Help is Here! Auditing Accounting Estimates under AS 2501 (Revised)

Accounting estimates are EVERYWHERE in the financial statements and they are often material. Examples include certain revenues from contracts with customers, valuations of financial and non-financial assets, impairment of long-lived assets, allowance for credit losses, and contingent liabilities. Add the fact that they require significant judgment and are subject to management bias and you have a recipe for an audit failure if you don’t get it right! And many don’t which is why the PCAOB released a new standard. This post discusses the requirements of auditors for auditing accounting estimates.

As noted in our free PCAOB eBook, auditing accounting estimates consistently ranks in the top 5 audit deficiencies noted during PCAOB inspections. Luckily, the PCAOB has issued AS 2501 (Revised), Auditing Accounting Estimates, Including Fair Value Measurements to provide guidance to auditors in this area. This standard is effective for audits of public company financial statements for fiscal years ending on or after December 15, 2020.

Do you audit private companies? Well, the guidance discussed in this post is coming to audits of private companies soon! SAS 143, Auditing Accounting Estimates and Related Disclosure contains much of the same guidance and is effective for audits of financial statements for periods ending on or after December 15, 2023.

Introducing a new standard for auditing accounting estimates

AS 2501 (Revised) replaces the following three PCAOB auditing standards:

• AS 2501, Auditing Accounting Estimates
• AS 2502, Auditing Fair Value Measurements and Disclosures
• AS 2503, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities

The new standard is designed to reflect a more uniform approach to substantive testing of accounting estimates. It focuses on estimates with greater risk of misstatement, prompting them to devote more attention to potential management bias.

The new standard is designed to be scalable. This means that more audit evidence is required for estimates with a higher risk of material misstatement. It builds on prior requirements related to risk assessment and addresses how the responsibilities of the auditor apply to auditing estimates. This process includes:

• Identifying accounting estimates in significant accounts and disclosures,
• Understanding the process by which accounting estimates are developed, and
• Identifying and assessing the risks of material misstatement related to accounting estimates, which includes determining whether the components of estimates in significant accounts and disclosures are subject to significantly differing risks, and which accounting estimates are associated with significant risks.

Approaches to auditing estimates

Although AS 2501 (Revised) does not set out detailed procedures, but prescribes three approaches to substantively test an accounting estimate. These three approaches are unchanged from previous guidance. 

Let’s briefly walk through these three approaches:

Testing the company’s process used to develop the estimate

This approach, which might be appropriate if the company uses complex, proprietary models to develop an estimate, generally involves:

• Evaluating the company’s methods to ensure they are in conformity with GAAP and are appropriate for the account or disclosure
• Testing and evaluating the completeness, accuracy, and relevance of data used, and
• Identifying significant assumptions and the reasonableness of such assumptions, including the consistency of the assumptions with other information.

Companies may use both internal company data and data from external sources when developing accounting estimates. For internal data, the auditor is required to test the accuracy and completeness of such data. If the data comes from external sources, the auditor is responsible for testing its relevance and reliability.

Probably one of the most important steps under this approach is to identify the significant assumptions used by the company. Examples of assumptions that would ordinarily be considered significant assumptions include those that:

• Are sensitive to variation, such that minor changes in the assumption can cause significant changes in the estimate
• Are susceptible to manipulation and bias
• Involve unobservable data or company adjustments to observable data
• Depend on the company’s intent and ability to carry out specific courses of action

Developing an independent expectation for comparison to the company’s estimate

This approach involves the auditor using their own methods, data, and/or assumptions to develop the expectation. This expectation is either a point estimate or a range, which will be compared to the company’s estimate. This approach may be appropriate if the company’s controls over an estimate are ineffective.

Remember, if the data and/or assumptions used by the auditor are obtained from a third party, the auditor is required to evaluate the relevance and reliability of the data and assumptions in accordance with AS 1105, Audit Evidence. And if the auditor is using company data, significant assumptions, or methods, they are required to test and evaluate such items as they do when testing the company’s process that we previously discussed.

Reviewing subsequent events or transactions

This approach generally involves using events or transactions occurring subsequent to the balance sheet date, but prior to the date of the auditor’s report, to provide evidence that either confirms or contradicts the reasonableness of the company estimate. The auditor should take into account changes in the company’s circumstances and other relevant conditions between the event or transaction date and the measurement date. As the length of time from the measurement date increases, the likelihood that events and conditions have changed during the intervening period also increases. Obviously, this approach is only possible when there are actually relevant transactions to evaluate.

An auditor can use one, two, or all three of the approaches when auditing an estimate. The selection of approach(es) is informed by the auditor’s understanding of the company’s process used to develop the estimate and, if relevant controls are tested, the results of those tests.

Appendix A to AS 2501 (Revised) provides specific requirements when auditing the fair value of financial instruments, primarily when pricing information is obtained from third parties. We will cover this appendix in a subsequent post.

Reminders of auditing estimates during COVID-19

Auditing accounting estimates has taken center stage as a result of the recent pandemic. This has prompted the PCAOB to release its Spotlight: Staff Observations and Reminders during the COVID-19 Pandemic. In this document, the PCAOB reminds auditors of the following:

• Auditors should evaluate whether the public company has a reasonable basis for the significant assumptions used and, when applicable, for its selection of assumptions from a range of potential assumptions.
• Auditors should also evaluate significant assumptions to determine whether they are consistent with relevant industry, regulatory, and other external factors, including economic conditions, and with other significant assumptions used by the public company in other estimates tested.
• The auditor’s assessment of significant assumptions involves considering whether management considered relevant evidence, regardless of whether it corroborates or contradicts the public company’s assumption.
• In the COVID-19 environment, assumptions based on past experience and management expectations may not reflect current market information or be representative of expected future conditions or events. Such assumptions may include, for example, those related to revenue projections, cash flow estimates, charge-off rates, or projected rate of return assumptions.
• In some cases, significant assumptions may be based on the public company’s intent and ability to carry out a particular course of action. Economic uncertainties may limit a public company’s means to carry out a planned action.

Closing thoughts

We hope this post has helped you understand the requirements when auditing accounting estimates (and avoid those pesky audit deficiencies). Want to learn more about auditing accounting estimates under both PCAOB auditing standards and U.S. GAAS? Check out our online course Auditing Accounting Estimates available now for purchase on the GAAP Dynamics Learning Library!

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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.