The estimates rule replaces three previous PCAOB rules with a more consistent risk-based approach, which stresses that auditors must apply professional skepticism when scrutinizing a company’s estimates. In particular, auditors must focus on estimates with the greatest risk of material misstatement—and should specifically address the possibility of management bias. Auditors were already required to do so under previous rules, but the new rule codifies and reemphasizes those requirements.
Auditors must consider areas including: the amount of uncertainty associated with the assumptions; the complexity of the process to develop the estimate; the number, complexity, and subjectivity of significant assumptions; and the length and degree of uncertainty in forecasts.
The estimates rule also gets more specific about what auditors must do in auditing one key type of estimate—the “fair value” a company assigns to its financial assets. The new rule applies the standards by which fair-value estimates are audited to all accounting estimates, helping to make the auditing of estimates more uniform.
The Amended Specialist Rules
The amended specialist rules expand and strengthen the requirements for auditing the work of specialists. Instead of simply understanding what specialists are doing, the auditors must use a risk-based approach to evaluate whether their qualifications, methods, assumptions, and data are appropriate.
The amended rules also cover the work of any specialists that the auditor itself uses to help with its audit. The auditor must be sure it properly supervises its specialists and determines whether they’re objective, especially if they also have a relationship with the company the auditor is auditing.
Both new rules are “scalable”—auditors can adjust the level of testing and evidence they need to assess a company’s estimates and specialists, rather than using a one-size-fits-all approach.
Learn more about the impact of these new rules, and other 2021 accounting trends, will impact your organization in our upcoming Virtual CPE: Accounting Trends for Financial Leaders on April 15th.