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SECURITIES AND EXCHANGE (‘‘EGCs’’).1 The Board’s request is set confirmatory over contradictory COMMISSION forth in section D. evidence. The Board’s oversight activities, A. Board’s Statement of the Purpose of, which have revealed a recurring pattern [Release No. 34–85434; File No. PCAOB– and Statutory Basis for, the Proposed 2019–02] of deficiencies in this area, also raise Rules concerns about auditors’ application of Public Company Oversight (a) Purpose professional skepticism, including addressing potential management bias, Board; Notice of Filing of Proposed Summary Rules on Auditing Accounting in this area of the . Over the years, Estimates, Including The Board has adopted amendments PCAOB staff has provided guidance for Measurements, and Amendments to to its standards for auditing accounting auditors related to auditing accounting PCAOB Auditing Standards estimates and fair value measurements, estimates, but this area remains under which three existing standards challenging and practices among firms March 28, 2019. will be replaced with a single, updated vary. standard (‘‘AS 2501 (Revised)’’ or the Currently, three PCAOB auditing Pursuant to Section 107(b) of the standards primarily relate to accounting Sarbanes-Oxley Act of 2002 (the ‘‘Act’’ ‘‘new standard’’). As discussed in more detail below, in the Board’s view, the estimates, including fair value or ‘‘Sarbanes-Oxley Act’’), notice is measurements. These three standards, hereby given that on March 20, 2019, new standard and related amendments will further investor protection by which were originally adopted between the Public Company Accounting 1988 and 2003, include common Oversight Board (the ‘‘Board’’ or strengthening audit requirements, applying a more uniform, risk-based approaches for substantive testing but ‘‘PCAOB’’) filed with the Securities and vary in the level of detail in describing Exchange Commission (the approach to an area of the audit that is of increasing prevalence and the auditor’s responsibilities with ‘‘Commission’’ or ‘‘SEC’’) the proposed respect to those approaches. In addition, rules described in Items I and II below, significance, and updating the standards in light of recent developments. because the three standards predate the which items have been prepared by the Board’s risk assessment standards, they Board. The Commission is publishing The financial statements of most companies reflect amounts in accounts do not fully integrate risk assessment this notice to solicit comments on the requirements that relate to identifying, proposed rules from interested persons. and disclosures that require estimation, which may include fair value assessing, and responding to the risks of I. Board’s Statement of the Terms of measurements or other types of material misstatement in accounting Substance of the Proposed Rules estimates. These estimates appear in estimates. The new standard builds on the items like from contracts with common approaches in the three On December 20, 2018, the Board customers, valuations of certain existing standards and will strengthen adopted a new rule and amendments to financial and non-financial , PCAOB auditing standards in the auditing standards (collectively, the impairments of long-lived assets, following respects: ‘‘proposed rules’’), under which the allowances for credit losses, and • Providing direction to prompt three existing standards related to contingent liabilities. As financial auditors to devote greater attention to auditing estimates, including fair value reporting frameworks evolve toward addressing potential management bias measurements, will be replaced with a greater use of estimates, accounting in accounting estimates, as part of single, updated standard. The text of the estimates are becoming more prevalent proposed rules appears in Exhibit A to applying professional skepticism. and more significant, often having a • Extending certain key requirements the SEC Filing Form 19b–4 and is significant impact on a company’s available on the Board’s website at in the existing standard on auditing fair reported financial position and results value measurements, the newest and https://pcaobus.org/Rulemaking/Pages/ of operations. docket-043-auditing-accounting- most comprehensive of the three estimates-fair-value-measurements.aspx By their nature, accounting estimates, existing standards, to other accounting and at the Commission’s Public including fair value measurements, estimates in significant accounts and Reference Room. generally involve subjective disclosures, reflecting a more uniform assumptions and measurement approach to substantive testing for II. Board’s Statement of the Purpose of, uncertainty, making them susceptible to estimates. and Statutory Basis for, the Proposed management bias. Some estimates • More explicitly integrating Rules involve complex processes and requirements with the Board’s risk methods. As a result, accounting assessment standards to focus auditors In its filing with the Commission, the estimates are often some of the areas of on estimates with greater risk of Board included statements concerning greatest risk in an audit, requiring material misstatement. the purpose of, and basis for, the additional audit attention and • Making other updates to the proposed rules and discussed any appropriate application of professional requirements for auditing accounting comments it received on the proposed skepticism. The challenges of auditing estimates to provide additional clarity rules. The text of these statements may estimates may be compounded by and specificity. be examined at the places specified in cognitive bias, which could lead • Providing a special topics appendix Item IV below. The Board has prepared auditors to anchor on management’s to address certain aspects unique to summaries, set forth in sections A, B, estimates and inappropriately weight auditing fair values of financial and C below, of the most significant instruments, including the use of aspects of such statements. In addition, 1 The term ‘‘emerging growth company’’ is pricing information from third parties the Board is requesting that, pursuant to defined in Section 3(a)(80) of the Securities such as pricing services and brokers or Section 103(a)(3)(C) of the Sarbanes- Exchange Act of 1934 (the ‘‘Exchange Act’’) (15 dealers. Oxley Act, the Commission approve the U.S.C. 78c(a)(80)). See also Inflation Adjustments The Board has adopted the new and Other Technical Amendments Under Titles I proposed rules for application to and III of the JOBS Act, Release No. 33–10332 (Mar. standard and related amendments after of emerging growth companies 31, 2017), 82 FR 17545 (Apr. 12, 2017). substantial outreach, including two

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rounds of public comment. Commenters (b) Statutory Basis Rulemaking History generally supported the Board’s The statutory basis for the proposed The PCAOB has engaged in extensive objective of improving the quality of rules is Title I of the Act. outreach to explore the views of market audits involving accounting estimates, participants and others on the potential and suggested areas where the proposed B. Board’s Statement on Burden on Competition for improvement of the auditing requirements could be modified or standards related to accounting clarified. The Board has taken all of Not applicable. The Board’s estimates. This includes discussions these comments, as well as observations consideration of the economic impacts with the Board’s Standing Advisory from PCAOB oversight activities and the of the proposed rules is discussed in Group (‘‘SAG’’) and the Pricing Sources relevant academic literature, into section D below. Task Force. In addition, in August 2014, account. C. Board’s Statement on Comments on the PCAOB issued the SCP, to solicit In a separate PCAOB release, the the Proposed Rules Received From comments on various issues, including Board also adopted amendments to its Members, Participants or Others the potential need for standard setting and key aspects of a potential new standards for using the work of The Board released the proposed rules standard and related requirements. specialists, which are often involved in for public comment in Proposed In June 2017, the Board proposed to developing, or assisting in the Auditing Standard—Auditing 2 replace three auditing standards that evaluation of, accounting estimates. Accounting Estimates, Including Fair primarily relate to accounting estimates, Certain provisions of the new standard Value Measurements, and Proposed include references to AS 1210, Using Amendments to PCAOB Auditing including fair value measurements, with the Work of an Auditor-Engaged Standards, PCAOB Release No. 2017– a single standard. The proposal Specialist; AS 1201, Supervision of the 002 (June 1, 2017) (‘‘proposal’’ or included a special topics appendix Audit Engagement; and AS 1105, Audit ‘‘Estimates Proposing Release’’). The addressing certain matters relevant to Evidence, as amended. PCAOB also issued for public comment auditing the fair value of financial instruments and amendments to several In its consideration of the new a Staff Consultation Paper, Auditing PCAOB standards to align them with the standard and related amendments, the Accounting Estimates and Fair Value single standard. A number of Board is mindful of the significant Measurements (Aug. 19, 2014) (‘‘SCP’’). commenters across many affiliations advances in technology that have Copies of Release No. 2017–002, the supported the Board’s efforts to occurred in recent years, including SCP, and the comment letters received strengthen auditing practices and increased use of data analysis tools and in response to the PCAOB’s requests for comment are available on the PCAOB’s update its standards in this area. emerging technologies. An increased In addition to this outreach, the use of technology-based tools, together website at https:/pcaobus.org/ Rulemaking/Pages/docket-043-auditing- Board’s approach has been informed by, with future developments in the use of among other things, observations from data and technology, could have a accounting-estimates-fair-value- measurements.aspx. The PCAOB PCAOB oversight activities and SEC fundamental impact on the audit enforcement actions and consideration process. The Board is actively exploring received 81 written comment letters. The Board’s response to the comments of academic research, the standard on these potential impacts through ongoing auditing accounting estimates recently staff research and outreach. received and the changes made to the rules in response to the comments adopted by the International Auditing In the context of this rulemaking, the received are discussed below. and Assurance Standards Board Board considered how changes in (‘‘IAASB’’), and the extant standard on technology could affect the processes Background auditing accounting estimates of the companies use to develop accounting Accounting estimates are an essential Auditing Standards Board (‘‘ASB’’) of estimates, including fair value part of financial statements. Most the American Institute of Certified measurements, and the tools and companies’ financial statements reflect Public . techniques auditors apply to audit them. accounts or amounts in disclosures that Overview of Existing Requirements The Board believes that the new require estimation. Accounting standard and related amendments are estimates are pervasive to financial The primary PCAOB standards that sufficiently principles-based and statements, often substantially affecting apply specifically to auditing flexible to accommodate continued a company’s financial position and accounting estimates, including fair advances in the use of data and results of operations. Examples of value measurements are: technology by both companies and accounting estimates include certain • AS 2501, Auditing Accounting auditors. The Board will continue to revenues from contracts with customers, Estimates (originally issued in April monitor advances in this area and any valuations of financial and non- 1988) (‘‘accounting estimates effect they may have on the application financial assets, impairments of long- standard’’)—applies to auditing of the new standard. lived assets, allowances for credit accounting estimates in general. • AS 2502, Auditing Fair Value The new standard and related losses, and contingent liabilities. The evolution of financial reporting Measurements and Disclosures amendments apply to all audits frameworks toward greater use of (originally issued in January 2003) (‘‘fair conducted under PCAOB standards. estimates includes expanded use of fair value standard’’)—applies to auditing Subject to approval by the Commission, value measurements that need to be the measurement and disclosure of the new standard and related estimated. For purposes of this assets, liabilities, and specific amendments will take effect for audits rulemaking, a fair value measurement is components of presented or for fiscal years ending on or after considered a form of accounting disclosed at fair value in financial December 15, 2020. estimate because it generally shares statements. many of the same characteristics with • AS 2503, Auditing Derivative 2 See Amendments to Auditing Standards for Instruments, Hedging Activities, and Auditor’s Use of the Work of Specialists, PCAOB other estimates, including subjective Release No. 2018–006 (Dec. 20, 2018) (‘‘Specialists assumptions and measurement Investments in Securities (originally Release’’). uncertainty. issued in September 2000) (‘‘derivatives

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standard’’)—applies to auditing • Reviewing subsequent events or Over the past few years, some audit assertions for transactions. This generally involves firms have updated their methodologies, derivative instruments, hedging using events or transactions occurring often in response to identified activities, and investments in securities. subsequent to the date, inspection deficiencies. For example, in Its scope includes requirements for but prior to the date of the auditor’s the area of auditing the fair value of auditing the valuation of derivative report, to provide evidence about the financial instruments, some firms have instruments and securities, including reasonableness of the estimate.11 directed resources to implement more those measured at fair value. In general, the fair value standard, rigorous procedures to evaluate the The accounting estimates standard, which is the most recent of the process used by third-party pricing fair value standard, and derivatives estimates standards, sets forth more sources to determine the fair value of standard are referred to collectively as detailed procedures for the common financial instruments. the ‘‘estimates standards.’’ approaches described above. The level The PCAOB has observed diversity in In addition, the Board’s risk of detail within the fair value standard, how audit firms use information assessment standards,3 which set forth however, varies.12 For example, the fair obtained from third-party sources in requirements for the auditor’s value standard sets forth a number of auditing fair value measurements. Such assessment of and response to risk in an different requirements for testing third-party sources include pricing audit, include requirements that relate management’s process but only a few services and brokers or dealers, which to accounting estimates. These general requirements for developing an provide pricing information related to 16 requirements involve procedures independent estimate.13 the fair value of financial instruments. regarding identifying and assessing risks Some larger audit firms have The derivatives standard primarily implemented centralized approaches to of material misstatement in accounting addresses auditing derivatives. This 4 developing independent estimates of the estimates, identifying and evaluating standard also includes requirements for 5 fair value of financial instruments. misstatements in accounting estimates, auditing the valuation of derivatives and and evaluating potential management These firms may use centralized, investment securities, including national-level pricing desks or groups to bias associated with accounting valuations based on an investee’s 6 assist in performing procedures relating estimates. PCAOB standards also set financial results, and testing assertions forth requirements for the auditor to to testing the fair value of financial about securities based on management’s instruments. The level of information plan and perform his or her work with intent and ability.14 due professional care, which includes provided by these centralized groups to the application of professional Existing Practice engagement teams varies. In some cases, 7 the national-level pricing desk obtains skepticism. The PCAOB’s understanding of audit Both the accounting estimates pricing information from pricing practice at both larger and smaller audit standard and the fair value standard services at the request of the firms under existing PCAOB standards provide that the auditor may apply one engagement team. Additionally, has been informed by, among other or a combination of three approaches to national-level pricing desks may things, the collective experience of substantively test an accounting periodically provide information about PCAOB staff, observations from estimate: a pricing service’s controls and • Testing management’s process. This oversight activities of the Board, methodologies, and provide information generally involves: enforcement actions of the SEC, on current market conditions for • Evaluating the reasonableness of comments received on the SCP and different types of securities to inform an assumptions used by management that proposal, and discussions with the SAG engagement team’s risk assessment. In are significant to the estimate, and and audit firms. other cases, the national-level pricing testing and evaluating the completeness, Overview of Existing Practice desk itself may develop estimates of fair accuracy, and relevance of data used; 8 value for certain types of securities, and The PCAOB has observed through its assist audit teams with evaluating the • Evaluating the consistency of oversight activities that some audit specific methods and assumptions management’s assumptions with other firms’ policies, procedures, and related to a particular instrument, or information.9 guidance (‘‘methodologies’’) use evaluate differences between a • Developing an independent approaches that apply certain of the company’s price and price from a estimate. This generally involves using basic procedures for auditing fair value pricing source. Smaller audit firms that management’s assumptions, or measurements to other accounting do not have a national pricing group alternative assumptions, to develop an estimates (e.g., evaluating the method may engage valuation specialists to independent estimate or an expectation used by management to develop perform some or all of these functions. of an estimate.10 estimates).15 The PCAOB has also Some smaller firms use a combination observed that when testing of external valuation specialists and 3 The Board’s ‘‘risk assessment standards’’ management’s process, some auditors internal pricing groups. include AS 1101, Audit Risk; AS 1105; AS 1201; have developed expectations of certain Commenters generally did not AS 2101, Audit Planning; AS 2105, Consideration significant assumptions as an additional disagree with the description of current of in Planning and Performing an Audit; practice in the proposal. A few AS 2110, Identifying and Assessing Risks of consideration in evaluating the Material Misstatement; AS 2301, The Auditor’s reasonableness of those assumptions. commenters pointed to additional areas Responses to the Risks of Material Misstatement; where company and firm size and and AS 2810, Evaluating Audit Results. 11 See generally AS 2501.13 and AS 2502.41–.42. available resources can result in diverse 4 See generally AS 2110.13. 12 See generally AS 2502.26–.40. audit approaches (e.g., impairment 5 See AS 2810.13. 13 See generally AS 2502.40. testing, estimates of environmental 6 See AS 2810.27. 14 See generally AS 2503.28–.34 and .56–.57. 7 See generally paragraph .07 of AS 1015, Due 15 Notably, most of those firms base their 16 Another type of third-party source—specialists Professional Care in the Performance of Work. methodologies largely on the standards of the who develop independent estimates or assist in 8 See generally AS 2501 and AS 2502.26–.39. IAASB or the ASB, both of which have adopted one evaluating a company’s estimate or the work of a 9 Id. standard for auditing both fair value measurements company’s specialist—is addressed separately in 10 See generally AS 2501.12 and AS 2502.40. and other accounting estimates. the Specialists Release. See supra note 2.

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liabilities, and obtaining evidence issuer audits that observed deficiencies Similarly, the SEC has brought Rule related to complex transactions). in this area are decreasing, as compared 102(e) proceedings against auditors for to earlier years. Some audit firms have substantive failures in auditing Observations From Audit Inspections updated their audit practices in light of accounting estimates, including failures Through its oversight activities, the deficiencies identified through to obtain sufficient appropriate audit PCAOB has historically observed inspections. Not all firms have evidence for significant accounting numerous deficiencies in auditing improved their practices in this area, estimates in an entity’s estimates. Audit deficiencies however, and PCAOB inspections staff statements and failures to exercise due have been observed in both larger and has continued to observe deficiencies professional care, including professional smaller audit firms.17 similar to those described above. skepticism, throughout the audit.20 In PCAOB inspections staff has observed Inspection observations continue to some cases, the auditor (1) obtained audit deficiencies in issuer audits raise concerns about auditors’ little, if any, reliable or persuasive related to a variety of accounting application of professional skepticism, evidence with respect to management’s estimates, including -related including addressing potential adjustments to stale appraised values; estimates and reserves, the allowance management bias, in auditing (2) failed to identify and address bias in for loan losses, the fair value of financial accounting estimates. management’s estimates; or (3) failed to instruments, the valuation of assets and evaluate the results of audit procedures Observations From Enforcement Cases liabilities acquired in a business performed, including whether the combination, and long-lived Over the years, there have been a evidence obtained supported or impairments, inventory valuation number of enforcement actions by the contradicted estimates in the financial allowances, and equity-related PCAOB and SEC for violations of statements.21 transactions. Examples of such PCAOB standards in auditing deficiencies include failures to (1) accounting estimates, demonstrating the Reasons To Improve Auditing Standards sufficiently test the accuracy and importance of this aspect of the audit. The Board believes that its standards completeness of company data used in Enforcement actions have been brought for auditing accounting estimates, fair value measurements or other against larger and smaller firms, with including fair value measurements, can estimates, (2) evaluate the domestic and international practices. be improved to provide better direction reasonableness of significant PCAOB enforcement cases related to to auditors with respect to both the assumptions used by management, and auditing estimates have generally application of professional skepticism, (3) understand information provided by involved one or more of the following including addressing potential third-party pricing sources. In audits of violations (1) failure to perform any management bias, and the use of third- brokers or dealers, deficiencies include procedures to determine the party pricing information. failures to (1) obtain an understanding reasonableness of significant First, the differences in requirements of the methods and assumptions assumptions; (2) failure to test the among the three estimates standards internally developed or obtained by relevance, sufficiency, and reliability of suggest that revising PCAOB standards third parties that were used by the the data supporting the accounting to set forth a more uniform, risk-based broker or dealer to determine fair value estimates; (3) failure to perform a approach to auditing estimates can lead of securities, and (2) perform sufficient retrospective review of a significant to improvements in auditing practices procedures to test valuation of accounting estimate to determine for responding to the risks of material securities. The observed deficiencies are whether management’s judgments and misstatement in accounting estimates, frequently associated with, among other assumptions relating to the estimate whether due to error or fraud. things, a failure to appropriately apply indicated a possible bias; and (4) failure Second, because the subjective professional skepticism in auditing the to adequately consider contradictory assumptions and measurement estimates.18 evidence or perform procedures to uncertainty of accounting estimates More recently, there are some obtain corroboration for management make them susceptible to management indications in PCAOB inspections of representations regarding accounting bias, the Board believes that PCAOB estimates.19 standards related to auditing accounting 17 See, e.g., on the Interim estimates will be improved by Inspection Program Related to Audits of Brokers 19 See, e.g., Deloitte & Touche LLP, PCAOB emphasizing the application of and Dealers, PCAOB Release No. 2018–003 (Aug. Release No. 105–2018–008 (May 23, 2018); professional skepticism, including 20, 2018); PCAOB Staff Inspection Brief, Preview of Tarvaran Askelson & Company, LLP, Eric Askelson, addressing potential management bias. Observations from 2016 Inspections of Auditors of and Patrick Tarvaran, PCAOB Release No. 105– Issuers (Nov. 2017); and Annual Report on the 2018–001 (Feb. 27, 2018); David M. Burns, CPA, Interim Inspection Program Related to Audits of PCAOB Release No. 105–2017–055 (Dec. 19, 2017); 20, 2016); Arturo Vargas Arellano, CPC, PCAOB Brokers and Dealers, PCAOB Release No. 2017–004 Grant Thornton LLP, PCAOB Release No. 105– Release No. 105–2016–045 (Dec. 5, 2016); and (Aug. 18, 2017). See also Estimates Proposing 2017–054 (Dec. 19, 2017); Anthony Kam & Goldman Kurland and Mohidin, LLP and Ahmed Release at 12, footnote 39. Associates Limited, and Anthony KAM Hau Choi, Mohidin, CPA, PCAOB Release No. 105–2016–027 18 Audit deficiencies have also been observed by CPA, PCAOB Release No. 105–2017–043 (Corrected (Sept. 13, 2016). See also Estimates Proposing other regulators internationally. For example, an Copy) (Nov. 28, 2017); BDO Auditores, S.L.P., Release at 13, footnote 41. International Forum of Independent Audit Santiago San˜ e´ Figueras, and Jose´ Ignacio Alga´ s 20 See, e.g., Paritz & Company, P.A., Lester S. Regulators (‘‘IFIAR’’) survey released in 2018 Ferna´ ndez, PCAOB Release No. 105–2017–039 Albert, CPA, and Brian A. Serotta, CPA, SEC reported that accounting estimates was one of the (Sept. 26, 2017); Kyle L. Tingle, CPA, LLC and Kyle Accounting and Auditing Enforcement Release audit areas with the highest rate and greatest L. Tingle, CPA, PCAOB Release No. 105–2017–027 (‘‘AAER’’) No. 3899 (Sept. 21, 2017); KPMG LLP and number of findings. The most commonly observed (May 24, 2017); Wander Rodrigues Teles, PCAOB John Riordan, CPA, SEC AAER No. 3888 (Aug. 15, deficiencies related to failures to assess the Release No. 105–2017–007 (Mar. 20, 2017); KAP 2017); William Joseph Kouser Jr., CPA, and Ryan reasonableness of assumptions, including Purwantono, Sungkoro & Surja, Roy Iman James Dougherty, CPA, AAER No. 3864 (Apr. 4, consideration of contrary or inconsistent evidence Wirahardja, and James Randall Leali, PCAOB 2017); Grassi & Co., CPAs, P.C., SEC AAER No. where applicable; sufficiently test the accuracy of Release No. 105–2017–002 (Feb. 9, 2017); HJ & 3826 (Nov. 21, 2016). See also Estimates Proposing data used; perform sufficient risk assessment Associates, LLC, S. Jeffrey Jones, CPA, Robert M. Release at 14, footnote 42. procedures; take relevant variables into account; Jensen, CPA, and Charles D. Roe, CPA, PCAOB 21 See, e.g., Miller Energy Resources, Inc., Paul W. evaluate how management considered alternative Release No. 105–2017–001 (Jan. 24, 2017); Arshak Boyd, CPA, David M. Hall, and Carlton W. Vogt, III, assumptions; and adequately consider indicators of Davtyan, Inc. and Arshak Davtyan, CPA, PCAOB CPA, SEC AAER Nos. 3780 (June 7, 2016) and 3673 bias. See IFIAR, Report on 2017 Survey of Release No. 105–2016–053 (Dec. 20, 2016); David C. (Aug. 6, 2015); Grant Thornton, LLP, SEC AAER No. Inspection Findings (Mar. 9, 2018), at 10 and B–6. Lee, CPA, PCAOB Release No. 105–2016–052 (Dec. 3718 (Dec. 2, 2015).

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Although the risk assessment standards to the persistence of audit deficiencies commenters, however, asserted that the and certain other PCAOB standards associated with auditing estimates and standard is sufficiently scalable. address professional skepticism and fair value measurements. The Board believes that the new management bias, the estimates The Board believes that a pattern of standard is well-tailored to address an standards provide little or no specific deficiencies over time raises questions increasingly significant and challenging direction on how to address those topics about whether professional skepticism area of the audit. The new standard is in the context of auditing accounting is being appropriately applied and about designed to be scalable because the estimates. overall audit quality in this area, and necessary audit evidence depends on Third, existing requirements do not supports the view that estimates are a the corresponding risks of material provide specific direction about how to challenging area of the audit. More misstatement. The new standard does evaluate the relevance and reliability of specific direction should contribute to not prescribe detailed procedures or the pricing information from third parties. more consistent, risk-based execution extent of procedures, beyond the PCAOB standards should be improved and improved audit quality. requirement to respond to risk, by revising the requirements in this area Some commenters questioned the including significant risk, and direction to drive a level of work effort need for the proposal citing, among for applying the primary approaches to commensurate with both the risks of other things, insufficient evidence that testing. Rather, it builds on the existing material misstatement in the valuation existing standards are deficient and the requirements of AS 2301 under which of financial instruments and the loss of certain content from the the auditor designs procedures that take relevance and reliability of the evidence estimates standards that the commenters into account the types of potential obtained. considered to be useful. One commenter misstatements that could result from the The Board received 38 comment argued that the standards for fair value identified risks and the likelihood and letters on the proposal. A number of measurements should be differentiated magnitude of potential misstatement.22 commenters supported the Board’s from the standards for other accounting Specific risk factors associated with the efforts to strengthen auditing practices estimates because the goals of the estimates—for example, subjective and update its standards related to standards are fundamentally different. assumptions, measurement uncertainty, estimates and fair value measurements. The Board believes it is appropriate to or complex processes or methods23— For example, investor groups asserted apply a more uniform approach to the affect the auditor’s risk assessment and that the proposal will strengthen auditor audit of accounting estimates, including in turn, the required audit effort. responsibilities, improve audit quality, fair value measurements, including by Aligning the new standard and related and further investor protection. Other bringing the requirements together into amendments with the risk assessment commenters pointed to better a single standard. The estimates standards directs auditors to focus on integration and alignment with the risk standards already reflect common estimates with greater risk of material assessment standards, noting, for approaches to substantive testing. While misstatement. The new standard allows example, that a risk-based approach to the level of detail varies across the three auditors to tailor their approach to best auditing estimates will help to resolve standards, these differences do not respond to identified risks and the differences in requirements among derive from differences in the assessed effectively obtain sufficient appropriate the current standards. Some risks of material misstatement. The evidence. To the extent the new commenters supported combining the Board believes that a single standard standard results in increased audit three existing standards into a single will promote auditor performance that effort, that effort should be scaled in standard, for example, because it would is more consistently responsive to risk. relation to the relevant risks, and any make the requirements easier to The new standard also includes an associated costs should be justified in navigate and comply with. Some appendix on valuation of financial light of the benefits of appropriate audit commenters also expressed support for instruments that provides specific attention and the appropriate the incremental direction in the direction in that area. application of professional skepticism. proposal on matters related to financial Some commenters asserted that the Some commenters also challenged the instruments, including the use of proposal would lead to unnecessary anticipated benefits of the proposal, pricing information from third parties as expansion of procedures and thus arguing that additional audit work audit evidence. increased costs. For example, one of would not improve the quality of Some commenters on the proposal those commenters contended that the financial reporting, given the inherent challenged the relevance of inspection proposed requirements could affect the uncertainty and subjectivity experience to the Board’s consideration ability of smaller accounting firms to surrounding estimates. of the new standard. For example, two audit certain types of issuers. Another The new standard and related commenters questioned whether the commenter cautioned against a one-size- amendments acknowledge that existence of audit deficiencies related to fits-all audit approach, expressing estimates have estimation uncertainty estimates warrant revision to the concern about expecting the same level and that it affects the risks of material estimates standards. Another of rigor in developing accounting misstatement. Neither the Board nor commenter suggested that development estimates from both the largest and auditors are responsible for placing of standards should be based on areas smallest public companies. One limits on the range of estimation where audit quality can be improved in commenter challenged the scalability of uncertainty. That uncertainty is a order to protect the public interest, not the proposal, arguing that auditors will function of the estimate’s measurement just through areas that have been assume that all listed factors and requirements under the applicable identified during the inspection process. considerations will have to be addressed financial reporting framework, the In contrast, other commenters expressed in every audit, and that nothing in the economic phenomena affecting that concern over continued audit proposal directed the auditor to estimate, and the fact that it involves deficiencies observed in this area and consider cost-benefit implications or assessments of future outcomes. Under supported the development of the whether further testing and analysis proposal. Another commenter argued would meaningfully improve the 22 AS 2301.09. that a lack of clarity in the estimates auditor’s ability to assess the 23 See paragraph AS 2110.60A, as amended, for standards might be a contributing factor reasonableness of an estimate. Other examples of specific risk factors.

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the new standard and related features of management bias), and those regard, the new standard and related amendments, the auditor will consider that cannot be addressed (e.g., time amendments will: estimation uncertainty in assessing risk constraints, limits on available • Amend AS 2110 to require a and performing procedures in response information). discussion among the key engagement to risk, which involves evaluating The Board acknowledges that given team members of how the financial whether the accounting estimates are the subjective assumptions and statements could be manipulated reasonable in the circumstances and in measurement uncertainty inherent in through management bias in accounting conformity with the applicable financial many estimates, bias cannot be estimates in significant accounts and reporting framework, as well as eliminated entirely. However, a disclosures. evaluating potential management bias in standard that reinforces the importance • Emphasize certain key requirements accounting estimates, and its effect on of professional skepticism, including to focus auditors on their obligations, the financial statements. These addressing the potential for when evaluating audit results, to responsibilities align with the auditor’s management bias, when auditing exercise professional skepticism, overall responsibility for planning and estimates will remind auditors of their including evaluating whether performing financial statement audits. existing responsibilities to evaluate management bias exists. Commenters generally acknowledged contradictory evidence and to address • Remind auditors that audit the Board’s efforts to emphasize the effects of bias on the financial evidence includes both information that professional skepticism, including statements. supports and corroborates the addressing management bias, in the Some commenters suggested that the company’s assertions regarding the proposal and provided varying views on standard include guidance on financial statements and information related aspects of the proposal. Some identifying and testing relevant controls that contradicts such assertions. commenters, for example, indicated that over accounting estimates. For example, • Require the auditor to identify the proposal should place even more one commenter suggested guidance significant assumptions used by the emphasis on the need to challenge related to auditor consideration of company and describe matters the management or the consideration of management’s controls over selection auditor should take into account when management bias, noting the existence and supervision of a company identifying those assumptions. of overly optimistic or skewed estimates specialist. Another commenter • Provide examples of significant in financial statements. One commenter suggested additional guidance on assumptions (important to the advocated for more discussion within identification and testing of relevant recognition or measurement of the the standard of the various types of bias controls, and identification and accounting estimate), such as that can affect auditing estimates. response to risks of material assumptions that are susceptible to In contrast, other commenters misstatement due to fraud in relation to manipulation or bias. asserted that the proposal auditing estimates. • Emphasize requirements for the overemphasized the need for The auditor’s responsibilities for auditor to evaluate whether the professional skepticism, or had a testing controls are already addressed in company has a reasonable basis for the negative tone that assumed a AS 2110, AS 2301, and AS 2201, An significant assumptions used and, when predisposition to management bias. One Audit of Internal Control Over Financial applicable, for its selection of commenter pointed out other practices Reporting That Is Integrated with An assumptions from a range of potential and requirements that, in the Audit of Financial Statements. These assumptions. commenter’s view, mitigate the risk of requirements apply to controls over • Explicitly require the auditor, when management bias, among them CEO and accounting estimates. Those developing an independent expectation CFO certification, management responsibilities are not altered by the of an accounting estimate, to have a reporting and auditor attestation on new standard and related amendments. reasonable basis for the assumptions internal control over financial reporting, However, after considering the and method he or she uses. , and audit committee comments, an amendment was made to • Require that the auditor obtain an oversight. Some of these commenters provide additional direction on testing understanding of management’s analysis expressed concern that the emphasis on controls related to auditing estimates. of critical accounting estimates and take professional skepticism would lead to that understanding into account when Overview of Final Rules unnecessary expansion of audit evaluating the reasonableness of procedures. The Board has adopted a single significant assumptions and potential A few commenters also argued that standard to replace the accounting management bias. management bias is inherent in estimates standard, the fair value • Recast certain existing requirements accounting estimates and cannot be standard, and the derivatives standard. using terminology that encourages eliminated. One of the commenters As described in more detail below, AS maintaining a skeptical mindset, such as added that, for those reasons, the 2501 (Revised) includes a special topics ‘‘evaluate’’ and ‘‘compare’’ instead of proposed requirements addressing appendix that addresses certain matters ‘‘corroborate.’’ management bias should not apply to relevant to auditing the fair value of • Strengthen requirements for estimates made pursuant to the new financial instruments. In addition, evaluating whether data was accounting standard on credit losses.24 several PCAOB auditing standards will appropriately used by a company that Another commenter suggested that the be amended to align them with the new build on requirements in the fair value proposal should differentiate between standard on auditing accounting standard, and include a new limitations that an auditor can address estimates. The new standard and related requirement for evaluating whether a (e.g., analytical ability), those that can amendments will make the following company’s change in the source of data be partially addressed (e.g., some changes to existing requirements: is appropriate. • Provide direction to prompt • Clarify the auditor’s responsibilities 24 See Financial Accounting Standards Board auditors to devote greater attention to for evaluating data that build on the (‘‘FASB’’) Accounting Standards Update No. 2016– addressing potential management bias existing requirements in AS 1105. 13, Financial Instruments—Credit Losses (Topic • 326): Measurement of Credit Losses on Financial in accounting estimates, as part of Amend AS 2401, Consideration of Instruments (June 2016). applying professional skepticism. In this Fraud in a Financial Statement Audit,

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to clarify the auditor’s responsibilities accounting estimates, consistent with • Establish requirements to determine when performing a retrospective review AS 2110. whether pricing information obtained of accounting estimates and align them • Remind auditors of their from third parties, such as pricing with the requirements in the new responsibility to evaluate conformity services and brokers or dealers, provides standard. with the applicable financial reporting sufficient appropriate evidence, • Extend certain key requirements in framework, reasonableness, and including: the fair value standard to other potential management bias and its effect • Focus auditors on the relevance and accounting estimates in significant on the financial statements when reliability of pricing information from accounts and disclosures to reflect a responding to the risks of material third-party sources,25 regardless of more uniform approach to substantive misstatement in accounting estimates in whether the pricing information was testing. For estimates not currently significant accounts and disclosures. obtained by the company or the auditor. subject to the fair value standard, this • Require the auditor, when • Establish factors that affect will: identifying significant assumptions, to relevance and reliability of pricing • Refine the three substantive take into account the nature of the information obtained from a pricing approaches common to the accounting accounting estimate, including related service. estimates standard to include more risk factors, the applicable financial • Require the auditor to perform specificity, similar to the fair value reporting framework, and the auditor’s additional audit procedures to evaluate standard. understanding of the company’s process the process used by the pricing service • Describe the auditor’s for developing the estimate. when fair values are based on responsibilities for testing the • Include matters relevant to transactions of similar financial individual elements of the company’s identifying and assessing risks of instruments. process used to develop the estimate material misstatement related to the fair • Require the auditor to perform (i.e., methods, data, and significant value of financial instruments. additional procedures on pricing assumptions). • Add a note in AS 2301 to information obtained from a pricing • Set forth express requirements for emphasize that performing substantive service when no recent transactions the auditor to evaluate the company’s procedures for the relevant assertions of have occurred for either the financial methods for developing the estimate, significant accounts and disclosures instrument being valued or similar including whether the methods are: involves testing whether the significant financial instruments. • In conformity with the accounts and disclosures are in • Establish conditions under which requirements of the applicable financial conformity with the applicable financial less information is needed about reporting framework; and reporting framework. particular methods and inputs of • Appropriate for the nature of the • Add a note to AS 2301 providing individual pricing services in related account or disclosure, taking that for certain estimates involving circumstances where prices are obtained into account the auditor’s complex models or processes, it might from multiple pricing services. understanding of the company and its be impossible to design effective • Establish factors that affect the environment. substantive tests that, by themselves, relevance and reliability of quotes from • Require the auditor to take into would provide sufficient appropriate brokers or dealers. account certain factors in determining evidence regarding the assertions. • Require the auditor to understand, whether significant assumptions that are • Make other updates to the if applicable, how unobservable inputs based on the company’s intent and requirements for auditing accounting were determined and evaluate the ability to carry out a particular course of estimates, including: reasonableness of unobservable inputs. action are reasonable. • Update the description of what The Board seeks to improve the • Further integrate requirements with constitutes an accounting estimate to quality of auditing in this area and the risk assessment standards to focus encompass the general characteristics of believes these changes strengthen and auditors on estimates with greater risk the variety of accounting estimates, enhance the requirements for auditing of material misstatement. The new including fair value measurements, in accounting estimates. standard and related amendments financial statements. Commenters largely supported a incorporate specific requirements • Set forth specific requirements for single, more uniform standard to relating to accounting estimates into AS evaluating data and pricing information address auditing accounting estimates, 2110 and AS 2301 to inform the used by the company or the auditor that including fair value measurements. For necessary procedures for auditing build on the existing requirements in example, one commenter observed that accounting estimates. Specifically, the AS 1105. the existence of three related standards new standard and related amendments • Establish more specific in this area made it difficult for auditors would: requirements for developing an to navigate to be certain that all • Amend AS 2110 to include risk independent expectation that vary requirements were met. A few factors specific to identifying significant depending on the source of data, commenters, however, asserted that fair accounts and disclosures involving assumptions, or methods used by the value measurements and derivatives are accounting estimates. auditor and build on AS 2810 to provide unique and involve different functions. • Align the scope of the new standard a requirement when developing an One of those commenters also expressed with AS 2110 to apply to accounting independent expectation as a range. concern about applying audit estimates in significant accounts and • Relocate requirements in the procedures in the fair value standard to disclosures. derivatives standard for obtaining audit other accounting estimates. The new • Amend AS 2110 to set forth evidence when the valuation of standard takes into account the unique requirements for obtaining an investments is based on investee results understanding of the company’s process as an appendix to AS 1105. 25 The requirements in this area focus primarily for determining accounting estimates. • Provide specific requirements and on pricing information from pricing services and • direction to address auditing the fair brokers or dealers, but also cover pricing Require auditors to respond to information obtained from other third-party pricing significantly differing risks of material value of financial instruments, sources, such as exchanges and publishers of misstatement in the components of including: exchange prices.

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aspects of auditing fair value consistency in practice, and suggested Comparison With Standards of Other measurements, such as the use of continued coordination of efforts in this Standard Setters observable and unobservable inputs. area. The Board considered the IAASB’s Further, the new standard includes a ISA 540 project while developing the The scope and nature of accounting separate appendix that addresses new standard. While there is some estimates described in ISA 540 Revised, auditing the fair value of financial commonality between the new standard AU–C Section 540, and the new instruments. and ISA 540 Revised, the new standard standard share some common concepts. Some commenters requested is aligned with the Board’s risk However, the accounting estimates covered by the new standard are supplemental or implementation assessment standards and designed for expressly linked to significant accounts guidance for various requirements audits of issuers and SEC-registered presented in the proposed standard and and disclosures. brokers and dealers. the related amendments. Several commenters also advocated for retaining Following is a discussion of Objective of the Standard portions of the derivatives standard that, significant comments received on the See Paragraph .03 in their view, provided helpful proposal along with revisions made by guidance. Two commenters suggested the Board after consideration of those In the proposal, the standard included that the Board consider issuing comments and additional guidance on a detailed objective expressly guidance specific to the audits of the implementation of the requirements addressing the fundamental aspects of brokers and dealers.26 of the new standard. The subsections auditing accounting estimates under the A few commenters observed that the also include a comparison of the final estimates standards: Testing and proposal did not explicitly address how requirements with the analogous evaluating whether accounting advances in technology, including use requirements of the following standards estimates (1) are reasonable in the of data analytics, could affect audit issued by the IAASB and the Auditing circumstances, (2) have been accounted procedures. In its consideration of the Standards Board (‘‘ASB’’) of the for and disclosed in conformity with the new standard and related amendments, American Institute of Certified Public applicable financial reporting the Board is mindful of the significant Accountants: framework, and (3) are free from bias advances in technology that have • that results in material misstatement. occurred in recent years, including ISA 540 Revised, adopted by the IAASB; and Commenters asserted that including increased use of data analysis tools and the phrase ‘‘free from bias that results in emerging technologies. An increased • AU–C Section 540, Auditing material misstatement’’ as a distinct use of these technology-based tools, Accounting Estimates, Including Fair element of the audit objective was not together with future developments in Value Accounting Estimates, and clear, could imply absolute assurance, the use of data and technology, could Related Disclosures (‘‘AU–C Section or could be interpreted as a broader have a fundamental impact on the audit 540’’), adopted by the ASB of the obligation than what is required under process. The Board is actively exploring American Institute of Certified Public the existing standards. Some these potential impacts through ongoing Accountants. staff research and outreach.27 commenters recommended deleting the In the context of this rulemaking, the The comparison does not necessarily reference to bias from the objective, and Board considered how changes in represent the views of the IAASB or others suggested revisions in order to technology could affect the approaches ASB regarding the interpretation of their clarify the intent of including the to auditing accounting estimates. The standards. Additionally, the information reference to bias in the objective. One Board believes that the new standard presented in the subsections does not commenter suggested that the objective and related amendments are sufficiently include the application and explanatory should be for auditors to determine principles-based and flexible to material in the IAASB standards or ASB whether accounting estimates and accommodate continued advances in standards.30 disclosures are reasonable in the context the use of data and technology by both of the applicable financial reporting AS 2501 (Revised) companies and auditors. The Board will framework, which in the commenter’s continue to monitor advances in this Scope of the Standard view would be broader than the area and any implications related to the proposed objective. See Paragraphs .01–.02 standard.28 After consideration of comments, the Some commenters advocated for As in the proposal, the new standard Board has (1) revised the objective to greater alignment of the proposal with applies when auditing accounting describe the overall purpose of the the IAASB’s exposure draft on estimates in significant accounts and procedures required under the new International Standard on Auditing 540 disclosures. Commenters on this topic standard and other relevant procedures 29 (‘‘ISA 540’’) to achieve greater supported the scope set forth in the under the risk assessment standards standard. (specifically, to determine whether 26 See below for further discussion of the accounting estimates in significant comments received on specific requirements and additional guidance on the implementation of the Related Disclosures, (Apr. 20, 2017). In October accounts and disclosures are properly requirements in the new standard. 2018, the IAASB released the final standard (‘‘ISA accounted for and disclosed in financial 27 For example, the staff is currently researching 540 Revised’’). statements); 31 (2) relocated the the effects on the audit of, among other things, data 30 Paragraph A59 of ISA 200, Overall Objectives description of more specific auditor analytics, artificial intelligence, and distributed of the Independent Auditor and the Conduct of an technology, assisted by a task force of the Audit in Accordance with International Standards responsibilities—evaluating conformity SAG. See Data and Technology Task Force on Auditing, and paragraph .A64 of AU–C Section with the applicable financial reporting overview page, available on the Board’s website. 200, Overall Objectives of the Independent Auditor framework, reasonableness, and 28 See PCAOB, Changes in Use of Data and and the Conduct of an Audit in Accordance with potential management bias—from the Technology in the Conduct of Audits, available at Generally Accepted Auditing Standards, indicate https://pcaobus.org/Standards/research-standard- that the related application and other explanatory setting-projects/Pages/technology.aspx. material ‘‘does not in itself impose a requirement’’ 31 This approach to formulating an objective is 29 See IAASB Exposure Draft, Proposed ISA 540 but ‘‘is relevant to the proper application of the similar to the approach in other PCAOB standards. (Revised), Auditing Accounting Estimates and requirements’’ of the respective standards. See, e.g., paragraph .02 of AS 2410, Related Parties.

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objective to the requirements; 32 and (3) AS 2501 (Revised) retains paragraph significantly differing risks of material provided additional context in the .04 as proposed, including the reference misstatement in the components of an requirements to enhance clarity, to components of estimates. This accounting estimate, and (3) applying including citing corresponding reference is not new and derives from professional skepticism in gathering and requirements in other PCAOB the concept in the risk assessment evaluating audit evidence, particularly standards. In addition, for conciseness, standards that components of a when responding to fraud risks. The the new standard and amendments have potential significant account or proposed standard also reminded been revised to consistently use the disclosure might be subject to auditors that, as the assessed risk of phrase ‘‘sufficient appropriate significantly differing risks 35 which material misstatement increases, the evidence,’’ which has the same meaning would need to be taken into account in evidence that the auditor should obtain in PCAOB standards as the phrase designing and performing audit also increases. The evidence provided ‘‘sufficient appropriate audit evidence.’’ procedures. For example, a valuation by substantive procedures depends on As discussed in more detail below, allowance in the company’s financial the mix of the nature, timing, and extent the revised objective links more closely statements may include a general of those procedures. with the requirements of the risk component and a specific component Commenters provided views on assessment standards 33 and continues with differing risks. various aspects of the proposed to focus auditors on their existing requirements. One commenter asked for obligations to evaluate potential Comparison With Standards of Other clarification on the role of professional management bias in the context of Standard Setters skepticism in relation to fraud risks and auditing accounting estimates. In identifying and assessing the risks management bias. Another commenter advocated for a framework against Comparison With Standards of Other of material misstatement, ISA 540 which auditor skepticism can be Standard Setters Revised requires the auditor to separately assess inherent risk and evaluated. Other commenters suggested The objective of ISA 540 Revised is to control risk. The auditor is required to including requirements to evaluate both obtain sufficient appropriate audit take into account, in assessing inherent corroborative and contradictory audit evidence about whether accounting risk (a) the degree to which the evidence similar to AS 1105.02. A few estimates and related disclosures in the accounting estimate is subject to commenters also requested clarification financial statements are reasonable in estimation uncertainty, and (b) the of how substantive procedures related to the context of the applicable financial degree to which (i) the selection and accounting estimates can be performed reporting framework. The objective of application of the method, assumptions at an interim date. AU–C Section 540 is substantially the and data in making the accounting The new standard retains the same but also includes whether related estimate; or (ii) the selection of discussion of the auditor’s disclosures in the financial statements management’s point estimate and responsibilities for responding to risks are adequate. related disclosures for inclusion in the associated with estimates substantially Identifying and Assessing Risks of financial statements, are affected by as proposed. The statements in the new Material Misstatement complexity, subjectivity, or other standard related to responding to the 36 risks of material misstatement are rooted See Paragraph .04 inherent risk factors. AU–C Section 540 requires the in the Board’s risk assessment standards The proposed standard discussed how auditor to evaluate the degree of and drew no critical comments. The new standard reflects two the auditor’s responsibilities regarding estimation uncertainty associated with changes from the proposal. As noted the process of identifying and assessing an accounting estimate in identifying above, the description of more specific risks of material misstatement, as set and assessing the risks of material auditor responsibilities—evaluating forth in AS 2110 apply to auditing misstatement. accounting estimates. The proposed conformity with the applicable requirement provided that, among other Responding to the Risks of Material accounting framework, reasonableness, things, identifying and assessing risks of Misstatement and potential management bias—has been relocated from the objective to material misstatement related to See Paragraphs .05–.07 accounting estimates includes paragraph .05 to provide additional determining whether the components of The proposed standard explained context for responding to risks of estimates in significant accounts and how the basic requirement in AS 2301 material misstatement. Specifically, the disclosures are subject to significantly to respond to the risks of material new standard states that responding to differing risks, and which estimates are misstatement applies when performing risks of material misstatement involves associated with significant risks.34 substantive procedures for accounting evaluating whether the accounting One commenter asserted that the term estimates in significant accounts and estimates are in conformity with the ‘‘components’’ should be defined and disclosures. Additionally, the proposal applicable financial reporting another commenter observed that provided that responding to risks of framework and reasonable in the ‘‘components of estimates’’ could be material misstatement in the context of circumstances, as well as evaluating interpreted to mean inputs used to accounting estimates involves, among potential management bias in develop the estimate, or individual other things, (1) testing whether accounting estimates and its effect on accounts that roll up into a financial estimates in significant accounts and the financial statements. Notably, the statement line item. disclosures are in conformity with the added language regarding potential applicable financial reporting management bias is aligned with 32 See first note to paragraph .05 of the new framework, (2) responding to paragraphs AS 2810.24–.27 to remind standard. auditors of existing requirements. 33 See supra note 3. The risk assessment 35 See AS 2110.63. Additionally, the new standard now standards set forth requirements relating to the 36 ISA 540 Revised and AU–C Section 540 also includes a reference to AS 1105.02, as auditor’s assessment of, and response to, the risks include requirements related to identification of of material misstatement in the financial significant risks related to accounting estimates. AS suggested by some commenters, statements. 2110 sets forth requirements for identifying reminding auditors that audit evidence 34 See AS 2110.70–.71. significant risks under PCAOB standards. consists of both information that

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supports and corroborates measurement uncertainty, or complex requirement may lead auditors to test management’s assertions regarding the processes or methods 38—would affect management’s process substantively, financial statements and information the auditor’s risk assessment and in regardless of whether another approach that contradicts such assertions. turn, the required audit effort. For will provide the same or more With respect to the comments example: persuasive audit evidence. Two regarding guidance on professional • Testing a simple calculation of commenters stressed the importance of skepticism and performing procedures , including developing an independent expectation at interim dates, other PCAOB standards evaluating remaining useful lives, for a and suggested this approach be selected already address the auditor’s group of assets of the same type with in addition to testing the company’s responsibilities in those areas, and the similar usage and condition would process. None of these commenters, new standard does not change that generally require less audit effort than however, suggested that the selection of direction with respect to auditing testing asset retirement obligations that substantive approaches should be estimates. For example, paragraphs .07– involve significant assumptions about limited. .09 of AS 1015, Due Professional Care costs not yet incurred based on Some commenters sought further in the Performance of Work, paragraph estimation of the probability of future direction on how the auditor would .13 of AS 2401, and AS 2301.07 address events. obtain sufficient evidence when using a the appropriate application of • In testing the valuation of assets combination of approaches, with some professional skepticism, and AS acquired and liabilities assumed in a commenters asserting that, for example, 2301.43–.46 discusses the auditor’s business combination, more audit effort the proposed requirement might result responsibilities when performing would need to be directed to assets and in inconsistent application or auditors substantive procedures at an interim liabilities whose valuation involves unnecessarily performing all procedures date. Those standards apply when more subjective assumptions, such as under each approach. One commenter auditing accounting estimates. identifiable intangible assets and asked the Board to clarify whether documentation of a specific testing Scalability of the Standard contingent consideration, than to assets with readily determinable values. approach is expected. In response to questions in the Additionally, the new standard Some commenters also requested proposal, commenters expressed mixed echoes language from AS 2301.37 in guidance on the application of specific views on the scalability of the proposed stating that, as the assessed risk of testing approaches. For instance, one requirements. Some commenters material misstatement increases, the commenter suggested that the Board indicated that the proposed evidence from substantive procedures consider directing auditors to always requirements were sufficiently scalable, that the auditor should obtain also evaluate audit evidence from events or while others identified challenges in increases. Consistent with AS 2301, for transactions occurring after the scaling the auditor’s response to an individual accounting estimate, measurement date related to the identified risks in accounting estimates different combinations of the nature, accounting estimate, as, in their view, and requested additional guidance. For timing, and extent of testing might there would be limited circumstances in example, some commenters opined that provide sufficient appropriate evidence which this approach would not provide it was not clear how auditors would to respond to the assessed risk of appropriate audit evidence to determine tailor their response to an estimate that material misstatement for the relevant whether accounting estimates are represented a significant risk of material assertion. reasonable. Another commenter added misstatement compared with a lower that events occurring after the risk estimate. One commenter advocated Selection of Approaches measurement date may effectively for further guidance to address The proposed standard retained the eliminate estimation uncertainty, which situations where an estimate is deemed requirement to test accounting estimates affects risk assessment and the audit to have a low inherent risk. Another using one or a combination of three response related to valuation. This commenter indicated that it is important basic approaches from the estimates commenter suggested the proposal to recognize that the amount of evidence standards: (1) Testing the company’s clarify the extent of additional may not necessarily increase, but the process, (2) developing an independent procedures required, if any, when such persuasiveness and sufficiency of the expectation, and (3) evaluating audit events are considered and tested. evidence should increase. evidence from events or transactions One commenter suggested more The new standard is designed to be occurring after the measurement date. guidance be provided about how an scalable because the necessary audit The proposed standard also included a auditor’s understanding of evidence depends on the corresponding note reminding auditors that their management’s process affects the risk of material misstatement. The understanding of the process the auditor’s planned response to assessed standard does not prescribe detailed company used to develop the estimate, risk in accordance with AS 2301. This procedures or the extent of procedures, along with results of tests of relevant commenter also observed that the note beyond the requirement to respond to controls, should inform the auditor’s to paragraph .07 may be read to mean the risk, including significant risk, and decisions about the approach he or she that relevant controls are expected to be the direction for applying the primary takes to auditing an estimate. tested in all audits and suggested a approaches for testing. Rather, it builds Several commenters expressed footnote reference to relevant on the requirements of AS 2301 to support for retaining the three common requirements of AS 2301. design procedures that take into account approaches, as set forth in the proposal. The new standard retains the the types of potential misstatements that Other commenters indicated that the requirements for testing accounting could result from the identified risks proposal should emphasize that testing estimates substantially as proposed, and the likelihood and magnitude of the company’s process may not always allowing the auditor to determine the potential misstatement.37 Specific risk be the best audit approach; with one approach or combination of approaches factors associated with the estimates— commenter noting that the proposed appropriate for obtaining sufficient for example, subjective assumptions, appropriate evidence to support a 38 See AS 2110.60A, as amended, for examples of conclusion about the particular 37 AS 2301.09. specific risk factors. accounting estimate being audited. The

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new standard takes into account that controls in a financial statement audit. Testing the Company’s Process Used To accounting estimates vary in nature and The new standard does not change those Develop the Accounting Estimate in how they are developed. Therefore, responsibilities, including the See Paragraph .09 mandating a particular testing approach circumstances under which the auditor may not be feasible or practical in the is required to test controls. Rather, the The proposed standard included an circumstances. For example, in some standard emphasizes that the results of introductory statement explaining the cases, data and significant assumptions the auditor’s tests of controls can affect purpose of and steps involved in testing underlying the estimate may be largely the nature, timing and extent of planned the company’s process. Specifically, the based on a company’s internal substantive procedures. Further, the standard explained that testing the information (e.g., sales projections or auditor’s understanding of the company’s process involves performing employee data), or the estimate may be company’s process related to an procedures to test and evaluate the generated using a customized company- estimate can provide insight into the methods, data, and significant specific model. In those situations, the nature and extent of available audit assumptions used to develop the auditor may not have a reasonable evidence, and thus inform the auditor’s company’s estimate in order to form a alternative to testing the company’s selection of approaches. conclusion about whether the estimate process. Similarly, there may not be any Lastly, the new standard does not set is reasonable in the circumstances, in events or transactions occurring after forth requirements for audit conformity with the applicable financial the measurement date related to certain documentation. The auditor’s reporting framework, and free from bias estimates (e.g., the outcome of a responsibilities with respect to audit that results in material misstatement. contingent liability might not be known documentation are addressed in AS Similar to the comments received on for a number of years). Rather than 1215, Audit Documentation. the proposed objective, some imposing limits on the selection of Accordingly, audit documentation commenters expressed concerns about approaches, the new standard describes relevant to selection of approaches the phrase ‘‘free from bias that results in the auditor’s responsibilities for should be evident to an experienced material misstatement’’ when describing appropriately applying the selected auditor, having no previous connection the auditor’s responsibilities in this approach, or combination of with the engagement.40 area. One commenter also asked approaches, to obtain sufficient whether these requirements would Comparison With Standards of Other apply to assumptions, models, and data appropriate evidence and performing an Standard Setters appropriate evaluation of the evidence provided by a company specialist. obtained. ISA 540 Revised requires the auditor’s Another commenter sought clarification As under the estimates standards, the procedures to be responsive to the on the meaning of the terms ‘‘test,’’ new standard allows for the auditor to assessed risks of material misstatement ‘‘data,’’ and ‘‘assumptions.’’ use a combination of approaches to test at the assertion level, considering the As with the objective of the standard, an estimate. For example, some reasons for the assessment given to paragraph .09 of the new standard was estimates consist of multiple those risks, and include one or more of revised to describe an overarching components (e.g., valuation allowances) the three approaches to substantive concept for testing the company’s and the auditor may vary the testing (similar to the new standard).41 process—that is, to form a conclusion approaches used for the individual ISA 540 Revised also includes a about whether the estimate is properly components. The auditor may also requirement for the auditor to take into accounted for and disclosed in financial choose to develop an independent account that the higher the assessed risk statements. These revisions are expectation of a significant assumption of material misstatement, the more responsive to comments and link the used by the company in conjunction persuasive the audit evidence needs to auditor’s responsibilities more closely to with testing the company’s process for be. The auditor is required to design and the requirements of the Board’s risk developing the estimate. Whether using perform further audit procedures in a assessment standards. a combination of approaches or a single manner that is not biased towards As discussed in more detail below, approach, the auditor is required to obtaining audit evidence that may be the new standard directs the auditor to have a reasonable basis for using corroborative or towards excluding look to the requirements in Appendix A 42 alternative methods or deriving his or audit evidence that may be of AS 1105 for the auditor’s her own assumptions, as discussed in contradictory. responsibilities with respect to using the more detail below. Similarly, when AU–C Section 540 requires the work of a company’s specialist in the using information produced by the auditor to determine whether audit. This direction has been modified company as audit evidence, the auditor management has appropriately applied from the proposal to align with changes is required to evaluate whether that the requirements of the applicable to the Specialists Release. information is sufficient and financial reporting framework relevant Finally, the meaning of the terms appropriate for the purposes of the to the accounting estimate. In ‘‘test,’’ ‘‘data,’’ and ‘‘assumptions’’ in audit, regardless of the approach the responding to the assessed risks of the new standard is consistent with the auditor uses to test the estimate.39 material misstatement, AU–C Section meaning of these terms used in the The new standard also carries forward 540 also requires the auditor to estimates standards and other PCAOB the point from the accounting estimate undertake one or more of the three standards. approaches discussed above, as well as standard that the auditor’s Comparison With Standards of Other providing an approach to perform a understanding of the company’s process Standard Setters for developing the estimate, and, if combination of tests of controls over the relevant controls are tested, the results estimate along with substantive ISA 540 Revised provides that, as part of those tests, informs the auditor’s procedures. of testing how management made the decision about which approach or accounting estimate, the auditor is approaches to take. AS 2301 describes 40 See AS 1215.06. 41 ISA 540 Revised also includes requirements for 42 The auditor’s responsibilities with respect to the auditor’s responsibilities for testing tests of controls. AS 2301 sets forth requirements using the work of a company specialist are for tests of controls in financial statement audits presented as Appendix A of AS 1105. See supra 39 See AS 1105.10. under PCAOB standards. note 2.

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required to perform procedures to applicable financial reporting associated with how the model was obtain sufficient appropriate audit framework. developed. In this example, the evidence regarding the risks of material The new standard retains internally-developed model scenario misstatement relating to (a) selection substantially as proposed the would require greater audit effort to and application of the methods, requirement to evaluate whether the respond to the broader range of risks, as significant assumptions and the data methods used by the company are in compared to the commercially available used by management in making the conformity with the applicable financial model scenario. In either case, the accounting estimate, and (b) how reporting framework, including auditor would evaluate whether the management selected the point estimate evaluating whether the data is method was used appropriately, and developed related disclosures about appropriately used and significant including whether adjustments, if any, estimation uncertainty.43 assumptions are appropriately applied to the output of the model were AU–C Section 540 provides that as under the framework. The applicable appropriate. part of testing how management made financial reporting framework may After consideration of comments, the the accounting estimate and the data on prescribe a specific method to develop requirement regarding evaluating the which it is based, the auditor should an estimate or allow for alternative appropriateness of the method was evaluate whether the method of methods, or provide guidance on how to revised to remove the reference to the measurement used is appropriate in the apply the method, including guidance company’s business and industry. circumstances, the assumptions used by on the selection or use of assumptions Under the new standard, the auditor is management are reasonable in light of or data. Evaluating whether the required to evaluate whether the the measurement objectives of the company’s method is in conformity company’s method is appropriate for the applicable financial reporting with the financial reporting framework nature of the related account or disclosure, taking into account the framework, and the data on which the involves evaluating whether the data is auditor’s understanding of the company estimate is based is sufficiently reliable appropriately used and significant and its environment. This revised for the auditor’s purposes. assumptions are appropriately applied by the method, which, if applicable, requirement is consistent with the risk Evaluating the Company’s Methods would include testing the mathematical assessment standards because the See Paragraphs .10–.11 accuracy of the calculations under the auditor’s evaluation of the method (a method. substantive procedure) is informed by The proposed standard provided that The methods used by the company the auditor’s understanding of the the auditor should evaluate whether the may involve the use of a model (e.g., company and its environment (obtained methods used by the company are (1) in expected future flows). The new through the auditor’s risk assessment conformity with the applicable financial standard does not prescribe specific procedures).46 Notably, part of the reporting framework, including procedures for testing models, as auditor’s procedures for obtaining an evaluating whether the data and suggested by one commenter.45 The understanding of the company and its significant assumptions are Board believes that requirements environment include obtaining an appropriately applied; and (2) specific to models are not necessary understanding of relevant industry, appropriate for the nature of the related because evaluating the method, as regulatory, and other external factors, account or disclosure and the discussed above, includes consideration and evaluating the company’s selection company’s business, industry, and of models to the extent necessary to and application of accounting environment. The proposed reach a conclusion on the principles.47 requirements were similar to certain appropriateness of the method. Under The proposed standard also addressed requirements of the fair value the new standard, the necessary audit circumstances in which a company has standard.44 procedures to evaluate the method used changed its method for developing an A number of commenters expressed by the company (which, as appropriate, accounting estimate by requiring the concerns about the requirement to include models involved in the method) auditor to determine the reasons for and evaluate whether the company’s are commensurate with the assessed evaluate the appropriateness of such methods are appropriate for the risks associated with the estimate. For change. company’s ‘‘business, industry, and example, the risks associated with a One commenter asserted that it would environment’’ because in their view, the method that uses a commercially be more appropriate to require the requirement seemed to suggest all available valuation model may relate to auditor to evaluate whether the companies within a particular industry whether the model is appropriate for the company’s reasons for making the use, or should use, the same method. related estimate under the applicable change are appropriate. This commenter Two commenters also suggested adding financial reporting framework, whereas also sought clarification on what specific requirements—to evaluate the risks associated with a method that constitutes a change in method and on models used by the company and test uses an internally-developed company the auditor’s responsibility when the the mathematical accuracy of the model may include additional risks company has not made a determination calculations used by the company to about whether different methods result translate its assumptions into the 45 This commenter advocated for the approach in significantly different estimates. accounting estimate. One commenter taken by the IAASB regarding models. ISA 540 Another commenter expressed concern sought clarification on the intent of the Revised requires that, when management’s that, because of a lack of clarity about application of the method involves complex the definition of ‘‘method’’ and what requirement to evaluate whether the modeling, the auditor’s procedures address whether data and significant assumptions are judgments have been applied consistently and, appropriately applied under the when applicable, whether (1) the design of the 46 Additionally, AS 2301.05d requires the auditor model meets the measurement objective of to evaluate whether the company’s selection and framework, is appropriate in the circumstances, and application of significant accounting principles, 43 The Board’s risk assessment standards address changes from the prior period’s model are particularly those related to subjective the auditor’s responsibilities for responding to risks appropriate in the circumstances; and (2) measurements and complex transactions, are of material misstatement and obtaining sufficient adjustments to the output of the model are indicative of bias that could lead to material appropriate evidence. consistent with the measurement objective and are misstatement of the financial statements. 44 See AS 2502.15 and .18. appropriate in circumstances. 47 AS 2110.09 and .12–.13.

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constitutes a change, the proposed Financial Statements).51 In addition, the data is internally consistent with its requirement could result in potentially contrary to the views of one commenter, use by the company in other estimates onerous documentation necessary to the new standard does not impose any tested; and (3) the source of the support changes to methods. Finally, new documentation requirements to the company’s data has changed from the one commenter suggested adding a existing provisions of AS 1215. prior year and, if so, whether the change requirement for the auditor to evaluate is appropriate. whether the company failed to revise its Comparison With Standards of Other A few commenters called for method to recognize changes in facts Standard Setters clarification of various aspects of the and circumstances. ISA 540 Revised provides that the proposed requirements pertaining to The new standard retains as proposed auditor’s procedures shall address (a) data. For example, one commenter the requirements for the auditor to (1) whether the method selected is suggested the requirements clarify that determine the reasons for changes to the appropriate in the context of the company data supplied to a third party method used by the company and applicable financial reporting or company specialist is not considered evaluate the appropriateness of such framework, and, if applicable, whether to be data from an external source. This change, and (2) evaluate the changes from the method used in prior commenter also asked for a framework appropriateness of methods selected by periods are appropriate; (b) whether for evaluating whether the source of the the company in circumstances where judgments made in selecting the method company’s data has changed from the the company has determined that give rise to indicators of possible prior year and, if so, whether the change different methods could result in management bias; (c) whether the is appropriate. Another commenter significantly different estimates. The calculations are applied in accordance sought more clarity on whether the requirements in the new standard are with the method and are mathematically requirement applies to all data or may similar to those in the fair value accurate; and (d) whether the integrity be limited to significant data. standard 48 and consistent with the of the significant assumptions and the Some commenters also suggested auditor’s responsibilities to obtain an data has been maintained in applying additional requirements in this area. For understanding of the company’s process the method.52 example, one commenter asserted that used to develop the estimate, including AU–C Section 540 requires the the existing requirements related to the methods used.49 These requirements auditor to determine whether the completeness and accuracy of data in also take into account that, in some methods for making the accounting AS 1105 do not themselves constitute a cases, more than one method may be estimate are appropriate and have been procedure that addresses risks of used to develop a particular estimate. It applied consistently, and whether material misstatement and instead, is important for the auditor to changes, if any, in accounting estimates suggested an express requirement to understand the basis for the company’s or in the method for making them from evaluate whether the data used in the change to its method, as changes that the prior period are appropriate in the estimate is accurate and complete. are not based on new information or circumstances. Further, AU–C Section Another commenter pointed to the other changes in the company’s 540 provides that as part of testing how existence of data analytics tools as an circumstances could be indicative of management made the accounting alternative to sampling, and advocated management bias (e.g., changing the estimate, and the data on which it is for some acknowledgement in the method to achieve a favorable financial based, the auditor evaluates whether the requirements of the importance of the result).50 method of measurement used is integrity of these tools and the controls With respect to other comments appropriate in the circumstance. over their development. One commenter raised above, a separate requirement to suggested a requirement to assess evaluate whether the company failed to Testing Data Used whether management has appropriately revise its method to recognize changes See Paragraphs .12–.14 understood or interpreted significant in facts and circumstances is data. unnecessary as auditors would make The proposed standard discussed the The new standard retains the this determination when evaluating auditor’s responsibilities for testing and requirements for testing and evaluating appropriateness of the method for the evaluating both internal and external data substantially as proposed, nature of the account or disclosure, data. This included (1) reiterating including requirements to evaluate taking into account the auditor’s existing requirements in AS 1105 to test whether the data is relevant to the understanding of the company and its the accuracy and completeness of measurement objective, internally environment. That understanding information produced by the company, consistent, and whether the source of or to test the controls over the accuracy the company’s data has changed from should inform the auditor about 53 conditions which might indicate that a and completeness of that information; the prior year and if so, whether the and (2) requiring the auditor to evaluate change is appropriate. The new change in method is needed. For 54 example, the use of a discounted cash the relevance and reliability of data standard builds on the auditor’s flow method to value a financial from external sources. responsibilities established by AS 1105, instrument may no longer be The proposed standard also provided including requirements to test the appropriate once an active market is that the auditor should evaluate accuracy and completeness of introduced for the instrument. whether the data is used appropriately information produced by the company. Moreover, changes to the method could by the company, including whether (1) Contrary to the views of one commenter, result in a change to the corresponding the data is relevant to the measurement AS 1105 currently includes an estimate and affect the consistency of objective for the accounting estimate; (2) obligation for the auditor to test the financial statements (as discussed in company-produced data. Accordingly, 51 See also FASB Accounting Standards AS 2820, Evaluating Consistency of an additional requirement to evaluate Codification Topic 250, Accounting Changes and whether the data used in the estimate is Error Corrections. 48 AS 2502.19. 52 See supra note 45 for additional requirements accurate and complete is not necessary. 49 See AS 2110.28, as amended. related to models. Furthermore, the determination of the 50 See AS 2810 for requirements related to 53 AS 1105.10. data to be tested—and the nature, evaluating bias in accounting estimates. 54 AS 1105.07–.08. timing, and extent of that testing—

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should be based on and responsive to Comparison With Standards of Other cover matters that materially affect the the assessed risks of material Standard Setters estimate. misstatement. Some commenters also voiced ISA 540 Revised provides that the Consistent with the proposed concerns that the proposed requirement auditor’s procedures shall address (a) standard, AS 2501 (Revised) makes a to include as significant those whether the data is appropriate in the distinction between procedures to be assumptions that the company has context of the applicable financial performed regarding internal data and identified as significant may not be reporting framework, and, if applicable, procedures regarding data from external appropriate because (1) management is changes from prior periods are sources used by the company to develop not required to designate assumptions appropriate; (b) whether judgments accounting estimates. Examples of as significant, and (2) auditors and made in selecting the data give rise to internal data include the company’s company management may reach indicators of possible management bias; historical warranty claims and historical different conclusions about which (c) whether the data is relevant and losses on defaulted loans. Examples of assumptions are significant. One reliable in the circumstances; and (d) external data include economic, market, commenter expressed the view that the whether the data has been appropriately or industry data. Company data omission of a requirement to identify understood or interpreted by supplied by the company to a third assumptions beyond what management management, including with respect to party or company specialist is not data identified may be inconsistent with the contractual terms. from an external source. The new requirements of AS 2110, and suggested standard also points auditors to AU–C Section 540 provides that in the Board clarify the auditor’s Appendix B of AS 1105 for situations in testing how management made the responsibilities when, for example, which the valuation of an investment is accounting estimate, and the data on management has not considered a based on the investee’s financial results. which it is based, the auditor should specific assumption needed to correctly The new standard also retains evaluate whether the data on which the apply the applicable accounting substantially as proposed requirements estimate is based is sufficiently reliable framework. Another commenter to evaluate whether the data was used for the auditor’s purposes. suggested that assumptions identified by the company as significant should be appropriately by the company. Identification of Significant reflected as an additional factor relevant Evaluating the manner in which data Assumptions was used by the company necessarily to identifying significant assumptions See Paragraph .15 builds on the auditor’s understanding of rather than a requirement. After consideration of comments the company’s process used to develop The proposed standard provided that received, the requirement was revised. the estimate. This includes evaluating the auditor should identify which of the Specifically, the factor regarding whether the company’s selection and assumptions used by the company are whether an assumption relates to an use of data is in conformity with the significant assumptions to the estimate identified and assessed risk of material requirements of the financial reporting and provided criteria to assist the misstatement was removed. Instead, the framework. Further, devoting audit auditor in making this determination. new standard requires the auditor to attention to changes in the data source Furthermore, the proposed standard take into account the nature of the might reveal potential contradictory provided that, if the company has accounting estimate, including related evidence and help the auditor identify identified significant assumptions used risk factors,56 the requirements of the potential management bias. For in an estimate, the auditor’s applicable financial reporting example, while a new source of data identification of significant assumptions framework, and the auditor’s might result in an estimate that better should also include those assumptions. understanding of the company’s process reflects a company’s specific Some commenters expressed concern for developing the estimate when circumstances, a change in data source about one of the factors to be considered identifying significant assumptions. could also be used by a company to in identifying significant assumptions— Further, the remaining factors from the achieve a desired financial result. The whether an assumption relates to an proposal—sensitivity to variation, new standard has been modified to identified and assessed risk of material susceptibility to manipulation and bias, clarify that evaluating whether the data misstatement. The commenters opined unobservable data or adjustments, and is used appropriately includes that the factor was too broad and could dependence on the company’s intent evaluating whether the data is internally result in an excessive number of and ability to carry out specific courses consistent with its use by the company assumptions being identified as of action—have been reframed in the in other significant accounts and significant. Some of those commenters new standard as examples of disclosures based on similar example suggested adding a note to describe how assumptions that would ordinarily be procedures in the fair value standard.55 all of the factors set forth in the proposal significant. The examples provided are As noted by one commenter, work together. A few commenters made not intended to be an exhaustive list of significant advances in technology have other suggestions with respect to this significant assumptions or a substitute occurred in recent years, including requirement including (1) incorporating for taking into account the auditor’s increased use of data analysis tools. The the requirement to identify assumptions understanding of the nature of the Board considered how changes in used by the company which are estimate, including risk factors, the technology could affect the approaches important to the recognition or requirements of the applicable financial to auditing accounting estimates and measurement of the accounting estimate reporting framework, and his or her believes that the new standard and in the financial statements into AS understanding of the company’s process related amendments are sufficiently 2110.28e, as amended; (2) adding a for developing the estimate. Rather, the principles-based and flexible to qualifying phrase, such as ‘‘as examples are provided to illustrate how accommodate continued advances in applicable,’’ to the factors because some the concepts in the new standard can be the use of data and technology by both factors may not always be relevant or applied to identify significant companies and auditors. may vary in significance; and (3) assumptions that are important to the incorporating the concept described in 55 See AS 2502.39. AS 2502.33 that significant assumptions 56 See AS 2110.60–.60A, as amended.

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recognition or measurement of an including evaluating whether (1) the significant assumptions for estimate. The revised company has a reasonable basis for bias. formulation provides better context for those assumptions and, when The new standard retains the the application of the requirement, as applicable, the company’s selection of requirements for evaluating suggested by some commenters, and assumptions from a range of potential reasonableness of significant prompts auditors to consider those assumptions; and (2) significant assumptions substantially as proposed. assumptions that drive or are associated assumptions are consistent with, among The requirements recognize that with identified risks of material other things, the company’s objectives, estimates are generally developed using misstatement. historical data, the economic a variety of assumptions and focus the The auditor is not expected to environment, and market information. auditor on how the company selects its document a detailed comparison of each In circumstances when the auditor assumptions. assumption used in the estimate to each develops an expectation of an The auditor’s assessment of whether factor or example described above. assumption to evaluate its the company has a reasonable basis for Instead, consistent with AS 1215, the reasonableness, the proposed standard a significant assumption (including an auditor should document the significant also provided that the auditor should assumption based on forward-looking assumptions identified and the auditor’s have a reasonable basis for that information) relates to whether the rationale for that determination. expectation. assumption used by the company is In addition, the proposed note— based on an analysis of relevant Some commenters asked for information, or determined arbitrarily, requiring auditors to include as clarification of certain aspects of the significant those assumptions that the with little or no such analysis. The requirement. For example, a few auditor’s assessment also involves company has identified as significant commenters asked for clarification on assumptions—was not included in the considering whether the company the requirement to assess whether considered relevant evidence, regardless new standard. As discussed above, the management has a reasonable basis for new standard requires the auditor, in of whether it corroborates or contradicts its assumptions. Another commenter the company’s assumption. identifying significant assumptions, to asked for an explanation of what take into account the auditor’s Under the new standard, the auditor ‘‘reasonable’’ is intended to mean in the should evaluate whether the significant understanding of the company’s process context of accounting estimates. One for developing the estimate, which assumptions are consistent with commenter sought clarification on how relevant information such as the would include understanding the to evaluate differences between company’s objectives; historical assumptions used by the company in management’s assumption and the experience (e.g., prior years’ that estimate (whether expressly auditor’s expectation in circumstances assumptions and past practices), taking identified or implicit in the nature of where the auditor develops an into account changes in conditions the estimate or method used). This expectation of an assumption to affecting the company; and other approach addresses commenter evaluate its reasonableness. Another significant assumptions in other concerns about whether the Board was commenter requested that the estimates tested (e.g., assumptions are imposing a responsibility on requirement address factors relevant to consistent with each other and other management to identify significant evaluating reasonableness of forward- information obtained). This requirement assumptions. looking information in anticipation of is consistent with requirements in the The intent of the proposed the new accounting standard on credit fair value standard.58 In making this requirement to include significant 57 losses. evaluation, the auditor uses his or her assumptions identified by the company With respect to evaluating understanding of the company and its was to provide the auditor with a consistency with baseline information environment, the assessed risks of starting point for the auditor’s described in the standard, one material misstatement, and his or her evaluation (consistent with the fair commenter asked for clarification of understanding of the process used to value standard). However, since the how the requirement to evaluate factors develop the estimates. revised requirement already focuses the in paragraph .16 works with the In circumstances where the auditor auditor on understanding the requirement to ‘‘test’’ in paragraph .09. develops an expectation of an assumptions used by the company to This commenter also asked for assumption to evaluate reasonableness, develop the estimate and the associated clarification of the extent of the the auditor is required to have a risk factors, the new standard does not procedures to be performed when reasonable basis for that expectation include a new factor for assumptions evaluating the consistency of significant (consistent with the requirements identified as significant by management, assumptions with the contextual regarding developing independent as suggested by a commenter. expectations), taking into account Lastly, the requirement to identify information set forth in the standard, where relevant, asserting that the relevant information, including the significant assumptions was not information set forth in the requirement. relocated to AS 2110.28, as suggested by requirement may be difficult to apply in practice. Another commenter suggested The new standard does not prescribe one commenter, because identifying specific follow-up procedures when significant assumptions is an inherent that the auditor be required to consider whether the assumptions are consistent there are differences between the part of testing the company’s process for auditor’s expectation and the company’s developing estimates. with the information provided in order to better align the provision with significant assumptions. The nature and Evaluation of Significant Assumptions language used by the IAASB. extent of procedures would depend on relevant factors such as the reason for See Paragraphs .16–.18 One commenter suggested inclusion of a specific requirement to assess the difference and the potential effect of The proposed standard set forth the difference on the accounting requirements to evaluate the estimate.59 57 See FASB Accounting Standards Update No. reasonableness of significant 2016–13, Financial Instruments—Credit Losses assumptions used by the company, both (Topic 326): Measurement of Credit Losses on 58 See generally AS 2502.29–.36. individually and in combination, Financial Instruments (June 2016). 59 See AS 2501.30–.31 (Revised).

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With respect to the comment significant assumptions and potential company in developing the critical regarding management bias, the new for management bias. accounting estimates disclosures for the standard was revised to provide that Some commenters expressed concern year under audit can provide important responding to risks of material that the proposed requirement may information about the significant misstatement involves, among other place undue emphasis on, or create an assumptions underlying those estimates. things, evaluating potential management inappropriate linkage with, a company’s The Board considered recasting the bias in accounting estimates, and its management discussion and analysis requirement to obtain an understanding effect on the financial statements (in (‘‘MD&A’’) disclosure. One commenter of management’s analysis of its critical paragraph .05). Furthermore, the also suggested that the requirement may accounting estimates as a risk requirements in paragraphs .30–.31 of not always apply (if, for example, assessment procedure, as suggested by the new standard, as well as AS 2810.27 management were unable to perform a some commenters. However, this address the evaluation of bias in sensitivity analysis), and suggested understanding is a necessary part of accounting estimates. Therefore, an clarification that the intent was for the evaluating the reasonableness of explicit requirement to evaluate bias as auditor to understand whether, and if significant assumptions and the part of evaluating reasonableness of so, how, management analyzed the potential for management bias in critical significant assumptions is not sensitivity of significant assumptions to accounting estimates, which is a necessary. change. substantive procedure. Moreover, Some commenters suggested the MD&A disclosures regarding critical Intent and Ability proposed requirement be recast or accounting estimates might not be As part of evaluating the aligned as a risk assessment procedure. available until late in the audit, and reasonableness of significant For example, one commenter observed therefore could affect the timing of assumptions, the proposed standard that the auditor’s and management’s related audit procedures. provided that the auditor take into judgment can differ with respect to The requirements in the new standard account factors (e.g., company’s past critical accounting estimates. That with respect to critical accounting history of carrying out stated intentions, commenter also stated that it was estimates would not change the written plans or other documentation, unclear whether the auditor should auditor’s responsibilities under AS 2710 stated reasons for course of action, and obtain this understanding if choosing a regarding other information in the company’s ability to carry out action substantive-only testing strategy. One documents containing audited financial based on financial resources, legal commenter suggested limiting the statements. restrictions, etc.) that affect the proposed requirement to critical Although there may be significant company’s intent and ability to carry accounting estimates with significant overlap between estimates with out a particular course of action when risks. Another commenter sought significant risks identified by the such action is relevant to the significant clarification that the requirement does auditor and the critical accounting assumption. not alter the auditor’s responsibilities estimates identified by management, the requirements for auditors under One commenter asserted that under AS 2710, Other Information in paragraph .18 of the new standard are compliance with the proposed Documents Containing Audited not limited to estimates with significant requirements would not be possible Financial Statements. risks as suggested by one commenter. when information described in factors The new standard retains the Rather, the paragraph is consistent with does not exist and suggested adding the requirement substantially as proposed. the requirements to evaluate the phrase ‘‘as applicable’’ to the In consideration of comments, the reasonableness of assumptions in requirement. requirement was clarified to better align significant accounts and disclosures. The new standard retains, as with the SEC’s requirement for critical 61 The MD&A disclosures regarding proposed, the requirement to take into accounting estimates by describing critical accounting estimates can account specific factors in evaluating that the sensitivity of management’s provide relevant information to inform the reasonableness of significant significant assumptions to change is the auditor’s evaluation of the assumptions when the significant based on other reasonably likely reasonableness of the significant assumption is based on the company’s outcomes that would have a material assumptions and potential for intent and ability to carry out a effect on the company’s financial management bias. particular course of action. As in other condition or operating performance. PCAOB standards, the auditor takes Under the new standard, the auditor Comparison With Standards of Other factors into account to the extent they is not expected to evaluate the Standard Setters are relevant. company’s compliance with the SEC’s MD&A requirements, but rather to ISA 540 Revised provides that the Critical Accounting Estimates obtain an understanding of auditor’s procedures shall address (a) whether the significant assumptions are With respect to critical accounting management’s analysis of critical accounting estimates and to use this appropriate in the context of the estimates, the proposed standard applicable financial reporting provided that the auditor should obtain understanding in evaluating the reasonableness of the significant framework, and, if applicable, changes an understanding of how management from prior periods are appropriate; (b) analyzed the sensitivity of its significant assumptions and potential for 60 management bias in accordance with AS whether judgments made in selecting assumptions to change, based on the significant assumptions give rise to other reasonably likely outcomes that 2810.27. In the Board’s view, the sensitivity analysis used by the indicators of management bias; (c) would have a material effect, and to take whether the significant assumptions are that understanding into account when 61 consistent with each other and with evaluating the reasonableness of the See Commission Guidance Regarding Management’s Discussion and Analysis of Financial those used in other accounting Condition and Results of Operations, Release No. estimates, or with related assumptions 60 For the purposes of this requirement, 33–8350 (Dec. 19, 2003), 68 FR 75056 (Dec. 29, significant assumptions identified by the company 2003), at Section V (‘‘Critical Accounting used in other areas of the entity’s may not necessarily include all of those identified Estimates’’) for management’s responsibilities business activities, based on the by the auditor as significant. related to critical accounting estimates. auditor’s knowledge obtained in the

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audit; and (d) when applicable, whether considered necessary, develop a range whether the company has used third- management has the intent to carry out with which to evaluate the party pricing information specific courses of action and has the reasonableness of the accounting ‘‘appropriately’’ when assessing ability to do so. estimate. whether the information provides ISA 540 Revised also requires the sufficient appropriate evidence. auditor to address whether, in the Company’s Use of a Specialist or Third- In consideration of comments context of the applicable financial Party Pricing Information (including those received on the reporting framework, management has See Paragraphs .19–.20 Specialists Proposal), the new standard taken appropriate steps to (a) The proposed standard would have requires the auditor to look to the understand estimation uncertainty; and required the auditor to also take into requirements of Appendix A of AS 1105 (b) address estimation uncertainty by account the work of a company’s that discuss the auditor’s selecting an appropriate point estimate responsibilities for using the work of specialist used in developing an 63 and by developing related disclosures accounting estimate when determining company specialists. Appendix A of about estimation uncertainty. When, in the evidence needed in testing the AS 1105 sets forth, among other things, the auditor’s judgment based on the procedures to be performed in company’s process. The proposed audit evidence obtained, management evaluating the data, assumptions, and standard also referenced Appendix B of has not taken appropriate steps to methods used by a company’s specialist. AS 1105 62 for testing and evaluating the understand or address estimation Further, rather than addressing specific work of a company’s specialist when uncertainty, ISA 540 Revised requires credentials of the specialist, Appendix that work is used to support a the auditor to, among other things, A of AS 1105 requires the auditor to conclusion regarding a relevant request management to perform assess the knowledge, skill, and ability assertion, such as a relevant assertion additional procedures to understand of the company’s specialist. related to an accounting estimate. estimation uncertainty or to address it The new standard retains as proposed In addition, when third-party pricing by reconsidering the selection of the requirement to evaluate, when third- information used by the company is management’s point estimate or party pricing information used by the significant to the valuation of financial considering providing additional company is significant to the valuation instruments, the proposed standard disclosures relating to the estimation of financial instruments, whether the required the auditor to evaluate whether uncertainty, and evaluate management’s company has used third-party pricing the company has used that information response. If the auditor determines that information appropriately and whether management’s response to the auditor’s appropriately and whether it provides it provides sufficient appropriate request does not sufficiently address sufficient appropriate evidence. evidence. The auditor’s determination One commenter expressed concern estimation uncertainty, to the extent as to whether third-party pricing that the proposed requirement would practicable, the auditor is required to information was used appropriately by result in practical challenges as it would develop an auditor’s point estimate or the company includes whether the require the auditor to test the methods, range. information is in conformity with the data, and significant assumptions used AU–C Section 540 provides that as applicable financial reporting or developed by a company specialist in part of testing how management made framework. the accounting estimate, and the data on the same manner that the auditor would which it is based, the auditor shall if the accounting estimate was Comparison With Standards of Other evaluate whether the assumptions used developed without the assistance of a Standard Setters by management are reasonable in light company specialist. Another commenter ISA 540 Revised provides that when of the measurement objectives of the advocated for closer alignment with the using the work of a management’s applicable financial reporting proposed requirements of Appendix B expert, the requirements in paragraphs framework. Further, for accounting of AS 1105, citing, for example, 21–29 of ISA 540 Revised 64 may assist estimates that give rise to significant requirements for testing the accuracy the auditor in evaluating the risks, AU–C Section 540 requires the and completeness of company-produced appropriateness of the expert’s work as auditor to evaluate: (a) How data used by the specialists and audit evidence for a relevant assertion management considered alternative evaluating the relevance and reliability in accordance with paragraph 8(c) of assumptions or outcomes and why it of data obtained from external sources. ISA 500, Audit Evidence.65 In rejected them, or how management has One commenter advocated for evaluating the work of the otherwise addressed estimation requiring auditors to consider whether management’s expert, the nature, uncertainty in making accounting company specialists possess specific timing, and extent of the further audit estimates; (b) whether the significant credentials as part of auditing estimates procedures are affected by the auditor’s assumptions used by management are under the proposed standard. reasonable; and (c) where relevant to the With respect to circumstances when 63 The auditor’s responsibilities with respect to reasonableness of the significant third-party pricing information used by using the work of a company’s specialist are assumptions used by management or the the company is significant to the presented as Appendix A of AS 1105. See valuation of financial instruments, one Specialists Release, supra note 2. The analogous appropriate application of the proposed requirements were originally presented as applicable financial reporting commenter requested additional Appendix B of AS 1105 in the Specialists Proposal. framework, management’s intent to guidance or criteria for evaluating 64 Paragraphs 21–29 of ISA 540 Revised describe carry out specific courses of action and the requirements for obtaining audit evidence from its ability to do so. 62 In a separate proposal, the Board proposed to events occurring up to the date of the auditor’s amend its standards regarding the auditor’s use of report; testing how management made the AU–C Section 540 further provides the work of specialists, including specialists accounting estimate; and developing an auditor’s that if, in the auditor’s professional employed or engaged by the company (‘‘company’s point estimate or range. judgment, management has not specialist’’). See Proposed Amendments to Auditing 65 ISA 540 Revised provides that in obtaining addressed adequately the effects of Standards for the Auditor’s Use of the Work of audit evidence regarding the risks of material Specialists, PCAOB Release No. 2017–003 misstatement relating to accounting estimates, estimation uncertainty on the (‘‘Specialists Proposal’’). The Specialists Proposal irrespective of the sources of information to be used accounting estimates that give rise to set forth these amendments in Appendix B of AS as audit evidence, the auditor shall comply with the significant risks, the auditor should, if 1105. relevant requirements in ISA 500.

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evaluation of the expert’s competence, required the auditor to take into account After consideration of these capabilities and objectivity, the the requirements of the applicable comments, the requirement is adopted auditor’s understanding of the nature of financial reporting framework. substantially as proposed. The the work performed by the expert, and The proposal also replaced certain determination of when to use an the auditor’s familiarity with the terms used in the estimates standards to approach or a combination of expert’s field of expertise. describe audit procedures with more approaches is at the auditor’s discretion neutral language (such as replacing based on the relevant facts and Developing an Independent Expectation ‘‘corroborate’’ with ‘‘compare’’) to of the Estimate circumstances. In addition, the use of reduce the risk of confirmation bias or the phrase ‘‘developing an independent See Paragraph .21 anchoring bias when auditing expectation of the estimate’’ is accounting estimates. consistent with the concept in the The proposal sought to retain the Commenters on this topic were general approach in the estimates estimates standards. The intention of generally supportive of the proposed the requirement is not to imply that the standards for developing an requirement for developing an 66 auditor could (or should) develop an independent expectation, and more independent expectation, indicating explicitly tailored the requirements to expectation of the estimate without that the requirement is clear and reference to the company’s methods, the different sources of the methods, sufficient. One commenter asked the data, and assumptions, but rather to data, and assumptions used by the Board to clarify situations where more explicitly acknowledge that, in auditor. Those sources include (1) developing an independent expectation developing an independent expectation independent assumptions and methods of the estimate would be appropriate. of the estimate, an auditor could use of the auditor, (2) data and assumptions Another commenter indicated that using methods, data, and assumptions obtained from a third party, and (3) the the phrase ‘‘developing an independent company’s data, assumptions, or expectation’’ implies that the auditor obtained from different sources. methods. would reach this expectation Consistent with the proposal, the new Additionally, while seeking to retain independently, without reference to standard tailors the requirements to the requirement under the fair value management’s methods, data, and develop an independent expectation to standard for an auditor to understand assumptions, and recommended that the the different sources of the methods, management’s assumptions to ensure Board consider changing this phrasing data, and assumptions used by the that his or her independent estimate to developing a ‘‘comparative estimate’’ auditor as set forth in the table below takes into consideration all significant or a ‘‘point estimate’’ to better reflect the and discussed further in the sections variables,67 the proposal expressly procedures described. that follow.

Auditor’s independent expectation developed using: Auditor responsibility under the new standard:

Assumptions and methods of the auditor ...... Have a reasonable basis for the assumptions and methods. Data and assumptions obtained from a third party ...... Evaluate the relevance and reliability of the data and assumptions. Company data, assumptions, or methods ...... Test and evaluate in the same manner as when testing the company’s process.

This approach provides more of developing an independent fair value expectation. Having a reasonable basis direction to auditors in light of the estimate ‘‘for corroborative purposes.’’ 68 would reflect consideration of, among other things, the nature of the estimate; various ways in which auditors develop Independent Assumptions and Methods relevant requirements of the applicable an independent expectation of of the Auditor accounting estimates. financial reporting framework; the See Paragraph .22 The new standard also expressly auditor’s understanding of the company, its environment, and the company’s prompts the auditor to take into account The proposal recognized that, when process for developing the estimate; and the requirements of the applicable developing an independent expectation other relevant audit evidence, regardless financial reporting framework when of an estimate, the auditor can of whether the evidence corroborates or developing an independent expectation. independently derive assumptions or use a method that differs from the contradicts the company’s assumptions. By taking into account the requirements company’s method. In those situations, of applicable financial reporting Data and Assumptions Obtained From a the auditor should have a reasonable Third Party framework, the auditor might identify basis for his or her assumptions and additional considerations relevant to the methods used. See Paragraph .23 estimate that the company did not take Commenters on this topic were into account in its own process for generally supportive of the proposed The proposal directed the auditor to developing the estimate. As with the requirement that the auditor have a the existing requirements in AS 1105 proposal, the new standard also uses reasonable basis for the assumptions when evaluating the relevance and more neutral terms, such as ‘‘evaluate’’ and methods used when developing an reliability of data or assumptions and ‘‘compare’’ to mitigate the risk of independent expectation of the obtained from a third party. This confirmation bias or anchoring bias estimate. The requirement is adopted as approach is consistent with the when auditing accounting estimates. For proposed. requirements for evaluating data from example, the new standard requires the Under the new requirement, the external sources as described above. auditor to compare the auditor’s auditor is required to have a reasonable The proposal also directed the auditor independent expectation to the basis for the assumptions and methods to comply with the requirements of company’s accounting estimate instead used to develop an independent proposed AS 1210 when the third party

66 See AS 2501.12, AS 2502.40, and AS 2503.40. 67 See AS 2502.40. 68 See AS 2502.40.

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is a specialist engaged by the auditor.69 independent expectation of an estimate, estimate, the auditor should determine The proposal did not set forth specific the auditor’s testing of management’s that the range was appropriate for requirements related to methods process is limited to those areas on identifying a misstatement of the obtained from a third party that is not which the auditor intends to rely for company’s accounting estimate and was a specialist. purposes of developing the expectation. supported by sufficient appropriate One commenter expressed concern This provision is adopted audit evidence.74 that the proposed requirements were too substantially as proposed. Under the Some commenters asked for restrictive and somewhat impractical new standard, when an auditor chooses clarification or guidance on how to and that it may not be possible or to develop an independent expectation determine that a range is appropriate for necessary to obtain data and using certain of the company’s data, identifying a misstatement. Some assumptions from a third party and to significant assumptions, or methods, the commenters stated that the proposed create assumptions independent of auditor is required to test such data or requirement implied a level of precision those of the company. The commenter evaluate such assumptions or methods, within a range that may not be feasible. recommended that the Board retain the using the corresponding procedures that Some commenters suggested expressly extant direction allowing the auditor to apply when the auditor tests the acknowledging situations where the use management’s assumptions when company’s process. In response to range is greater than the materiality developing independent expectations. comments, the text was revised from the threshold by including, for example, After consideration of the comment, proposal to clarify the scope of the language similar to IAASB’s Exposure the requirement is adopted as proposed. obligation to test. The new standard also Draft, Proposed ISA 540 (Revised) (‘‘ED As described below, consistent with the includes a note referring the auditor to 540’’), paragraph A134.75 One of these estimates standards and the proposal, look to the requirements in Appendix A commenters argued that for certain the new requirement continues to allow of AS 1105 in situations where the highly judgmental estimates, additional the use of company data, assumptions, company’s data, assumptions or audit work cannot reduce the size of the or methods while also allowing the methods were those of a company’s range below the materiality threshold, auditor to use other sources.70 specialist.72 and that the proposed requirement Also consistent with the proposal, the could lead to excessive work. Another Comparison With Standards of Other commenter suggested that the proposed new standard does not set forth specific Standard Setters requirements related to methods standard did not sufficiently address obtained from a third party, as the Board When the auditor develops a point estimation uncertainty, including what understands that auditors typically use estimate or a range to evaluate constitutes a reasonable range of either the company’s methods or their management’s point estimate and estimation uncertainty and how own (which may include specialists’ related disclosures about estimation auditors are to address and disclose methods) in developing an independent uncertainty, ISA 540 Revised provides such uncertainty. expectation. that the auditor’s further audit After considering the comments, the procedures include procedures to requirement has been revised to clarify Use of Company Data, Assumptions, or evaluate whether the methods, that, when establishing an independent Methods assumptions or data used are expectation as a range, the auditor See Paragraph .24 appropriate in the context of the should determine that the range applicable financial reporting encompasses only reasonable outcomes, The proposal sought to retain the framework. ISA 540 Revised also in conformity with applicable financial existing requirements for the auditor to provides that regardless of whether the reporting framework, and is supported test data from the company and evaluate auditor uses management’s or the by sufficient appropriate evidence. the company’s significant assumptions auditor’s own methods, assumptions or Also, a footnote has been added to for reasonableness, when used by the data, further audit procedures be paragraph .26 of the new standard auditor to develop an independent designed and performed to address the reminding auditors that, under AS 71 estimate. The proposal also required matters in paragraphs 23–25 of ISA 540 2810.13, if a range of reasonable the auditor to evaluate the company’s Revised.73 estimates is supported by sufficient method, if the auditor uses that method AU–C Section 540 provides that if the appropriate evidence and the recorded to develop an independent expectation. auditor uses assumptions or methods estimate is outside of the range of The proposal recognized that auditors that differ from management’s, the may use a portion or a combination of auditor shall obtain an understanding of 74 The estimates standards provide for the data, assumptions, and method management’s assumptions or methods development of an independent point estimate as provided by the company in developing one approach for testing accounting estimates, but sufficient to establish that the auditor’s these standards do not discuss developing an their expectations. If the company’s point estimate or range takes into independent expectation as a range of estimates. AS data, assumptions, or methods are those account relevant variables and to 2810 provides for developing a range of possible of a company’s specialist, the proposal evaluate any significant differences from estimates for purposes of the auditor’s evaluation of also directed the auditor to comply with management’s point estimate. misstatements relating to accounting estimates. the requirements in proposed Appendix 75 ED 540, paragraph A134 stated that ‘‘In certain Developing an Independent Expectation circumstances, the auditor’s range for an accounting B of AS 1105 for using the work of a estimate may be multiples of materiality for the company specialist as audit evidence. as a Range financial statements as a whole, particularly when One commenter suggested that the See Paragraph .25 materiality is based on operating results (for Board clarify that when developing an example, pre-tax income) and this measure is The proposal provided that, if the relatively small in relation to assets or other balance auditor’s independent expectation sheet measures. In these circumstances, the 69 See paragraph .08 of the proposed standard. consisted of a range rather than a point auditor’s evaluation of the reasonableness of the 70 Appendix A of AS 2501 (Revised) applies when disclosures about estimation uncertainty becomes the auditor develops an independent expectation of increasingly important. Considerations such as the fair value of financial instruments using pricing 72 See Specialists Release, supra note 2. those included in paragraphs A133, A144, and information from a third party. These requirements 73 Paragraphs 23–25 of ISA 540 Revised describe A145 may also be appropriate in these are discussed further below. the auditor’s further procedures for addressing circumstances.’’ Substantially similar guidance 71 See AS 2502.40. methods, significant assumptions, and data. appears in paragraph A125 of ISA 540 Revised.

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reasonable estimates, the auditor should involve assessments of future outcomes. recorded estimate is outside of the range treat the difference between the Under the new standard, the auditor’s of reasonable estimates, the auditor recorded accounting estimate and the responsibility is to consider estimation should treat the difference between the closest reasonable estimate as a uncertainty in assessing risk and recorded accounting estimate and the misstatement. performing procedures in response to closest reasonable estimate as a The requirement that the range should risk, which involves evaluating whether misstatement. be supported by sufficient appropriate the accounting estimates are reasonable evidence is consistent with the in the circumstances and in conformity Evaluating Audit Evidence From Events principle in the new standard that the with the applicable financial reporting or Transactions Occurring After the auditor should have a reasonable basis framework, as well as evaluating Measurement Date for the data, assumptions, and methods management bias in accounting See Paragraphs .27–.29 used in developing an independent estimates, and its effect on the financial The proposal noted that events and expectation. The sufficiency and statements. These responsibilities are transactions that occur after the appropriateness of the evidence needed better aligned with the auditor’s overall measurement date can provide relevant will depend on the relevant responsibility for planning and evidence to the extent they reflect circumstances, including the nature of 76 performing financial audits. conditions at the measurement date. the accounting estimate, the The proposal provided that the auditor requirements of the applicable financial Comparison With Standards of Other should evaluate whether the audit reporting framework, and the number Standard Setters evidence from events or transactions and nature of significant assumptions ISA 540 Revised provides that if the occurring after the measurement date is and data used in the independent auditor develops an auditor’s range, the sufficient, reliable, and relevant to the expectation. auditor shall (a) determine that the Notably, the new standard does not range includes only amounts that are company’s accounting estimate and restrict the size of the auditor’s range to supported by sufficient appropriate whether the evidence supports or the level of materiality for the evidence and have been evaluated contradicts the company’s estimate. statements as a whole determined under by the auditor to be reasonable in the Commenters were generally AS 2105 (‘‘financial statement context of the measurement objectives supportive of the proposed materiality’’). An appropriate range in and other requirements of the applicable requirements, indicating they were clear accordance with paragraph .25 of the financial reporting framework; and (b) and sufficient. Two commenters new standard might be very large, even design and perform further audit requested additional clarity regarding exceeding financial statement procedures to obtain sufficient the assessment of whether the audit materiality. For example, under certain appropriate audit evidence regarding evidence is sufficient, reliable, and market conditions, comparable the assessed risks of material relevant to the company’s accounting transactions for some assets, even after misstatement relating to the disclosures estimate, one in the context of appropriate adjustment, might indicate in the financial statements that describe subsequent events and one more a wide range of fair value the estimation uncertainty. generally. Another commenter measurements. As another example, AU–C Section 540 provides that if the suggested including cautionary language some accounting estimates are highly auditor concludes that it is appropriate with respect to fair value estimates sensitive to one or more assumptions, to use a range, the auditor should indicating that fair value measurements such that a small change in an narrow the range, based on audit are derived from information that would assumption can result in a large change evidence available, until all outcomes be known or knowable to a market in the value of the estimate. In those within the range are considered participant at the measurement date. situations, the auditor’s responsibility is reasonable. The Board considered these to determine an appropriate range based comments and determined that the Comparing the Auditor’s Independent on the criteria set forth in the new requirements in the proposal are Expectation to the Company’s standard. sufficiently clear and has adopted the The Board considered the comments Accounting Estimate requirements as proposed. asking for a statement in the standard See Paragraph .26 The new standard, as with the acknowledging that an independent The proposal set forth the proposal, requires the auditor to expectation as a range could exceed the requirement for the auditor to compare evaluate whether audit evidence from materiality level determined under AS the auditor’s independent expectation to events or transactions occurring after 2105. However, such a statement was the company’s estimate and evaluate the the measurement date is sufficient, not added because it would not have differences in accordance with AS reliable, and relevant to the company’s changed the auditor’s responsibility 2810.13.77 accounting estimate and whether the under the new standard. No comments were received on this evidence supports or contradicts the Finally, with respect to estimation topic. The requirement is adopted company’s estimate. This would include uncertainty, the new standard and substantially as proposed, with an evaluating pertinent information that is related amendments acknowledge that expanded footnote reminding auditors known or knowable at the measurement estimates have estimation uncertainty, that under AS 2810.13, if a range of date. For example, the sale of a bond which affects the risks of material reasonable estimates is supported by shortly after the balance-sheet date misstatement. Neither the Board nor sufficient appropriate evidence and the (which in this case is also the auditors are responsible for placing measurement date) may provide limits on the range of estimation 76 Auditors may also have disclosure and relevant evidence regarding the uncertainty. That uncertainty is a reporting responsibilities in relation to these company’s fair value measurement of function of the estimate’s measurement matters. See AS 3101, The Auditor’s Report on an the bond as of the balance sheet date if requirements under the applicable Audit of Financial Statements When the Auditor the intervening market conditions Expresses an Unqualified Opinion, and AS 1301, financial reporting framework, the Communications with Audit Committees. remain the same. As another example, economic phenomena affecting that 77 See additional discussion of evaluating audit when a business combination occurred estimate, and the fact that estimates results below. during the year, events occurring

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subsequent to the measurement date, clarification as to whether the proposed Appendix A—Special Topics such as the cash settlement of short- standard required the auditor to Introduction term receivables, may provide relevant evaluate bias in individual assumptions. evidence about the accounting estimate The new standard retains paragraphs Appendix A of the proposed standard as of the measurement date if they .30 and .31 regarding evaluating audit set forth requirements for the auditor to reflect conditions at the measurement results substantially as proposed. In perform specific procedures when date. In those situations, the audit consideration of comments, paragraphs auditing the fair value of financial procedures would be focused on .30 and .31 were revised to include a instruments, focusing on the use of evaluating the relevance and reliability reference to potential bias, consistent pricing information from third parties of the evidence provided by the with AS 2810.24–.27. The requirements such as pricing services and brokers or subsequent event, including the extent in the new standard are intended to dealers. The proposal also incorporated to which the subsequent event reflects remind auditors of their existing and built on topics discussed in the conditions existing at the measurement responsibilities to evaluate potential derivatives standard, including certain date. bias in accounting estimates (both procedures for auditing the valuation of Additionally, the new standard individually and in the aggregate) and derivatives and securities measured at requires the auditor to take into account its effect on the financial statements. For fair value. The proposed requirements changes in the company’s circumstances example, indicators of management bias were informed by outreach, including and other relevant conditions between may affect the assessed risk of material the Pricing Sources Task Force, and the event or transaction date and the misstatement and the auditor’s publications of other standard setters. measurement date. It also notes that as conclusions about whether accounting Paragraph .A1 of Appendix A the length of time from the estimates are reasonable in the prompts the auditor to obtain an measurement date increases, the circumstances. As discussed above, understanding of the nature of the likelihood that events and conditions individual assumptions that are financial instruments being valued in have changed during the intervening susceptible to manipulation or bias are order to identify and assess risks of period also increases. ordinarily considered significant and material misstatement related to the fair evaluated for reasonableness.78 value of those instruments. Paragraph Comparison With Standards of Other .A2 provides the general framework, Standard Setters Comparison With Standards of Other specifically, the auditor’s responsibility Standard Setters The corresponding ISA 540 Revised to determine whether the pricing requirement provides that when the ISA 540 Revised requires the auditor information from a third party 80 auditor’s further audit procedures to evaluate whether judgments and provides sufficient appropriate evidence include obtaining audit evidence from decisions made by management in to respond to the risks of material events occurring up to the date of the making the accounting estimates misstatement. auditor’s report, the auditor shall included in the financial statements, Paragraphs .A3–.A9 provide more evaluate whether such audit evidence is even if they are individually reasonable, specific direction for cases where sufficient and appropriate to address the are indicators of possible management pricing information from pricing risks of material misstatement relating bias. When indicators of possible services and brokers or dealers are used. to the accounting estimate, taking into management bias are identified, the Paragraph .A10 sets forth factors for the account that changes in circumstances auditor shall evaluate the implications auditor to take into account when and other relevant conditions between for the audit. Where there is intention obtaining an understanding of how the event and the measurement date to mislead, management bias is unobservable inputs were determined may affect the relevance of such audit fraudulent in nature.79 and evaluating the reasonableness of evidence in the context of the applicable AU–C Section 540 requires the unobservable inputs when the financial reporting framework. auditor to review the judgments and unobservable inputs are significant to AU–C Section 540 provides that the decisions made by management in the the valuation of financial instruments. auditor should determine whether making of accounting estimates to A number of commenters expressed events occurring up to the date of the identify whether indicators of possible general support for the proposed auditor’s report provide audit evidence management bias exist. Appendix A but commented on specific regarding the accounting estimate. Both ISA 540 Revised and AU–C aspects of the proposed requirements. Section 540 provide that the auditor Evaluating Audit Results These comments are addressed below in should determine whether the a section-by-section discussion of the See Paragraphs .30–.31 accounting estimates and related proposal and the new standard. In The proposed standard incorporated disclosures are reasonable in the context addition, there were two areas of existing requirements of AS 2810 for of the applicable financial reporting comment that relate to several aspects of evaluating the results of audit framework, or are misstated. the proposed Appendix: (1) The extent procedures performed on accounting to which audit procedures could be estimates, including evaluating bias in 78 See discussion of identification of significant performed over groups or classes of assumptions above. financial instruments, rather than accounting estimates (both individually 79 ISA 540 Revised further requires the auditor to and in the aggregate). evaluate, based on the audit procedures performed individual instruments; and (2) the role One commenter noted that the and audit evidence obtained, whether (a) the played by centralized groups within an requirements could be interpreted as a assessments of the risks of material misstatement at accounting firm, such as a pricing desk, the assertion level remain appropriate, including in performing procedures related to presumption that bias always exists in when indicators of possible management bias have accounting estimates or a requirement to been identified; (b) management’s decisions relating determine whether actual bias exists, to the recognition, measurement, presentation and 80 Appendix A focuses primarily on pricing and suggested that the standard include disclosure of these accounting estimates in the information from pricing services and brokers or financial statements are in accordance with the dealers, but paragraph .A2 also covers pricing the word ‘‘potential’’ when referencing applicable financial reporting framework; and (c) information obtained from other third-party bias, similar to the requirements of AS sufficient appropriate audit evidence has been sources, such as exchanges and publishers of 2810. Another commenter sought obtained. exchange prices.

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testing the fair value of financial does not prescribe the role or where appropriate, to stratify financial instruments. responsibilities of centralized pricing instruments into groups with similar On the first area of comment, groups in audits, and Appendix A does characteristics for purposes of commenters asked for clarification on not provide specific direction in that performing procedures to evaluate whether all of the required procedures regard. Instead, the new standard allows pricing information for financial in Appendix A were to be applied to engagement teams to continue seeking instruments. In those situations, the financial instruments individually; assistance from centralized groups when auditor’s stratification is to be based on expressing concerns that doing so performing the procedures required his or her understanding of the nature would lead to excessive work. Some under the new standard. This approach of the financial instruments obtained commenters suggested clarifying gives audit firms the flexibility to under paragraph .A1. changes to the proposed Appendix, determine the most appropriate way to Use of Pricing Information From Third such as inserting ‘‘type of’’ or ‘‘types of’’ use their centralized pricing groups on Parties as Audit Evidence before the term ‘‘financial instrument’’ an audit to satisfy the requirement of the in various requirements in the new standard. See Paragraphs .A2–.A3 appendix. One commenter suggested As under the proposal, centralized The proposal addressed pricing adding a note indicating that the groups within the firm that assist information from organizations that procedures in paragraphs .A4–.A8 of the engagement teams with evaluating the routinely provide uniform pricing proposal were not required to be specific methods and assumptions information to users, generally on a applied to each individual financial related to a particular instrument, subscription basis (pricing services), instrument. Another commenter identifying and assessing risks of and brokers or dealers. The proposal suggested that auditors be allowed to material misstatement, or evaluating provided that when the auditor uses understand and evaluate the methods differences between a company’s price pricing information from a third party to and inputs used by pricing services at and a pricing service’s price generally the level of the asset class for financial develop an independent expectation or would be subject to the supervision tests pricing information provided by a instruments with lower estimation requirements of AS 1201.81 uncertainty. third party used by management, the The Board did not intend that all Identifying and Assessing Risks of auditor should perform procedures to required procedures in Appendix A be Material Misstatement Related to the determine whether the pricing applied to individual financial Fair Value of Financial Instruments information provides sufficient appropriate audit evidence to respond instruments in all cases. Rather, the See Paragraph .A1 Board intended that financial to the risks of material misstatement. instruments with similar characteristics Under the proposal, the auditor was Commenters on this topic were and risks of material misstatement could to obtain an understanding of the nature generally supportive of the proposed be grouped for purposes of applying of the financial instruments being requirement. One commenter substantive procedures. In some valued to identify and assess the risks questioned whether the use of the word circumstances, however, it may not be of material misstatement related to their ‘‘tests’’ is appropriate in relation to appropriate to group financial fair value, taking into account specified pricing information provided by a third instruments (for example, where matters. party used by management, because it financial instruments are dissimilar, or Commenters were generally might be inconsistent with other where the auditor does not have a supportive of the proposed requirement. requirements in the proposed standard. reasonable basis upon which to base the One commenter suggested that the The commenter requested clarification grouping). As discussed in greater detail auditor should be permitted to stratify as to whether the use of the word below, Appendix A of the new standard financial instruments into groups as part ‘‘tests’’ in paragraph .A2 is intended to has been revised to clarify areas where of identifying and assessing risks of set out a different work effort than what it may be appropriate for procedures to material misstatement, and suggested AS 1105 would require to evaluate be performed over groups of financial reframing one of the required information from external sources. instruments rather than individual procedures to refer to the type of Another commenter questioned financial instruments. financial instruments. Paragraph .A1 is whether receiving prices from a third- On the second area, commenters not intended to require auditors to party service, in and of itself, amounts asked for additional guidance about the obtain an understanding of each to using a service organization. The role of centralized groups that the financial instrument one-by-one. The commenter claimed that, based solely largest accounting firms often use to language has been revised to refer to on the criteria in paragraph .03 of AS assist in performing procedures related financial instruments (plural) or type of 2601, Consideration of an Entity’s Use to testing the fair value of financial financial instruments to make this clear. of a Service Organization, without the instruments. The specific services The new standard allows auditors, context provided by AS 2503.11–.14, it performed and the nature and level of is likely that third-party pricing services detail of information provided by 81 Additionally, centralized groups may would often be considered service centralized groups to engagement teams periodically provide general information within the organizations, and that this outcome is firm about a pricing service’s controls and can vary. Some commenters suggested methodologies or general information on current not warranted given the relatively low that the proposal further address how market conditions for different types of securities. risks involved. The same commenter the requirements apply when a Such general information may inform engagement asked about how paragraph .A3 would centralized pricing desk is used and teams’ risk assessments, to the extent that the be applied to situations in which information is reliable and relevant to their raised specific issues regarding the use engagements. The activities of centralized groups to pricing services prepare pricing of centralized groups under the obtain and communicate such general information information upon client request, but proposed requirements. One commenter are different in nature from the engagement-specific follow uniform procedures that cause advocated for more precise services provided by the centralized groups, which the preparer of the specific information are subject to supervision. Thus, it is important for requirements about the degree to which firm quality control systems to have policies and to be unaware of the identity of the user, procedures may be executed by a procedures related to the accuracy of such general such that bias of the user would not be centralized group. The new standard information from centralized groups. introduced.

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Paragraphs .A2 and .A3 of the being a service organization under of third-party pricing information. One standard are adopted as proposed, PCAOB standards have not changed. commenter argued that the requirements except for the revision discussed below. The applicability of either Appendix of paragraphs .A4b, .A5c, and .A7 are Under the new standard, as with the A or the requirements for using the unrealistic in some cases because proposal, when the auditor uses pricing work of specialists to pricing services auditors will not have access to the information from a third party to depends on the nature of the service details of pricing service methodology, develop an independent expectation or provided and the characteristics of the data, and assumptions. According to the evaluates pricing information provided instrument being valued. Appendix A commenter, requiring auditors to by a third party that is used by the applies when the auditor uses uniform perform additional procedures in such company, the auditor is required to pricing information from pricing cases without further guidance on perform procedures to determine services that is routinely provided to procedures to be performed is unhelpful whether the pricing information their users, generally on a subscription to the smaller companies who, in the provides sufficient appropriate evidence basis. This pricing information may be commenter’s view, are most likely to be to respond to the risks of material generated at various points in time and unable to obtain an independent misstatement. This approach focuses is available to all subscribers including valuation, and to smaller audit firms auditors on assessing the relevance and both companies and audit firms. In without a pricing desk. reliability of the pricing information general, financial instruments covered Additionally, some commenters regardless of whether it is obtained by by these services tend to be those with requested guidance on how the auditor the company or the auditor, which more direct or indirect observable should determine that the pricing should lead to more consistency in inputs. service, broker or dealer does not have practice. The new standard also As with the proposal, the new a relationship with the company that includes a reminder that under AS standard includes a footnote providing could directly or indirectly or 2301.09, the auditor should design audit that, when a pricing service is engaged significantly influence the pricing procedures to obtain more persuasive by a company or auditor to individually service or broker or dealer. Other audit evidence the higher the auditor’s develop a price for a specific financial commenters suggested that auditors assessment of risk. This added reminder instrument not routinely priced for consider the results of their procedures reinforces the principle that the subscribers, the requirements in regarding related parties under AS 2410 required procedures are scalable based Appendix A of AS 1105 (company- when considering the relationship of a on the assessed risks of material engaged specialists) or AS 1210 pricing service or broker or dealer to the misstatement. In general, fair values of (auditor-engaged specialists) apply, issuer. Other commenters suggested financial instruments based on trades of depending on who engaged the pricing clarifying that a price challenge by identical financial instruments in an service.83 In general, financial management based on substantive active market have a lower risk of instruments covered by these services information that causes the pricing material misstatement than fair values have few direct or indirect observable service to change its price should not derived from observable trades of market inputs (for example, because of generally be deemed significant similar financial instruments or an issuer’s default, a delisting, or a influence by management. unobservable inputs. Thus, the major change in liquidity of the related After consideration of the comments necessary audit response would also asset class). received, the new standard has been differ. For example, for exchange-traded revised as follows: Using Pricing Information From Pricing • The requirements have been revised securities in active markets, quoted Services to clarify that the procedures in this prices obtained from a stock exchange paragraph are not required to be applied may provide sufficient appropriate See Paragraph .A4 separately for each instrument (e.g., evidence. The proposal set forth a number of through the use of phrases such as After consideration of comments, the factors that affect the reliability of ‘‘types of financial instruments’’). word ‘‘tests’’ has been replaced with pricing information provided by a • The new standard includes a note 84 ‘‘evaluates’’ to clarify that the pricing service. These factors built on clarifying that procedures performed requirement is consistent with the work existing requirements for evaluating the under AS 2410 should be taken into effort ordinarily required by AS 1105 reliability of audit evidence under AS account in determining whether the when evaluating information from 1105. pricing service has a relationship with external sources. Some commenters suggested changes the company by which company As is the case under existing PCAOB to or asked for clarification of the management has the ability to directly standards, a pricing service would proposed factors for assessing the or indirectly control or significantly continue to be a service organization if reliability of pricing information from influence the pricing service as the services it provides to a subscriber pricing services. For example, some described in paragraph .A4c. The Board are part of the subscriber’s information commenters asked for clarification or believes that pricing information from 82 system over financial reporting. In guidance regarding the required work parties not considered to be related those instances, the auditor would effort to evaluate the pricing service, parties would ordinarily be more apply the requirements of the new such as the nature and extent of reliable than pricing information from standard when performing substantive procedures to evaluate the expertise and sources determined to be related parties. testing and look to the requirements of experience of the pricing service and The results of procedures performed AS 2601 regarding his or her whether the required procedures were under AS 2410 would provide responsibilities for understanding and to be applied separately for each information about whether the pricing evaluating controls of the pricing financial instrument. Also, one service is a related party and, if so, the service. The Board does not intend that commenter made specific suggestions nature of relationships between the the new standard would change practice regarding factors to be considered in company and the pricing service. The in this area, given that the criteria for evaluating the reliability and relevance 84 See first note to paragraph .A4 in AS 2501 82 See AS 2601.03. 83 See Specialists Release, supra note 2. (Revised).

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nature and extent of further procedures experience. The Board agrees with the assessing the relevance and reliability of that might be needed depend on the commenters that the number and the pricing information obtained, rather relevant circumstances. For example, if financial industry experience levels of than of the third party itself, and is the results of AS 2410 procedures evaluators employed by the pricing better aligned with the assessed risks of identified relationships between the service, the extent of informational material misstatement. company and pricing service, the resources that the pricing service See Paragraph .A5 auditor would need to evaluate whether provides to assist users in the relationships gave company understanding its data and evaluation The proposal set forth certain factors management the ability to directly or methodologies, and the pricing service’s that are important to the auditor’s indirectly control or significantly evaluation quality controls and price assessment of the relevance of pricing influence the pricing service. Also, challenge processes, among other information provided by a pricing additional procedures might be needed things, are relevant considerations when service. to ascertain whether the pricing service evaluating experience and expertise. Two commenters suggested that the was economically dependent on the However, the absence of lengthy description of the factors seemed to company’s business, if the pricing experience pricing a particular indicate that auditors need to service was a smaller entity with few instrument does not necessarily mean understand how each financial subscribers. that the pricing service is incapable of instrument in the portfolio is valued • The new standard also includes a providing relevant audit evidence. The individually, whereas in their view, note 85 clarifying that the existence of a evaluation of experience and expertise auditors should be able to assess these process by which subscribers can should be based on the relevant facts factors based on the asset class and challenge a pricing service’s pricing and circumstances including the need to other characteristics. information does not, by itself, mean obtain more persuasive audit evidence The Board did not intend to require that company management has the as the assessed risk of material auditors to assess the factors set forth in ability to directly or indirectly control misstatement increases. this paragraph individually for each or significantly influence that pricing Similar to the proposal, the new financial instrument in all cases, but service. The Board agrees with standard contemplates that pricing rather, where applicable, to allow commenters that the existence of such a services use different methodologies to auditors to consider the factors for price challenge process ordinarily determine fair value. The Board groups of financial instruments with would not, on its own, suggest understands, based on observation from similar characteristics and risks of significant influence over the pricing oversight activities and outreach that material misstatement. Accordingly, the service. many pricing services provide new standard has been revised to use • The new standard also includes a information to their subscribers about the plural term ‘‘financial instruments’’ note 86 indicating that if the auditor their methodology, which can be to clarify where a broader application is performs procedures to assess the assessed to determine whether that intended. reliability of pricing information methodology is in conformity with the Like the proposal, the new standard provided by a pricing service at an applicable financial reporting provides direction on evaluating the interim date, the auditor should framework. Under the new standard, the relevance of pricing information evaluate whether the pricing service has evaluation of pricing service provided by a pricing service, building changed its valuation process relative to methodology can be performed for on the requirements related to the the types of financial instruments being groups of financial instruments, relevance of audit evidence under AS valued, and, if so, the effect of such provided that certain conditions set 1105.88 Under the new standard, the changes on the pricing information forth in the Appendix are met. When an procedures to be performed generally provided at period end. The Board auditor is unable to obtain information depend on whether there is available understands that firms may perform about the methodology used by the information about trades in the same or procedures at various times during the pricing service to determine fair values similar securities. year with respect to the methodology of the types of financial instruments Fair values based on quoted prices in used by pricing service. The note being valued, additional or alternative active markets for identical financial reminds auditors that if the pricing procedures to obtain the necessary instruments. The relevance of pricing service changes its process, e.g., because evidence may include, for example, information depends on the extent to of changes in market conditions, it is obtaining and evaluating pricing which the information reflects market important for the auditor to evaluate the information from a different pricing data as of the measurement date. Recent effect of such changes on the pricing source, obtaining evidence about the trades of identical financial instruments information provided at period end to inputs used from public data about generally provide relevant audit determine whether the pricing service similar trades, or developing an evidence. continues to provide relevant evidence independent expectation. Fair values based on transactions of at that date. The new standard, as with the similar financial instruments. Only a As with the proposal, the new proposal, also provides that the fraction of the population of financial standard recognizes that pricing procedures in Appendix A apply to instruments is traded actively. For many information that is routinely provided pricing information obtained from financial instruments, the available by a pricing service with experience and pricing sources used by the company in audit evidence consists of market data expertise relative to the type of financial their estimation process as well as from for trades of similar financial instrument being valued is generally those obtained by the auditor for the more reliable than a price developed by interpretive releases issued by the SEC. See, e.g., purpose of developing an independent SEC, Codification of Financial Reporting Policies 87 a pricing service that has limited or no expectation. This approach focuses on Section 404.03, Accounting, Valuation and Disclosure of Investment Securities, Accounting 85 See second note to paragraph .A4 in AS 2501 87 An auditor’s ability to use sampling Series Release No. 118 (Dec. 23, 1970), which (Revised). methodologies and pricing information obtained provides requirements for audits of SEC-registered 86 See third note to paragraph .A4 in AS 2501 from pricing sources used by the company may investment companies. (Revised). differ under other requirements, such as 88 See AS 1105.07.

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instruments or trades of the identical regarding firm-level due diligence over by a national-level pricing desk and not instruments in an inactive market. This pricing services, arguing that the undertaken by each engagement team. is the context in which the Board thinks standard as proposed would preclude The determination of whether the due it is most likely that procedures would the use of centralized pricing desks or diligence procedures over a pricing be performed for groups of financial firm-level due diligence procedures in service should be performed by an instruments of a similar nature (taking evaluating a pricing service’s process. engagement team or by the national into account the matters in paragraph After consideration of comments office centralized group is at the .A1) that are priced by the pricing received, this paragraph in the new discretion of the auditor, based on the service using the same process. standard has been revised in two relevant facts and circumstances. The How a pricing service identifies and respects. First, a phrase was added to Board does not intend that the new considers transactions comparable to clarify that the additional procedures to standard would give rise to a change in the financial instrument being valued be performed relate to how transactions current practice in this area. affects the relevance of the pricing of similar instruments are identified, information provided as audit evidence. considered comparable, and used to See Paragraph .A7 When fair values are based on value the types of financial instruments The proposal provided that when transactions of similar instruments, the selected for testing. there are no recent transactions either new standard requires the auditor to Second, in light of previously for the financial instrument being perform additional audit procedures to discussed comments requesting valued or for similar financial evaluate the process used by the pricing clarification about the unit of testing, a instruments, the auditor should perform service, including evaluating how note was added to paragraph .A6 of the additional audit procedures, including transactions are identified, considered new standard providing that that when evaluating the appropriateness of the comparable, and used to value the types a pricing service uses the same process valuation method and the of financial instruments selected for to price a group of financial reasonableness of observable and testing, as discussed below. instruments, the audit procedures to unobservable inputs used by the pricing No recent transactions have occurred evaluate the process can be performed service. for the same or similar financial for those financial instruments as a One commenter requested instruments. When no recent group, rather than for each instrument clarification or guidance on the transactions have occurred for either the individually, if the financial additional procedures to be performed financial instrument being valued or instruments are similar in nature (taking in circumstances when no recent similar financial instruments, pricing into account the matters in paragraph transactions have occurred for either the services may develop prices using .A1 of the new standard). The note was financial instrument or similar financial broker quotes or models. How a pricing included with this paragraph because, instruments, expressing concern about service develops prices for these as previously noted, these are the smaller firms’ ability to comply with the financial instruments, including situations in which the Board believes proposed requirement. whether the inputs used represent the auditors would be most likely to The requirement has been adopted assumptions that market participants perform procedures at a group level. To substantially as proposed. Given the would use when pricing the financial address the use of group-level diverse nature of financial instruments instruments, affects the relevance of the procedures in other contexts, a footnote that fall into this category, prescribing pricing information provided as audit was added to the note indicating that detailed procedures is impractical. The evidence. other procedures required by the necessary audit procedures to evaluate When pricing information from a Appendix may also be performed at a the valuation methods and inputs will pricing service indicates no recent group level, provided that the vary based on the relevant risks, type of conditions described in the note are trades for the financial instrument being inputs, and valuation methods involved. met. valued or similar instruments, the new Additionally, when an auditor is standard requires the auditor to perform The new standard does not prescribe detailed procedures because the unable to obtain information from a additional audit procedures, including pricing service about the method or evaluating the appropriateness of the necessary audit procedures will vary in nature and extent depending on a inputs used to develop the fair value of valuation method and the a financial instrument when no recent reasonableness of the observable and number of factors, including the relevant risks and the process used by transactions have occurred for either the unobservable inputs used by the pricing financial instrument being valued or for service, as discussed below. These types the pricing service (e.g., matrix pricing, algorithm, or cash flow projections). For similar financial instruments, the of financial instruments would auditor is required under the new generally be valued individually. example, evaluating the reasonableness of a fair value based on the estimated standard to perform additional See Paragraph .A6 cash flows from a pool of securitized procedures, such as obtaining and The proposal provided that when the mortgage loans would differ from evaluating pricing information from a fair values are based on transactions of evaluating an input derived from different pricing source, obtaining similar financial instruments, the adjusted observable data. Procedures evidence about the inputs used from auditor should perform additional audit may include for example, evaluating public data about similar trades, or procedures to evaluate the process used how comparable transactions are developing an independent expectation. by the pricing service. selected and monitored or how matrix Using Pricing Information From Some commenters requested pricing is developed. Multiple Pricing Services clarification or guidance on the Additionally, the new standard does additional procedures to be performed not prescribe who is to perform the See Paragraph .A8 when evaluating the process used by a procedures with respect to pricing The proposal provided direction for pricing service, and guidance for services. It is the Board’s understanding using pricing information from multiple situations in which the auditor is unable of current practice that, in large firms, pricing services to assess the valuation to perform the procedures. Another firm-level due diligence over pricing of financial instruments. Specifically, commenter asked for clarification services is typically performed centrally the proposal set forth certain conditions

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under which less information is needed obtained an understanding of the Websites that publish, for the general about the particular methods and inputs pricing services’ methodologies at an public, prices for exchange-traded used by the individual pricing services asset class level of the financial securities in active markets are not when pricing information is obtained instrument. pricing services as described in the new from multiple pricing services. In Another commenter suggested that standard, and the auditor’s general, these factors relate to situations the standard should require taking the responsibility for information from in which there is reasonably consistent average of a reasonable number of those sources is set forth in paragraph pricing information available from available prices, excluding outliers, and .A2 of the new standard. Evaluating several sources with ample observable that procedures such as those outlined whether securities prices from these inputs. in paragraph .A4 should be performed websites provide sufficient appropriate Commenters on this paragraph for at least one pricing source. The same evidence includes evaluating whether generally supported the underlying commenter also requested clarification the websites obtain the prices directly principle that less evidence may be of whether and how pricing sources like from original sources (e.g., stock needed when pricing information is Google and Yahoo may be used. exchanges). obtained from multiple pricing services. After consideration of the comments Some commenters questioned one of the Using Pricing Information From a received, paragraph .A8 in the new Broker or Dealer conditions set forth in the proposal, standard has been revised to remove the related to the methods used to value the reference to valuation methods and to See Paragraph .A9 financial instruments. Those make other wording changes that, along The proposal set forth certain factors commenters suggested that requiring the with the footnote to paragraph .A6, that affect the relevance and reliability auditor to understand the valuation clarify that procedures under this of the evidence provided by a quote methods used was inconsistent with the paragraph can be performed at a group from a broker or dealer. In addition, the concept of obtaining less information. level, provided that the conditions One commenter suggested that proposal included an amendment to AS described in the note to paragraph .A6 1105.08 to more broadly address sufficient appropriate audit evidence are met. could be obtained solely on the basis of restrictions, limitations, and disclaimers Regarding the comment on usage of in audit evidence from third parties. two of the conditions: That the the terms ‘‘multiple’’ and ‘‘several’’ in instruments are routinely priced by Some commenters asked for guidance Paragraph .A8, the term ‘‘multiple’’ several pricing services, and the prices on the proposed requirement to evaluate refers to more than one pricing service. obtained are reasonably consistent. the relationship of the source of the The term ‘‘several’’ is used to clarify Some commenters asked for pricing information with the company, that, under the condition in paragraph clarification on whether the conditions including the factors to be evaluated. .A8, pricing information is to be can be applied on a group basis or Another commenter suggested that the obtained from more than two pricing would be required to be applied to standard state that the list of factors services, all of which routinely price the individual financial instruments, affecting relevance and reliability is not instruments. expressing concern that the latter all inclusive, although the commenter approach would lead to excessive work. The new standard includes the did not suggest additional factors to be Other commenters sought clarification condition that prices obtained are included. One commenter asserted that or offered suggestions regarding the reasonably consistent across pricing the proposal would result in a wording of some of the conditions set services (as of a relevant point in time), significant change in practice, and forth in the proposal. One commenter taking into account the nature and suggested that the Board should suggested consistently using the terms characteristics of the financial consider whether there were lower risk ‘‘multiple’’ and ‘‘several’’ in relation to instruments being valued and market circumstances for which a broker quote pricing services. Another commenter conditions. For example, the range of may be sufficient appropriate audit asked for clarification of the meaning of prices that would be reasonably evidence without meeting all criteria. the phrase ‘‘reasonably consistent consistent would be narrower for a type Another commenter noted that the first between or among the pricing services of financial instrument with a number sentence of the paragraph reads as from which pricing information is of observable market inputs, such as though it applies only when the auditor obtained,’’ specifically, whether the recent trades of identical or tests the company’s price based on a phrase referred to consistent over a substantially similar instruments, than quote from a broker or dealer. The period of time or as of a point in time. for a type of instrument with relatively commenter suggested that the proposal Another commenter suggested a few observable market inputs. should clarify whether the requirement different set of conditions for when less The suggestion to compute averages of would also apply when the auditor evidence may be needed. In that prices from different sources was not develops an independent expectation commenter’s view, the auditor would included in the new standard because using a broker quote. have obtained sufficient appropriate averages could obscure a wide range of The new standard has been revised to audit evidence with respect to the price variation and no consideration include a note providing that auditors valuation of a financial instrument if: (i) would be given to whether certain should take into account the results of The auditor assesses the financial prices are more indicative of the fair the procedures performed under AS instrument to have ‘‘lower estimation value of the instrument than others. The 2410, Related Parties, when determining uncertainty’’ (e.g., based on the asset Board considered the other factors whether the broker or dealer has a class and other characteristics of the suggested by commenters and relationship with the company by financial instrument), (ii) the auditor determined that those factors generally which company management has the obtains multiple prices from pricing were similar in nature to requirements ability to directly or indirectly control services for the financial instrument, in Appendix A. For example, the or significantly influence the broker or (iii) those pricing services routinely suggested factor based on lower dealer. Otherwise, the requirements in price that type of financial instrument, estimation uncertainty is, in the Board’s the new standard have been adopted (iv) the prices obtained are reasonably view, subsumed in the other listed substantially as proposed. The Board consistent, and (v) the auditor has factors. believes that the factors set forth in the

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standard provide sufficient direction to in an area that is inherently subjective estimates and its effect on financial the auditor to evaluate the relevance and judgmental in nature and therefore statements. and reliability of the evidence provided poses a higher risk of material Amendments to AS 1105, Audit by the quote, in order to determine misstatement. Evidence whether the quote provides sufficient Additional Amendments to PCAOB appropriate evidence in light of the risks The proposed amendment to AS Auditing Standards of material misstatement. 1105.08 would require the auditor to The requirements in the proposal The Board has also adopted evaluate the effect of any restrictions, were framed in terms of when the amendments to several of its existing limitations, or disclaimers imposed by a company’s fair value measurement is auditing standards to conform to the third party on the reliability of evidence based on a quote from a broker or dealer new standard, as reflected in Exhibit A provided by that party. because the Board understands that this to the SEC Filing Form 19b–4, available A few commenters sought guidance is the situation typically encountered in on the Board’s website at https:// on how to apply the requirement, practice. However, the factors set forth pcaobus.org/Rulemaking/Pages/docket- including how the auditor would in the standard relate to the relevance 043-auditing-accounting-estimates-fair- determine if the evidence was and reliability of audit evidence from value-measurements.aspx and at the sufficiently reliable. The amendment to AS 1105.08 is those quotes, and thus are equally Commission’s Public Reference Room. adopted as proposed. Third-party applicable to those less common Significant amendments are described information often contains restrictions, situations when the auditor uses a below.89 limitations, or disclaimers as to the use broker quote to develop an independent Amendments to AS 1015, Due of such information and its conformity expectation. The requirement in the Professional Care in the Performance of with the applicable financial reporting new standard has been revised to Work framework. The nature of the restriction, remove the reference to the limitation, or disclaimer and how the ‘‘company’s’’ measurement. The proposed amendments to AS information provided is being used If the broker quote does not provide 1015.11 included two changes to the would inform the auditor’s assessment sufficient appropriate evidence, the discussion of reasonable assurance of whether the evidence provided by the auditor would be required to perform when auditing accounting estimates (1) third-party information is sufficiently procedures to obtain relevant and clarifying that many (although not all) reliable, or whether additional reliable pricing information from accounting presentations contain procedures need to be performed (and, another source (for example, obtaining a accounting estimates, the measurement if so, the nature and extent of such quote from a different broker or dealer, of which is inherently uncertain and procedures). For example, language in a obtaining pricing information from a depends on the outcome of future business valuation disclaiming pricing service, or developing an events; and (2) providing that, in responsibility for company-provided independent expectation). auditing accounting estimates, the auditor considers information through data used to prepare the valuation may Unobservable Inputs the date of the auditor’s report, which not affect the reliability of that valuation See Paragraph .A10 under PCAOB standards is a date no as long as the auditor performs audit procedures to test company-provided The proposal set forth a requirement earlier than the date on which the auditor has obtained sufficient data used. for the auditor to obtain an 90 understanding of how unobservable appropriate evidence. Appendix B, Audit Evidence Regarding inputs were determined and to evaluate One commenter advocated for Valuation of Investments Based on the reasonableness of those inputs. This including language in AS 1015 that Investee Financial Results explains inherent limitations that an understanding would involve, among The proposal set forth amendments to auditor may face with regard to other things, taking into account the add Appendix A, Audit Evidence identifying and evaluating management assumptions that market participants Regarding Valuation of Investments bias in accounting estimates. In this would use when pricing the financial Based on Investee Financial Condition commenter’s view, financial reporting instrument, including assumptions or Operating Results, to AS 1105. The frameworks do not distinguish between about risk, and how the company proposed amendments would have reasonable judgment latitude, determined its fair value measurement, retained and updated certain subconscious management bias, and including whether it appropriately requirements from the derivatives willful biased manipulation. considered available information. For standard for situations in which the The amendments are adopted example, if management adjusts interest valuation of an investment selected for substantially as proposed. The Board rates, credit spread, or yield curves used testing is based on the investee’s acknowledges that various to develop a fair value measurement, the financial condition or operating results, circumstances can give rise to auditor would be required to evaluate including certain investments management bias and that, given the whether the adjustments reflect the accounted for by the equity method and subjective assumptions and uncertainty assumptions that market participants investments accounted for by the cost inherent in many estimates, bias cannot would ordinarily use when pricing that method for which there is a risk of be eliminated entirely. The new type of financial instrument. material misstatement regarding standard, as well as other PCAOB The two commenters on this impairment. paragraph expressed opposing views. standards, address the auditor’s Commenters expressed concerns that One commenter supported the responsibilities for evaluating potential the updated requirements in the requirement while the other commenter management bias in accounting proposal were written in a manner that suggested deleting the paragraph. was overly prescriptive, impracticable, The requirement is adopted as 89 The discussion that follows excludes burdensome, or inconsistent with the conforming amendments that make reference to the proposed. By providing factors that the new standard. application of a risk-based approach. auditor takes into account, the new 90 See paragraph .01 of AS 3110, Dating of the For example, commenters asserted that standard provides additional direction Independent Auditor’s Report. certain procedures involving interaction

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with investee management or the • Assessing additional risk factors amendment to AS 2110.28 was revised investee auditor were not practicable specifically for accounts and disclosures to clarify that the auditor’s because the investor company’s auditor involving accounting estimates. understanding of the processes used to might not have access to those parties. One commenter suggested that develop accounting estimates includes Commenters also sought clarification on requirements related to identifying and the extent to which the company uses the intent and application of several assessing risks of material third parties other than specialists.91 procedures set forth in the appendix. misstatements in accounting estimates The amendment emphasizes elements After consideration of comments, the should be in one standard (i.e., new of assessing the risks of material Board has decided to retain the existing standard) rather than amending the misstatement that are specifically requirements from the derivatives various risk assessment standards. In relevant to accounting estimates, standard, with only limited conforming contrast, another commenter expressed recognizing that the methods, data and changes. The requirements are set forth support for amending other PCAOB assumptions used by the company in its as Appendix B, Audit Evidence standards as a result of a new standard process to develop accounting Regarding Valuation of Investments on accounting estimates. estimates, including how they are The amendments to AS 2110, Based on Investee Financial Results, to selected and applied, drive the risk described in more detail below, are AS 1105. The intent of updating the associated with the estimate. In adopted substantially as proposed. requirements from the derivatives addition, as part of obtaining an standard was to better align the required Information and Communication understanding the information system, procedures with the risk assessment the amendment reminds the auditor to standards, not to substantively change The proposed amendment to AS 2110.28 would require the auditor, as consider whether the requirements of audit practice in this area. Retaining the AS 2601 are applicable to the third language of the existing requirements is part of obtaining an understanding of a company’s information system and party used by the company in consistent with the intention not to developing an accounting estimate. change audit practice. The requirements related business processes, to obtain an of the risk assessment standards understanding of the processes used to A separate requirement for the auditor continue to be applicable to investments develop accounting estimates, including to obtain an understanding of how audited under Appendix B of AS 1105. (1) the methods used, which may management identifies and addresses include models; (2) the data and the risk of management bias was not Amendment to AS 1205, Part of the assumptions used, including the source necessary as the new standard requires Audit Performed by Other Independent from which they are derived; and (3) the the auditor to evaluate management bias Auditors extent to which the company uses and its effect on financial statements as AS 1205.14 discusses the specialists or other third parties, part of responding to risks of material applicability of that standard to including the nature of the service misstatements in accounting estimates. situations where the company being provided and the extent to which the Comparison With Standards of Other audited has an investment accounted for third parties use company data and Standard Setters under the equity method or the cost assumptions. method and the investee is audited by The proposed amendment also Similar to this amendment, ISA 540 another auditor. In consideration of included a note emphasizing that the Revised sets forth requirements to comments on the appendix to AS 1105 requirements in AS 2601 with respect to obtain an understanding of how discussed above, the Board is also the auditor’s responsibilities for management identifies the relevant amending AS 1205 to help auditors obtaining an understanding of controls methods, assumptions or sources of determine the appropriate standard to at a service organization would apply data, and the need for changes in them, apply in those situations. Specifically, when the company uses a service that are appropriate in the context of the the amendment provides that the organization that is part of the applicable financial reporting auditor should look to the requirements company’s information system over framework, including how management of Appendix B of AS 1105 for situations financial reporting. In addition, for (a) selects or designs, and applies, the in which the valuation of an investment critical accounting estimates, the methods used, including the use of selected for testing is based on the proposed amendment referenced a models; (b) selects the assumptions to investee’s financial results and neither requirement in the proposed standard be used, including consideration of AS 1201 nor AS 1205 applies. The for the auditor to obtain an alternatives, and identifies significant amendment clarifies that Appendix B of understanding of how management assumptions; and (c) selects the data to AS 1105 applies when AS 1205, by its analyzed the sensitivity of its significant be used. terms, does not apply and the investee assumptions to change, based on other reasonably likely outcomes that would Discussion of the Potential for Material auditor is not supervised under AS Misstatement Due to Fraud 1201. have a material effect. One commenter suggested a AS 2110.52 requires the key Amendments to AS 2110, Identifying requirement for the auditor to obtain an engagement team members to discuss and Assessing Risks of Material understanding of how management the potential for material misstatement Misstatement identifies and addresses the risk of due to fraud. The proposed amendment The proposal included a number of management bias. Another commenter to AS 2110.52 would require the auditor amendments to AS 2110 related to: suggested adding language similar to the to include, as part of this discussion, • Obtaining an understanding of the existing note on evaluation of risk and how the financial statements could be processes used to develop accounting controls within the information system manipulated through management bias estimates and evaluating the use of to clarify that a service organization is in accounting estimates in significant service organizations that are part of a part of the evaluation, not a separate accounts and disclosures. company’s information system; consideration. • In light of related amendments to AS Discussing how the financial 91 See the Specialists Release, supra note 2, for a statements could be manipulated 2110 in the Board’s rulemaking on the discussion of auditors’ responsibilities with respect through management bias; and auditor’s use of specialists, the to specialists.

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Commenters that addressed this topic uncertainty regarding trends affecting recognize that the degree of uncertainty were generally supportive of the the forecast. associated with some estimates affect amendment but provided some One commenter suggested including the assessed risks and direct auditors to suggestions for refinements. One additional factors such as (1) the extent plan and perform audit procedures to commenter suggested that the standard to which the process involves respond to those risks. include discussion of different types of specialized skills or knowledge; (2) the bias. Another commenter also indicated complexity of the data used for Amendments to AS 2301, the Auditor’s that, in their view, the consideration of developing the accounting estimate, Responses to the Risks of Material bias may be better placed in paragraphs including the difficulty, if any, in Misstatement .49–.51 of AS 2110 as part of the overall obtaining relevant and reliable data and The proposal included a note to AS discussion of the susceptibility of the maintaining the integrity of the data; 2301.36 emphasizing that performing financial statements to material and (3) the potential for management substantive procedures for the relevant misstatement. Further, in one bias. Another commenter questioned assertions of significant accounts and commenter’s view, the requirement whether the Board intends management disclosures involves testing whether the implied that the auditor should seek out bias to extend beyond a fraud risk, significant accounts and disclosures are bias in every accounting estimate. This suggesting the requirement highlight in conformity with the applicable commenter suggested the language be management bias as a specific risk financial reporting framework. revised to focus on estimates that are factor. A different commenter asked for Commenters did not express concerns ‘‘more susceptible’’ to material clarification on how instances of high with the proposed amendment. misstatement from management bias or measurement uncertainty are However, some commenters called for where management bias is ‘‘more likely contemplated. additional guidance on identifying and to’’ result in a material misstatement. One commenter sought clarity on testing relevant controls over accounting The amendment to AS 2110.52 is whether the above risk factors are estimates. For example, one commenter adopted as proposed. Contrary to the intended to be considered when suggested guidance related to auditor view of one commenter, the requirement identifying and assessing the risks of consideration of management controls does not direct the auditor to seek out material misstatement related to over selection and supervision of a accounting estimates (in addition to bias in each estimate. Rather, by company specialist. Another commenter identifying significant accounts and including the potential for management suggested additional guidance on disclosures). bias (regardless of type) as part of the identification and testing of relevant engagement team’s overall The amendment to AS 2110.60 is adopted as proposed. The additional controls, and identification and brainstorming discussion, the response to risks of material requirement focuses the auditor’s risk factors included in the amendment describe those characteristics and misstatement due to fraud in relation to attention on a risk that is particularly auditing estimates. This commenter relevant to accounting estimates in conditions that are associated with expressed the view that testing the significant accounts and disclosures. In accounting estimates and that can affect operating effectiveness of controls, addition, including the requirement as the auditor’s determination of the likely including controls over complex models part of paragraph .52 provides sources of potential misstatement. or methods used, can be critical in additional context as to the nature of the While the factors assist the auditor in auditing accounting estimates and, in discussion about susceptibility of the identifying significant accounts and some circumstances, may be required company’s financial statements to disclosures and their relevant (e.g., in situations in which substantive material misstatement due to fraud. assertions, these factors also prompt auditors to appropriately assess the procedures alone do not provide Identifying Significant Accounts and associated risks in the related accounts sufficient appropriate evidence). Disclosures and Their Relevant and disclosures and develop The auditor’s responsibilities for Assertions appropriate audit responses. As testing controls are addressed in AS AS 2110.60 provides risk factors discussed above, AS 2810 requires the 2110, AS 2301, and AS 2201, An Audit relevant to the identification of auditor to evaluate management bias of Internal Control Over Financial significant accounts and disclosures and and its effect on the financial Reporting That Is Integrated with An their relevant assertions. The proposed statements. In circumstances where Audit of Financial Statements. These amendment to AS 2110.60 provided the management bias gives rise to a fraud requirements would apply to controls auditor with additional risk factors that risk, the auditor looks to the over accounting estimates. Nonetheless, are relevant to identifying significant requirements of AS 2301 to respond to in the Board’s view, providing accounts and disclosures involving those risks. additional direction on the need to test accounting estimates, including (1) the The factors were not expanded to controls related to accounting estimates degree of uncertainty associated with include extent of specialized skills used, could help promote an appropriate the future occurrence or outcome of potential for management bias, or audit response in cases where only a events and conditions underlying the complexity of the data used, as financial statement audit is performed. assumptions; (2) the complexity of the suggested by one commenter. These Accordingly, after consideration of process for developing the accounting characteristics are already captured comments, the Board is amending AS estimate; (3) the number and complexity within the factors presented in the 2301.17 to include a note reminding of significant assumptions associated amendment or elsewhere in the risk auditors that for certain accounting with the process; (4) the degree of assessment standards. For example, estimates involving complex models or subjectivity associated with significant assessing the complexity of the process processes, it might be impossible to assumptions (for example, because of for developing an accounting estimate design effective substantive tests that, significant changes in the related events would necessarily include by themselves, would provide sufficient and conditions or a lack of available understanding the data and assumptions appropriate evidence regarding relevant observable inputs); and (5) if forecasts that are used within the process. assertions. are important to the estimate, the length Further, as discussed above, the new The amendment to AS 2301.36 is also of the forecast period and degree of standard and related amendments adopted as proposed.

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Amendments to AS 2401, Consideration assumptions used in accounting take effect, subject to approval by the of Fraud in a Financial Statement Audit estimates. SEC, for audits of financial statements for fiscal years ending on or after To better align requirements with the Comparison With Standards of Other scope of the proposed standard, the December 15, 2020. Standard Setters The Board sought comment on the proposed amendment to AS 2401.64 ISA 540 Revised requires the auditor amount of time auditors would need would have deleted reference to to review the outcome of previous before the proposed standard and ‘‘significant accounting estimates accounting estimates, or, where amendments would become effective, if reflected in the financial statements’’ applicable, their subsequent re- adopted by the Board and approved by and clarified that, when an auditor estimation to assist in identifying and the SEC. A number of commenters performs a retrospective review, the assessing the risks of material recommended that the Board provide an review should be performed for misstatement in the current period. The effective date two years after SEC accounting estimates in significant auditor shall take into account the approval, which they asserted would accounts and disclosures. The proposed characteristics of the accounting give firms the necessary time to update amendment would also have clarified estimates in determining the nature and firm methodologies, develop and that the retrospective review involves a extent of that review. The review is not implement training, and ensure effective comparison of the prior year’s estimates intended to call into question judgments quality control process to support to actual results, if any, to determine about previous period accounting implementation. Some commenters whether management’s judgments and estimates that were appropriate based supported an earlier effective date, with assumptions relating to the estimates on the information available at the time one commenter indicating that the indicate a possible bias on the part of they were made. proposed standard should be effective management. AU–C Section 540 includes a similar contemporaneously with the Some commenters expressed concern requirement. implementation of the new accounting that the proposed amendment would standard on credit losses. One expand the population of accounting Amendment to AS 2805, Management commenter also suggested a phased in estimates subject to retrospective Representations approach for EGCs. Two commenters review, resulting in excessive work. The proposed amendment to AS noted that the proposal should be Other commenters suggested either 2805.06 would require the auditor to effective at the same time as any including the requirement to perform a obtain specific representations related to amendments related to the auditor’s use retrospective review within the accounting estimates in connection with of the work of specialists. proposed standard, or providing a an audit of financial statements While recognizing other clearer linkage between the proposed presented in conformity with generally implementation efforts, the effective standard and the requirements for accepted accounting principles. date determined by the Board is retrospective review in AS 2401. One Consistent with the fair value standard, designed to provide auditors with a commenter suggested a requirement to the auditor would obtain reasonable period of time to implement evaluate the accuracy of management’s representations about the the new standard and related prior estimates going back a minimum appropriateness of the methods, the amendments, without unduly delaying of three years. consistency in application, the accuracy the intended benefits resulting from After consideration of comments, the and completeness of data, and the these improvements to PCAOB amendment to AS 2401.64 was revised reasonableness of significant standards. The effective date is also to further clarify that the accounting assumptions used by the company in aligned with the effective date of the estimates selected for testing should be developing accounting estimates. amendments being adopted in the those for which there is an assessed Commenters did not address the Specialists Release. fraud risk. The scope of the requirement and the Board has adopted D. Economic Considerations and retrospective review, as amended, is this amendment as proposed. better aligned with the new standard Application to Audits of Emerging and focuses the auditor on accounting Amendment To Rescind AI 16, Auditing Growth Companies estimates already identified through the Accounting Estimates: Auditing The Board is mindful of the economic risk assessment process as being Interpretations of AS 2501 impacts of its standard setting. The susceptible to material misstatement As discussed in the proposal, the economic analysis describes the due to fraud. Board is rescinding AI 16. That baseline for evaluating the economic A separate requirement for performing interpretation addresses performance impacts of the new standard, analyzes a retrospective review is not necessary and reporting guidance related to fair the need for the changes adopted by the in the new standard as the requirement value disclosures, primarily voluntary Board, and discusses potential in AS 2401 would achieve the same disclosures including fair value balance economic impacts of the new standard objective. Further, for some estimates, sheets. Fair value disclosure and related amendments, including the the outcome of the estimate may not be requirements in the accounting potential benefits, costs, and known within a reporting period to standards have changed since the unintended consequences. The analysis facilitate such a review. Similarly, issuance of this interpretation, and fair also discusses the alternatives requiring a review over multi-year value balance sheets covered by the considered. There are limited data and period would not be feasible for some interpretation are rarely included in research findings available to estimate estimates. Obtaining an understanding issuer financial statements. quantitatively the economic impacts of of the company’s process for developing Accordingly, this interpretation is discrete changes to auditing standards an estimate would necessarily provide unnecessary. Commenters did not object in this area, and furthermore, no information about the company’s ability to rescinding this interpretation. additional data was identified by to make the estimate. In addition, the commenters that would allow the Board new standard requires the auditor to Effective Date to generally quantify the expected evaluate whether the company has a The Board determined that AS 2501 economic impacts (including expected reasonable basis for significant (Revised) and related amendments will incremental costs related to the

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proposal) on audit firms or companies. consistency in the application of value measurements, and current Accordingly, the Board’s discussion of requirements. At the same time, other practices in the application of those the economic impact is qualitative in commenters cautioned against raising requirements. This section expands on nature. expectations among investors about the the current practices of the profession The Board sought information impact of the proposal on audit quality and currently observed patterns. relevant to economic consequences over by noting various inherent limitations As discussed in Section C, the PCAOB the course of the rulemaking. The Board that the auditor faces in auditing has historically observed numerous has considered all the comments estimates. A number of commenters deficiencies in auditing accounting received and has developed an suggested that additional audit work estimates. PCAOB staff gathered data economic analysis that evaluates the required by the new standard would potential benefits and costs of the final increase cost without necessarily from reported inspection findings requirements and facilitates comparison improving audit quality related to related to issuer audits between 2008 to alternative actions considered. auditing estimates. In addition, some and 2016 for the eight accounting firms Commenters who discussed the commenters expressed concern that that have been inspected every year economic analysis in the Board’s some of the increase in cost might be since the PCAOB’s inspection program 92 proposal provided a range of views. A passed through to companies in the began. The chart below shows the number of commenters agreed with the form of increased audit fees. number of audits with deficiencies economic analysis relating to the need related to the accounting estimates for the proposal. Some commenters Baseline standard and fair value standard based agreed with the potential benefits Section C above discusses the Board’s on the 2008–2016 reported inspection outlined in the proposal, including an current requirements for auditing findings 93 for those eight firms.94 increase in investor confidence and accounting estimates, including fair BILLING CODE 8011–01–P

BILLING CODE 8011–01–C

92 The eight accounting firms are BDO USA, LLP; reviewed, and therefore considered insignificant for compared to the total audits with deficiencies for Crowe Horwath LLP; Deloitte & Touche LLP; Ernst purposes of this analysis. that year. For example, in inspection year 2010, & Young LLP; Grant Thornton LLP; KPMG LLP; 94 The chart identifies the audits with deficiencies 66% of all audits with deficiencies had at least one PricewaterhouseCoopers, LLP; and RSM US LLP reported in the public portion of inspection reports. deficiency related to the accounting estimates (formerly McGladrey, LLP). It shows the relative frequency of audits with standard or the fair value standard (total 2016 93 Deficiencies related to the derivatives standard deficiencies citing the existing accounting estimates reported inspection findings are based on were infrequent over the inspection period standard or the existing fair value standard preliminary results).

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Audits that had deficiencies related to measurements and estimates.100 estimates.’’ 105 Glover et al. find similar the estimates standards represent a Glendening, in his 2017 study, uses a issues with expertise from significant number of total audits with large sample of CAE disclosures data management’s side, with results that deficiencies (including deficiencies in covering 2002–2010 and finds that on indicate that a majority of audit partners audits of internal control over financial average about half of the issuers in his participating in their survey reported reporting) although the overall sample disclose such estimates every encountering problems with percentage has declined since 2011.95 year, with the disclosure rate increasing ‘‘management’s lack of valuation This is consistent with a recent PCAOB over time.101 In Glendening’s sample, process knowledge.’’ 106 Staff Inspection Brief, which observed on average, firms disclose between two In addition to the findings regarding that during the 2016 inspection cycle, and three critical accounting estimates. inspections staff continued to find high auditing challenges, academic research Also, commenters generally agreed with provides evidence on auditors’ use of numbers of deficiencies and ‘‘identify the characterization that financial instances in which auditors did not the available approaches for testing an reporting has continued to require more accounting estimate. A study by Griffith fully understand how the issuer’s accounting estimates that involve estimates were developed or did not et al. suggests that, among the three complex processes and have a approaches available under current sufficiently test the significant inputs significant impact on companies’ and evaluate the significant standards, auditors primarily choose to operating results and financial assumptions used by management.’’ 96 test management’s process, rather than positions. Given the pattern of the data, one can use subsequent events or develop an conclude that, although deficiencies Academic research also confirms the independent estimate.107 In doing so, were increasing in the early periods, challenges auditors face in auditing some auditors tend to verify more recently they have declined. estimates, including fair value management’s assertions on a piecemeal Despite this recent decline, the measurements. Griffith et al., in basis; the authors of the study argue that deficiencies have remained high over an providing a brief summary of the this may result in overreliance on extended period. relevant literature, note that, while management’s process rather than a Accounting estimates are prevalent accounting estimates are increasingly critical analysis of the estimate. Another and significant in financial reporting, as important to financial statements, study by Glover et al., however, finds confirmed by academic research and auditors experience ‘‘difficulty in that auditors primarily use the approach supported with empirical evidence. For auditing complex estimates, suggesting of testing management’s process when example, Griffith et al. note that that audit quality may be low in this auditing lower-risk or typical complex complex accounting estimates, area.’’ 102 Martin, Rich, and Wilks estimates and are more likely to use a including fair value measurements, attribute much of the difficulty in combination of substantive approaches impairments, and valuation allowances, auditing fair value measurements to as the complexity and associated risk of are increasingly important to financial estimation based on future conditions the estimate increase.108 97 statements. In addition, some studies and events and also note that auditors provide evidence on the significance of face many of the same challenges when 105 See Emily Griffith, Jacqueline S. Hammersley, accounting estimates by using large auditing other accounting estimates.103 and Kathryn Kadous, Audits of Complex Estimates as Verification of Management Numbers: How samples of critical accounting policy Cannon and Bedard, using a survey of (‘‘CAP’’) disclosures and critical Institutional Pressures Shape Practice, 32 auditors, find that features such as Contemporary 833, 836 accounting estimate (‘‘CAE’’) (2015). 98 ‘‘management assumptions, complexity, disclosures. Levine and Smith, using a subjectivity, proprietary valuations, and 106 See Steven M. Glover, Mark H. Taylor, and Yi- Jing Wu, Current Practices and Challenges in large sample of CAP disclosures from a lack of verifiable data . . . all annual filings, estimate that on average Auditing Fair Value Measurements and Complex contribute to the challenges in auditing issuers disclose 6.46 policies as critical, Estimates: Implications for Auditing Standards and [fair value measurements].’’ 104 Other the Academy, 36 Auditing: A Journal of Practice & with a median of 6.99 Their analysis studies point to the lack of sufficient Theory 63, 82 (2017). shows that issuers most frequently 107 See Griffith et al., Audits of Complex knowledge on the part of auditor or disclose policies relating to fair value Estimates as Verification of Management Numbers: management as a contributing factor to How Institutional Pressures Shape Practice 841. 108 See Glover et al., Current Practices and 95 PCAOB inspection reports for the same eight auditing challenges. Griffith et al. report Challenges in Auditing Fair Value Measurements firms covering the inspection period from 2004 to that ‘‘[i]nsufficient valuation knowledge and Complex Estimates: Implications for Auditing 2009 similarly found deficiencies in auditing fair is problematic in that relatively Standards and the Academy 65. See also Cannon value measurements, including impairments and inexperienced auditors, who also likely and Bedard, Auditing Challenging Fair Value other estimates. See also Bryan Church and Lori Measurements: Evidence from the Field 81, 82–83. Shefchik, PCAOB Inspections and Large Accounting lack knowledge of how their work fits Glover et al. provide additional insight regarding Firms, 26 Accounting Horizons 43 (2012). into the bigger picture, perform many auditor’s selection of substantive testing 96 See PCAOB Staff Inspection Brief, Preview of audit steps, even difficult ones such as approaches, specifically, the use of developing Observations from 2016 Inspections of Auditors of preparation of independent independent estimates and reviewing subsequent Issuers, at 7. For a more detailed discussion of events and transactions. Glover et al., Current observations from audit inspections, see Section C. Practices and Challenges in Auditing Fair Value 97 100 Id. at 49–50. See Emily Griffith, Jacqueline S. Hammersley, Measurements and Complex Estimates: 101 Kathryn Kadous, and Donald Young, Auditor See Matthew Glendening, Critical Accounting Implications for Auditing Standards and the Mindsets and Audits of Complex Estimates, 53 Estimate Disclosures and the Predictive Value of Academy 69, 71. The study shows that, in Journal of Accounting Research 49 (2015). Earnings, 31 (4) Accounting Horizons 1, 12 (2017). developing independent estimates, availability of 98 Disclosure in Management’s Discussion and 102 See Griffith et al., Auditor Mindsets and independent data, availability of verifiable data, Analysis about the Application of Critical Audits of Complex Estimates 50. and the reliability of management’s estimates are Accounting Policies, Release No. 33–8098 (May 10, 103 See Roger D. Martin, Jay S. Rich, and T. Jeffrey the most commonly cited factors that drive 2002), 67 FR 35619 (May 20, 2002); and Wilks, Auditing Fair Value Measurements: A auditors’ decisions to use management’s versus the Commission Guidance Regarding Management’s Synthesis of Relevant Research, 20 Accounting audit team’s assumptions. Regarding the use of Discussion and Analysis of Financial Condition and Horizons 287, 289 (2006). reviewing subsequent events and transactions, over Results of Operations, Release No. 33–8350. 104 See Nathan Cannon and Jean C. Bedard, 96% of the participating auditors in the study 99 See Carolyn B. Levine and Michael J. Smith, Auditing Challenging Fair Value Measurements: report using the most recent trades that have Critical Accounting Policy Disclosures, 26 Journal of Evidence from the Field, 92 The Accounting Review occurred in the market to support the fair values of Accounting, Auditing & Finance 39, 48 (2011). 81, 82 (2017). recorded securities.

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Need for the Rulemaking asymmetry 110 in such a principal-agent themselves in managerial behavior.115 The academic literature suggests that From an economic perspective, the relationship results in an inherent 111 individuals often overstate their own primary reasons to improve PCAOB incentive problem (moral hazard) capacity and rate their attributes as standards for auditing accounting where the objectives of the agent better than average.116 Moreover, estimates are as follows: (management) may differ from the evidence indicates that, on average, • The subjective assumptions and objectives of the principal (investors), such that the actions of management CEOs and CFOs tend to be more measurement uncertainty of accounting optimistic than the broader estimates make them susceptible to may be suboptimal from the investors’ perspective. For example, academic population.117 For example, managerial potential management bias. The Board overconfidence has been linked to believes that PCAOB standards related research suggests that management may engage in , in aggressive earnings forecasts by to auditing accounting estimates will be 118 which they choose reporting methods management. improved by emphasizing the Given the degree of subjectivity in application of professional skepticism, and estimates that do not adequately reflect their companies’ underlying many financial statement estimates, including addressing potential these incentive and information issues, economics, for a variety of reasons, management bias. Although the risk coupled with cognitive biases, present including to increase their own assessment standards and certain other particular problems in the context of compensation and job security.112 The PCAOB standards address professional estimates. Managerial biases (conscious information asymmetry between skepticism and management bias, the or otherwise) may lead managers to pick investors and managers also leads to an estimates standards provide little or no a more favorable estimate within the specific direction on how to address information problem (adverse permissible range.119 That is, incentive those topics in the context of auditing selection) 113 resulting in a higher cost 114 problems and cognitive biases may push accounting estimates. of capital, because investors may not management toward the most favorable • Existing requirements do not be able to accurately assess the quality estimates, either with respect to specific provide specific direction about how to of management or of management accounts or in the overall presentation. evaluate the relevance and reliability of reporting. Audits are one of the mechanisms for pricing information from third parties In addition to the potential incentive mitigating the information and incentive and might have led to additional work problem, cognitive biases, such as problems arising in the investor- and cost for some audits. PCAOB management optimism or management relationship.120 Audits are standards should be improved by overconfidence, can manifest intended to provide a check of revising the requirements in this area to management’s financial statements, and drive a level of work effort 110 Economists often describe ‘‘information thus reduce management’s potential commensurate with both the risks of asymmetry’’ as an imbalance, where one party has material misstatement in the valuation more or better information than another party. For 115 For a discussion of the manifestation of of financial instruments and the a discussion of the concept of information overconfidence in managerial behavior, see, e.g., asymmetry, see, e.g., George A. Akerlof, The Market Anwer S. Ahmed and Scott Duellman, Managerial relevance and reliability of the evidence for ‘‘Lemons’’: Quality Uncertainty and the Market Overconfidence and Accounting Conservatism, 51 obtained. Mechanism, 84 The Quarterly Journal of Economics (1) Journal of Accounting Research 1 (2013); Itzhak • The differences among the three 488 (1970). Ben-David, John R. Graham, and Campbell R. 111 existing estimates standards suggest that The moral hazard problem is also referred to Harvey, Managerial Miscalibration, 128 (4) The as a hidden action, or agency problem in economics Quarterly Journal of Economics 1547 (2013); and revising PCAOB standards to set forth a literature. The term ‘‘moral hazard’’ refers to a Catherine M. Schrand and Sarah L.C. Zechman, more uniform, risk-based approach to situation in which an agent could take actions (such Executive Overconfidence and the Slippery Slope to auditing estimates should lead to as not working hard enough) that are difficult to Financial Misreporting, 53 Journal of Accounting improvements in auditing practices in monitor by the principal and would benefit the and Economics 311, 320 (2012). agent at the expense of the principal. To mitigate 116 This and other biases are discussed in, among responding to the risks of material moral hazard problems, the agent’s actions need to others, Gilles Hilary and Charles Hsu, Endogenous misstatement in accounting estimates, be more closely aligned with the interests of the Overconfidence in Managerial Forecasts, 51 Journal whether due to error or fraud. principal. Monitoring is one mechanism to mitigate of Accounting and Economics 300 (2011). these problems. See, e.g., Bengt Holmstro¨m, Moral 117 See John R. Graham, Campbell R. Harvey, and Economic theory provides an Hazard and Observability, 10 The Bell Journal of Manju Puri, Managerial Attitudes and Corporate analytical framework for the Board’s Economics 74 (1979). Actions, 109 Journal of Financial Economics 103, consideration of these potential needs, 112 See Paul M. Healy and James M. Wahlen, A 104 (2013). Managerial attitude has been linked to as discussed below. Review of the Earnings Management Literature and a variety of corporate decisions, including corporate Its Implications for Standard Setting, 13 (4) investment and mergers & acquisitions. See Ulrike Principal-Agent Problems and Bounded Accounting Horizons 365 (1999). For a seminal Malmendier and Geoffrey Tate, CEO Rationality work on the agency problem between managers and Overconfidence and Corporate Investment, 60 The investors, see Jensen and Meckling, Theory of the Journal of Finance 2661 (2005); and Ulrike Principal-agent theory is commonly Firm: Managerial Behavior, Agency Costs and Malmendier and Geoffrey Tate, Who Makes used to describe the economic Ownership Structure. Acquisitions? CEO Overconfidence and the 113 Adverse selection (or hidden information) Market’s Reaction, 89 Journal of Financial relationship between investors and problems can arise in circumstances where quality Economics 20 (2008). managers, and the attendant information is difficult to observe, including in principal-agent 118 See Paul Hribar and Holly Yang, CEO and incentive problems that result from relationships where the principal’s information Overconfidence and Management Forecasting, 33 the separation of ownership and problem means it cannot accurately assess the Contemporary Accounting Research 204 (2016). 119 109 quality of the agent or the agent’s work. In addition For purposes of this discussion, a ‘‘favorable’’ control. The presence of information to diminishing the principal’s ability to optimally estimate can reflect either an upward or a select an agent, the problem of adverse selection downward bias, for example in earnings, depending 109 For studies of principal-agent relationships can manifest in markets more broadly, leading to an on management incentives. and the attendant information and incentive undersupply of higher-quality products. For a 120 See Paul M. Healy and Krishna G. Palepu, problems in the context of the separation of discussion of the concept of adverse selection, see, Information Asymmetry, Corporate Disclosure, and ownership and control of public companies and its e.g., Akerlof, The Market for ‘‘Lemons’’: Quality the Capital Markets: A Review of the Empirical implications in financial markets, see, e.g., Michael Uncertainty and the Market Mechanism. Disclosure Literature, 31 Journal of Accounting and C. Jensen and William H. Meckling, Theory of the 114 See, e.g., Richard A. Lambert, Christian Leuz, Economics 405, 406 (2001). See also Mark DeFond Firm: Managerial Behavior, Agency Costs and and Robert E. Verrecchia, Information Asymmetry, and Jieying Zhang, A Review of Archival Auditing Ownership Structure, 3 Journal of Financial Information Precision, and the Cost of Capital, 16 Research, 58 Journal of Accounting and Economics Economics 305 (1976). (1) Review of Finance 1, 21 (2012). 275 (2014).

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incentive to prepare and disclose biased and to process information,123 resort to simplifications that might or inaccurate financial statements. especially when faced with time increase the potential for biases or errors Audit reports and auditing standards constraints.124 Research has shown that that have seeped into financial provide information to the market that even sell-side research analysts, statements to go undetected.127 generally understood to be sophisticated may affect perceptions about the The literature has linked cognitive financial experts, have trouble assessing reliability of the financial statements issues to auditors’ actions and attitudes, and therefore mitigate investors’ the impact on earnings of companies’ specifically to professional information problem, potentially derivative instruments, where the skepticism.128 For example, ‘‘research in lowering the company’s cost of associated financial reporting involves psychology and accounting has capital.121 fair value measurements.125 In the context of auditing estimates, identified that auditors’ judgments are The auditor is also an agent of one such bound may be the ability of vulnerable to various problems, such as investors, however, and the information auditors to analyze and integrate difficulty recognizing patterns of asymmetry between investors and different existing standards or process evidence, applying prior knowledge to auditors can also give rise to risks of the information required to audit the current judgment task, weighting moral hazard and adverse selection. estimates that involve complex evidence appropriately, and preventing Auditors have incentives that align their processes, which may require incentives from affecting judgment in interests with those of investors, such as sophisticated analytical and modeling unconscious ways.’’ 129 As a result, legal considerations, professional techniques. In the presence of bounded cognitive limitations may pose a threat responsibilities, and reputational rationality, individuals may resort to to professional skepticism 130 and concerns. However, they may also have heuristics (i.e., rules of thumb).126 In incentives to behave sub-optimally from ‘‘[b]ias-inducing tendencies can lead particular, auditors facing challenges in investors’ point of view by, for example, even the brightest, most experienced auditing an accounting estimate may (1) not sufficiently challenging professionals, including auditors, to 131 management’s estimates or underlying make suboptimal judgments.’’ 123 Daniel Kahneman refers to the mind as having Accordingly, the existence of bounded assumptions in order not to disturb the two systems, System 1 and System 2. ‘‘System 1 client relationship; (2) shirking, if they operates automatically and quickly . . . ’’ System rationality and, in particular, some are not properly incentivized to exert 2 is the slower one that ‘‘can construct thoughts in inherent cognitive biases might affect the effort considered optimal by an orderly series of steps.’’ System 2 operations auditor judgment when auditing ‘‘require attention and are disrupted when attention accounting estimates, even separate shareholders; or (3) seeking to maximize is drawn away.’’ Daniel Kahneman, Thinking, Fast profits and/or minimize costs— and Slow 4, 20–22 (1st ed. 2011). Examples of from any potential conflict of interest. sometimes at the expense of audit System 2 operations include ‘‘[f]ill[ing] out a tax Some of the biases that might affect form’’ and ‘‘[checking] the validity of a complex quality. As a result of such misaligned logical argument,’’ both of which require time and auditors include, but are not limited to: incentives, auditors may engage in attention. Without time, one cannot dedicate • Anchoring Bias—decision makers practices that do not align with attention to a task and fully engage System 2, and anchor or overly rely on specific investors’ needs and preferences. hence is left with the automatic instinctual operation of System 1, which can lead to use of information or a specific value and then In addition to the auditor’s potential rules of thumb (heuristics) and ‘‘biases of adjust to that value to account for other moral hazard problem, the presence of intuition.’’ Id. elements of the circumstance, so that bounded rationality can inject another 124 Time is an essential limitation to problem solving, being fundamental to the definition of there is a bias toward that value. In the layer of challenges into auditing bounded rationality—‘‘[t]he principle that auditing of estimates, the potential estimates. In economic theory, bounded organisms have limited resources, such as time, exists for anchoring on management’s rationality refers to the idea that when information, and cognitive capacity, with which to individuals make decisions, their find solutions to the problems they face.’’ Andreas Wilke and R. Mata, Cognitive Bias, as published in 127 For a discussion and examples of heuristics rationality may be limited by certain The Encyclopedia of Human Behavior 531 (2nd ed. used by auditors, see, e.g., Stanley Biggs and bounds, such as limits on available 2012). Theodore Mock, An Investigation of Auditor information, limits on analytical ability, 125 See Hye Sun Chang, Michael Donohoe, and Decision Processes in the Evaluation of Internal limits on the time available to make the Theodore Sougiannis, Do Analysts Understand the Controls and Audit Scope Decisions, 21 (1) Journal Economic and Reporting Complexities of of Accounting Research 234 (1983). decision, and inherent cognitive 128 Nelson argues that ‘‘[p]roblem-solving ability, 122 Derivatives? 61 Journal of Accounting and biases. Even if incentives between Economics 584 (2016). For a discussion of the ethical predisposition, and other traits like self- principal and agent are aligned, the bounded rationality of audit judgments, see Brian confidence and tendency to doubt are all related to agent, being boundedly rational, may be Carpenter and Mark Dirsmith, Early Debt [professional skepticism] in judgment and action,’’ and, furthermore ‘‘[c]ognitive limitations affect unable to execute appropriately. Hence, Extinguishment Transactions and Auditor Materiality Judgments: A Bounded Rationality [professional skepticism] in predictable ways.’’ some auditors may find auditing certain Perspective, 17 (8) Accounting, Organizations and Mark Nelson, A Model and Literature Review of estimates challenging because, like all Society 709, 730 (1992) (‘‘[T]he self-reported actions Professional Skepticism in Auditing, 28 Auditing: A individuals, they may have limits on taken by auditors on actual engagements appear to Journal of Practice & Theory 1, 2 (2009). 129 their ability to solve complex problems reveal less complexity in the sense that they are Id. at 6. boundedly rational and tend to emphasize only a 130 ‘‘[A]uditors’ judgments can be flawed because, single judgment criterion than do the cognitive like all people, sometimes they do not consistently 121 See, e.g., Richard A. Lambert, Christian Leuz, judgment processes of which they are capable.’’). follow a sound judgment process and they fall prey and Robert E. Verrecchia, Accounting Information, 126 ‘‘The essence of bounded rationality is thus to to systematic, predictable traps and biases. People, Disclosure, and the Cost of Capital, 45 Journal of be a ‘process of thought’ rather than a ‘product of including experienced professionals . . . often Accounting Research 385 (2007). thought’: Individuals have recourse to reasonable unknowingly use mental ‘‘shortcuts’’ . . . to 122 For a seminal work in this field, see Herbert procedures rather than to sophisticated efficiently navigate complexity . . . [S]ituations can A. Simon, A Behavioral Model of Rational Choice, computations which are beyond their cognitive arise where they systematically and predictably 69 The Quarterly Journal of Economics 99 (1955). capacities.’’ Bertrand Munier, Reinhard Selten, D. lead to suboptimal judgments and potentially Simon introduced this theory and argued that Bouyssou, P. Bourgine et al., Bounded Rationality inhibit the application of appropriate professional individuals cannot assimilate and process all the Modeling, 10 Marketing Letters 233, 234 (1999). In skepticism.’’ Steven M. Glover and Douglas F. information that would be needed to maximize ‘‘[s]ituations where evolved task-general procedures Prawitt, Enhancing Auditor Professional Skepticism their benefits. Individuals do not have access to all are helpful (heuristics, chunks) . . . agents have (Nov. 2013) (a report commissioned by the the information required to do so, but even if they difficulty finding even qualitatively appropriate Standards Working Group of the Global Public did, they would be unable to process it properly, responses . . . agents are then left with heuristics Policy Committee), at 10. since they are bound by cognitive limits. ... ’’ Id. at 237. 131 Id.

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estimates.132 This can be seen as a All of these cognitive biases would point out that fair value measurements manifestation of findings that auditors pose a threat to the proper application frequently incorporate forward-looking may, at times, experience difficulties of professional skepticism and an information as well as judgments, and weighting evidence appropriately.133 appropriate focus on the potential for that, since future events cannot be • Confirmation Bias—a phenomenon management bias in accounting predicted with certainty, an element of wherein decision makers have been estimates. Academic research illustrates judgment is always involved.142 The shown to actively seek out and assign how cognitive biases may affect measurement uncertainty inherent in more weight to evidence that confirms auditing. Griffith et al. find that auditors estimates allows room for both their hypothesis, and ignore or focus primarily on confirming, rather management bias and error to affect underweight evidence that could than challenging, management’s model, preparers’ valuation judgments, and disconfirm their hypothesis. As such, and appear to accept management’s estimates become less useful to capital confirmation bias can be thought of as model as a starting point and then verify market participants as they become less a form of selection bias in collecting aspects of that model.138 None of the reliable.143 evidence. It becomes even more auditors in the study indicated that he To help auditors overcome, or problematic in the presence of or she considered whether additional compensate for, potential biases and anchoring bias, since auditors may factors beyond the assumptions made by identify situations where management is anchor on management’s estimate and management should be included in consistently optimistic, and to may only seek out information to management’s model. This type of discourage shirking, the new standard corroborate that value (or focus behavior is suggestive of anchoring emphasizes the auditor’s existing primarily on confirming, rather than bias.139 responsibility to apply professional challenging, management’s model).134 Importantly, bounded rationality and skepticism, including addressing For example, in the accounting the associated biases exist in addition to potential management bias. It does so by estimates standard, as one of the any incentive problems (moral hazard). emphasizing these professional available three approaches in evaluating Cognitive biases and moral hazard could obligations in the specific context of the reasonableness of an estimate, the work in the same direction to increase auditing accounting estimates. It also auditor is instructed to ‘‘develop an the likelihood of auditors agreeing with includes revised terminology to describe independent expectation of the estimate management, not considering the nature of the auditor’s responsibility to corroborate the reasonableness of contradictory evidence, or discounting and the new requirements described in management’s estimate’’ (emphasis the potential importance or validity of Section C to guide the auditor in the added).135 appropriate application of professional • alternative methods, data, and Familiarity Bias—‘‘Familiarity is assumptions. It is important for auditors skepticism, including addressing associated with a general sense of to be wary of their own biases as well potential management bias, when comfort with the known and discomfort as management’s biases when auditing auditing estimates. with—even distaste for and fear of—the Some commenters on the proposal 136 accounting estimates (e.g., in order to alien and distant.’’ In the context of avoid merely searching for evidence that were supportive of a new standard auditing accounting estimates, auditors corroborates management’s taking into consideration management may be biased toward procedures, bias and emphasizing the application of assertions).140 methods, models, and assumptions that It is also logical to conclude that the professional skepticism while some seem more familiar to them, and potential for bias increases in the others highlighted the difficulties in auditors’ familiarity with management presence of measurement uncertainty, evaluating and identifying management may lead them to tend to accept since there is more latitude in recording bias in accounting estimates due to the uncertainty and subjectivity involved. management’s assertions without an estimate in such circumstances. sufficient challenge or consideration of Some commenters were critical of Academic studies find that the other options.137 ‘‘negative’’ tone or overemphasis on measurement uncertainty associated management bias and the application of with accounting estimates can be 132 For a discussion on anchoring biases and some professional skepticism. Some substantial.141 Martin, Rich, and Wilks evidence, see, e.g., Robert Sugden, Jiwei Zheng, and commenters, on the other hand, Daniel John Zizzo, Not All Anchors Are Created Equal, 39 Journal of Economic Psychology 21 experience and increases client-specific knowledge, recommended that the new standard (2013). while excessive familiarity impairs audit quality, further expand the discussion and 133 Nelson, A Model and Literature Review of resulting in lower earnings quality. emphasis of management bias and the Professional Skepticism in Auditing 6. 138 See Griffith et al., Audits of Complex need to challenge management’s 134 For a discussion of confirmation bias, see, e.g., Estimates as Verification of Management Numbers: assertions. As discussed above, the Raymond S. Nickerson, Confirmation Bias: A How Institutional Pressures Shape Practice. Board believes that reinforcing the Ubiquitous Phenomenon in Many Guises, 2 Review 139 The problem resulting from this bias can be of General Psychology 175 (1998). For a discussion ameliorated, but not completely eliminated. The importance of professional skepticism of the manifestation of this bias in auditing, see, audit, by its nature, uses the company’s financial when auditing estimates, in light of the e.g., Griffith et al., Audits of Complex Estimates as statements as a starting point. For that reason, potential for management bias, will Verification of Management Numbers: How starting with management’s number is often remind auditors of their responsibilities Institutional Pressures Shape Practice. unavoidable since the auditor is opining on 135 AS 2501.10b. whether the company’s financial statements are to evaluate contradictory evidence and 136 Gur Huberman, Familiarity Breeds Investment, fairly presented, in all material respects, in 14 Review of Financial Studies 659, 678 (2001). conformity with the applicable financial reporting for Audit Assurance, 31 Auditing: A Journal of 137 Academic research also argues and provides framework. When reference is made to anchoring Practice & Theory 127 (2012); Cannon and Bedard, evidence that some level of auditor familiarity with bias in this release, it is therefore not intended to Auditing Challenging Fair Value Measurements: the client can help the auditing process. See refer to the auditor’s responsibility to start with Evidence from the Field. Wuchun Chi and Huichi Huang, Discretionary management’s financial statements, but instead to 142 See Martin et al., Auditing Fair Value , Audit-Firm Tenure and Audit-Partner the auditor’s potential failure to effectively Measurements: A Synthesis of Relevant Research. Tenure: Empirical Evidence from Taiwan, 1 (1) challenge management. 143 See, e.g., Russell Lundholm, Reporting on the Journal of Contemporary Accounting and 140 See, e.g., Martin et al., Auditing Fair Value Past: A New Approach to Improving Accounting Economics 65, 67 (2005). Although the study does Measurements: A Synthesis of Relevant Research. Today, 13 Accounting Horizons 315 (1999); and not address familiarity bias, the results indicate that 141 See, e.g., Brant E. Christensen, Steven M. Griffith et al., Audits of Complex Estimates as auditor familiarity with the client produces higher Glover, and David A. Wood, Extreme Estimation Verification of Management Numbers: How earnings quality as it has an effect on learning Uncertainty in Fair Value Estimates: Implications Institutional Pressures Shape Practice.

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to address the effects of bias on the hand, and brokers or dealers on the one commenter suggested inclusion of financial statements. other, that warrant differential differences in valuation approaches of treatment. Based on outreach and pricing services as an additional factor Fostering a More Efficient Audit observations from the Board’s oversight in evaluating reliability. Although the Tailoring Requirements for Different activities, the Board understands that differences in valuation approaches Types of Pricing Information pricing services tend to accumulate could create biased valuations, auditors The new standard requires different overall market information, rather than are required to evaluate the relevance audit procedures for the different types engage directly in market transactions, and reliability of pricing information of third-party pricing information used and typically have well-defined provided by pricing services. for fair value measurements of financial methodologies that are used consistently over time. Therefore, they Multiple Standards With Overlapping instruments, and is intended to drive a Requirements level of work effort commensurate with tend to provide customers with more both the risks of material misstatement uniform pricing information. Brokers or Having multiple standards with in the valuation of financial instruments dealers, on the other hand, are in the similar approaches but varying levels of and the relevance and reliability of the business of providing liquidity to the detail in procedures may create evidence obtained. Existing market (by acting as a buyer or seller) unnecessary problems. Perceived requirements do not provide specific and connecting buyers and sellers. As inconsistencies among existing direction about how to evaluate the such, it is likely their pricing is more standards may result in (1) different relevance and reliability of pricing idiosyncratic (i.e., dependent on the auditor responsibilities for accounts for party asking for a quote, timing, and information from third parties and which a similar audit approach would other factors related to the business might have led to additional work and seem appropriate; (2) inconsistent operations of the broker or dealer) and cost for some audits and insufficient application of standards; and (3) brokers or dealers may occasionally be work and effort for some audits. Under inappropriate audit responses. less transparent in pricing the the new standard, auditors will be Academic research speaks to the instruments. In addition, not all brokers prompted to direct more effort toward undesirable nature of overlapping or dealers necessarily have a firm-wide pricing information that may be more standards addressing the same issue, methodology, as they typically provide subject to bias or error based on the type which adds to task difficulty 144 and prices on an as-requested basis. of instrument being valued and how or may, therefore, create unnecessary Therefore, the Board believes that additional costs, as it is costly to sift by whom the pricing information is auditors’ consideration of pricing through the standards and reconcile generated. For certain types of third information obtained from a broker or potential conflicts. These costs may parties—specifically, pricing services dealer should differ from their exacerbate the principal-agent and and brokers or dealers—the new consideration of pricing information cognitive challenges discussed above. standard provides more specific from a pricing service. direction. The issue of different types of pricing For example, auditors might, The Board understands that pricing information provided by third-party consciously or otherwise, apply the information generated by pricing sources is addressed in the special standards in a manner that satisfies their services generally tends to have three topics appendix of the new standard. objectives but not those of investors main characteristics not shared by other This appendix more broadly addresses (e.g., auditors may choose an approach estimates (1) uniformity of product auditing financial instruments and with fewer procedures and requirements (with little to no differentiation across includes procedures specific to an to minimize audit cost, or for users, so there is less risk of inherent auditor’s use of evidence from third- expediency, hence maximizing their bias); (2) work of the pricing service party pricing sources. These procedures profits). The existence of overlapping that, in most cases, is not prepared at allow the auditor to use pricing requirements might also lead to the direction of a particular client; and information from pricing sources used uncertainty about compliance, if (3) buyers of the product with little, if by the company in some circumstances auditors do not understand what is any, market power. These (e.g., generally in cases where the required. Finally, overlapping characteristics reduce the risk of bias, company uses a pricing service based on requirements may increase perceived unless the pricing service has a trades of similar instruments to value uncertainty about audit quality, since relationship with the company by securities with a lower risk of material market participants may not fully which company management has the misstatement). This would be an understand what standard is being, or ability to directly or indirectly control appropriate risk-based audit response, even should be, applied. or significantly influence the pricing since there is a lower chance of To address the issues stemming from service. The potential for bias is further management bias when the company having multiple, overlapping estimates attenuated for pricing services since uses a pricing service. standards, the new standard replaces there is monitoring by the market as a One commenter who provided views the existing three standards related to whole, and most of the prices provided on the third-party pricing information auditing accounting estimates. by these services are for traded agreed that the reliability of the pricing Moreover, it aligns the requirements securities or for securities for which information from the third-party pricing with the risk assessment standards quotes are available or for which similar sources may differ and that factors through targeted amendments to securities are traded. Overall, the Board covered in the proposal captured that promote the development of appropriate believes that these characteristics variability. A few commenters also responses to the risks of material contribute to a lower risk of bias in asserted that third-party pricing services information provided by pricing generally provide pricing that is free 144 See Brian Bratten, Lisa Milici Gaynor, Linda services relative to other estimates and from influence of any one user of the McDaniel, Norma R. Montague, and Gregory E. warrant tailored audit requirements. services, and one of these commenters Sierra, The Audit of Fair Values and Other Estimates: The Effects of Underlying The Board believes that there also are opined that this absence of management Environmental, Task, and Auditor-Specific Factors, differences between the information bias increased the relevance and 32 Auditing: A Journal of Practice & Theory 7, 15– provided by pricing services on the one reliability of the evidence. In addition, 16 (2013).

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misstatement related to accounting distributed, they face a potential The extent of these benefits, which estimates. collective action problem that creates are discussed further below, will largely A number of commenters supported additional barriers to jointly negotiating depend on the extent to which firms the development of a single standard to with auditors over requirements for have to change their practices and replace the three existing standards. For auditing accounting estimates. methodologies. Benefits will be less in example, some noted that a single, For the mitigation of this collective the case of firms that have already consistent set of requirements aligned action problem and other potential adopted practices and methodologies with the risk assessment standards sources of market failure,147 investors similar to the requirements being would provide greater uniformity and generally rely on auditing standards that proposed. clarity and eliminate the need to are based on investor and public First, the new standard should reduce navigate among three related standards interests. PCAOB auditing standards the problems generated by moral hazard in order to ensure that all requirements establish performance requirements and potential cognitive biases by were met. On the other hand, one that, if not implemented, can result in strengthening the performance commenter cautioned that a single costly penalties to the auditor in the requirements for auditing accounting standard would lead to a one-size-fits- form of litigation and reputational risk. estimates and by emphasizing the all audit approach and not allow the Economic Impacts importance of addressing potential tailoring of audit procedures based on management bias and the need to the issuer-specific risks of material Benefits maintain a skeptical mindset while misstatement. By aligning with the risk The new standard should lead to two auditing accounting estimates. assessment standards and describing the broad categories of benefits. The first Reinforcing the need for professional basic requirements for testing and relates directly to audit quality and the skepticism should encourage auditors, evaluating estimates, the Board believes second relates to fostering an efficient for example, to ‘‘refram[e] hypotheses so the new standard is designed to allow risk-based approach to auditing that confirmation biases favor auditors to tailor their procedures in accounting estimates, including fair [professional skepticism],’’ and thereby order to respond to specific risks of value measurements. The new standard mitigate the effect of such biases on material misstatement. strengthens auditor responsibilities for auditor judgment.150 It should Lack of Market Solutions auditing accounting estimates, encourage auditors to be more conscious including fair value measurements, when weighing audit evidence and The issues discussed above are not, which should increase the likelihood should reduce instances where auditors and cannot efficiently be, addressed that auditors detect material fail to consider contradictory evidence. through market forces alone because the misstatements, and more explicitly For example, the use of terms such as auditor may not be fully incentivized to integrates the risk assessment standards, ‘‘evaluate’’ and ‘‘compare’’ instead of address them and market forces may not which should encourage a uniform ‘‘corroborate,’’ and greater emphasis on be effective in making the auditor more approach to achieve a more efficient and auditors identifying the significant responsive to investors’ concerns risk-based audit response. These assumptions in accounting estimates regarding the auditing of estimates. The improvements should enhance audit should promote a more deliberative auditor may not be fully incentivized quality and, in conjunction with the approach to auditing estimates, rather because auditors may incur additional clarification of the procedures the than a mechanical process of looking for costs to produce higher audit quality but auditor should perform, should provide evidence to support management’s would earn lower profits on the audit, greater confidence in the accuracy of assertions. Academic research also since audit quality may not be companies’ financial statements.148 provides evidence on the effect of 145 observable and auditors may be From a capital market perspective, an framing in the context of auditors’ fair unable to charge more for better increase in the information quality of value judgments.151 In an experimental audits.146 Furthermore, because companies’ financial statements investors are diverse and geographically resulting from improved audit quality 388 (finding that information quality directly can reduce the non-diversifiable risk to influences a company’s cost of capital and that 145 An ‘‘audit is a credence service in that its investors and generally should result in improvements in information quality by individual quality may never be discovered by the company, companies unambiguously affect their non- the shareholders or other users of the financial investment decisions by investors that diversifiable risks.); and Ahsan Habib, Information statements. It may only come into question if a more accurately reflect the financial Risk and the Cost of Capital: Review of the ‘clean’ audit report is followed by the collapse of position and operating results of each Empirical Literature, 25 Journal of Accounting the company.’’ See Alice Belcher, Audit Quality company, increasing the efficiency of Literature 127, 128 (2006) (‘‘[H]igh quality auditing and the Market for Audits: An Analysis of Recent 149 could provide credible information in the market UK Regulatory Policies, 18 Bond Law Review 1, 5 capital allocation decisions. regarding the future prospect of the [company] and (2006). Credence services are difficult for users of hence could reduce the cost of capital in general, the service (such as investors in the context of 147 For a discussion of the concept of market and cost of equity capital in particular.’’). See also company audit services) to value because their failure, see, e.g., Francis M. Bator, The Anatomy of Jukka Karjalainen, Audit Quality and Cost of Debt benefits are difficult to observe and measure. See Market Failure, 72 The Quarterly Journal of Capital for Private Firms: Evidence from Finland, also Monika Causholli and W. Robert Knechel, An Economics 351 (1958); and Steven G. Medema, The 15 International Journal of Auditing 88 (2011). Examination of the Credence Attributes of an Audit, Hesitant Hand: Mill, Sidgwick, and the Evolution of 150 Nelson, A Model and Literature Review of 26 Accounting Horizons 631 (2012). the Theory of Market Failure, 39 History of Political Professional Skepticism in Auditing 2. In addition, 146 The general effect of cost pressures on audit Economy 331 (2007). another experimental study found other factors, quality has been studied in the academic literature 148 For a discussion on the relationship between such as improved cognitive tools, might be with varying empirical findings. See, e.g., James L. audit quality and financial reporting quality, see necessary to enhance the use of professional Bierstaker and Arnold Wright, The Effects of Fee DeFond and Zhang, A Review of Archival Auditing judgment and critical thinking skills. See Anthony Pressure and Partner Pressure on Audit Planning Research 275, 281 (‘‘. . . [A]udit quality is a Bucaro, Enhancing Auditors’ Critical Thinking in Decisions, 18 Advances in Accounting 25 (2001); B. component of financial reporting quality, because Audits of Complex Estimates, Accounting, Pierce and B. Sweeney, Cost-Quality Conflict in high audit quality increases the credibility of the Organizations and Society 1, 11 (2018). Audit Firms: An Empirical Investigation, 13 financial reports. This increased credibility arises 151 See Jeffrey Cohen, Lisa Gaynor, Norma European Accounting Review 415 (2004); and Scott through greater assurance that the financial Montague, and Julie Wayne, The Effect of Framing D. Vandervelde, The Importance of Account statements faithfully reflect the [company’s] on Information Search and Information Evaluation Relations When Responding to Interim Audit underlying economics.’’). in Auditors’ Fair Value Judgments (Feb. 2016) Testing Results, 23 Contemporary Accounting 149 See, e.g., Lambert et al., Accounting (working paper, available in Social Science Research 789 (2006). Information, Disclosure, and the Cost of Capital, Research Network).

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study, Cohen et al. found that when one increase in efficiency for easier-to- and judgment involved in estimates, group of auditors were instructed to measure and lower-risk estimates. some argued that unreasonable bias ‘‘support and oppose’’ management’s Fourth, uniformity of the standards would be difficult to detect and a level assertions, they recommended should lead to benefits to auditors and of bias and uncertainty would remain significantly different fair value users of financial statements. A single, irrespective of the level of audit effort. estimates than another group of auditors consistent set of requirements should While auditing cannot eliminate the who were instructed to ‘‘support’’ lead to more consistent and efficient uncertainty and judgment involved in management’s assertions. audits with greater comparability since estimates, it can help identify material Several commenters on the proposal there should be no doubt as to what omissions and errors. Furthermore, even supported the emphasis on professional requirements to apply, and no need to if more robust auditing procedures do skepticism and one commenter agreed navigate among multiple standards to not yield more accuracy and precision that the new requirements would make sure that all relevant requirements for each individual estimate, to the prompt auditors to devote greater are met. In turn, assuming that firms extent that any pattern of bias or error attention to identifying and addressing comply with the new requirements, this can be eliminated, this should result in management bias. Moreover, some should increase and make more uniform more reliable financial reporting. The commenters confirmed that raising the quality of the information presented financial statements as a whole may not awareness of cognitive biases and in the financial statements. Having a be fairly presented if the most optimistic including reminders of professional uniform set of requirements might also estimates are consistently selected by skepticism could help mitigate the enhance the audit committee’s the preparer even when each individual effects of auditors’ own biases. In understanding of the auditor’s estimate is within a reasonable range. addition, a few commenters supported responsibilities and, therefore, Emphasizing the risk of management the change in terminology and agreed potentially facilitate communications bias in accounting estimates and the that it would further reinforce the between the audit committee and the auditor’s responsibility to apply application of professional skepticism auditor. Moreover, a single standard professional skepticism can help focus by moving from a corroborative mindset will facilitate the development of timely auditors on the effects of management to an evaluation mindset, while one guidance for specific issues when bias on financial statements. commenter expressed skepticism about needed. the impact of terminology on auditor Finally, establishing more clarity and Costs behavior. Some commenters noted the specificity in requirements for estimates The Board recognizes that imposing difficulties and limitations in evaluating should lead to efficiency gains by new requirements may result in and identifying management bias in providing auditors with a better additional costs to auditors and the accounting estimates due to the understanding both of their duties and companies they audit. In addition, to uncertainty and subjectivity involved. of the Board’s expectations, reducing the extent that auditors pass on any Given the subjective assumptions and the risk that auditors would perform increased costs through an increase in inherent measurement uncertainty in unnecessary or ineffective procedures. audit fees, companies and investors many estimates, bias may not be Hence, holding audit quality constant, could incur an indirect cost. eliminated entirely. However, the Board auditors should gain efficiencies. Auditors may incur certain fixed costs believes that a standard that reinforces Overall, these changes should lead to (costs that are generally independent of the application of professional greater confidence in financial the number of audits performed) related skepticism and reminds auditors of risk statements, reducing investors’ to implementing the new standard and of management bias and their information asymmetry. Reinforcing and related amendments. These include responsibilities to evaluate clarifying auditors’ responsibilities costs to update audit methodologies and contradictory evidence and to address should enhance investors’ trust that tools, prepare training materials, and the effects of bias can help ameliorate auditors are obtaining sufficient conduct training. Larger firms are likely the problems resulting from this bias. appropriate evidence regarding to update methodologies using internal Second, requirements specific to the management’s accounting estimates, resources, whereas smaller firms are use of pricing information from third thereby increasing investors’ confidence more likely to purchase updated parties as audit evidence should lead to in companies’ financial statements and methodologies from external vendors. a more efficient audit as these new the corresponding audit work In addition, auditors may incur requirements will prompt more tailored performed. Also, the new standard may certain variable costs (costs that are audit procedures (including by lead to fewer restatements as a result of generally dependent on the number of performing procedures over groups of increased audit quality for higher-risk audits performed) related to similar instruments, where appropriate) estimates and, hence, increase investor implementing the new standard. These and direct more audit effort toward confidence in financial statements. include costs of implementing the pricing information that may be more Increased confidence in companies’ standard at the audit engagement level subject to bias or error. financial statements should ameliorate (e.g., in the form of additional time and Third, in addition to achieving these investors’ information asymmetry effort spent on the audit). For example, efficiencies, the new standard should problem (adverse selection) and allow the new standard requires, in some lead to a better allocation of auditing for more efficient capital allocation instances, performing more procedures resources more generally by aligning decisions. related to assessing risk and testing the more closely with the risk assessment Some commenters on the proposal company’s process, such as evaluating standards, with more hours, effort, and cautioned against raising investor which of the assumptions used by the work being dedicated to higher-risk expectations about the impact of company are significant. This could areas. Essentially, the new standard auditing procedures on the reliability impose additional costs on auditors and should lead to increased audit quality and accuracy of accounting estimates require additional management time. for harder-to-measure estimates (e.g., and expressed skepticism about Recurring costs (fixed or variable) estimates with high inherent potential benefits related to investor may also increase if firms decide to subjectivity) due to enhanced confidence and audit quality. For increase their use of specialists in procedures and should lead to an example, citing the inherent uncertainty response to the final auditing

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requirements. If this were to occur, it distribute their fixed costs over fewer the proposal would in effect require may in particular affect firms that do not audit engagements. However, larger some companies to increase their use of currently employ or engage specialists accounting firms will likely incur quantitative models that employ and instead rely on the work of greater variable costs than smaller firms, mathematical and statistical techniques company specialists for some of their because larger firms more often perform producing precise calculations. The audit engagements, potentially affecting larger audits and it seems likely that Board acknowledges the possibility of the competitiveness of such firms for these larger audits will more frequently increased costs to companies related to such audit engagements.152 involve accounting estimates with the new requirements, but believes that To the extent the new standard and complex processes. It is not clear it is reasonable to expect corresponding related amendments require new or whether these costs (fixed and variable), increases in audit quality, which will additional procedures, they may as a percentage of total audit costs, will benefit companies and investors as well increase costs. For example, the be greater for larger or for smaller as auditors, as discussed in the previous amendment to AS 2110.52 requires the accounting firms. One commenter on section. auditor to include, as part of the key the proposal cautioned that the costs Some commenters argued that the engagement team members’ discussion associated with implementing the new new requirements would likely lead to of the potential for material standard might be significant for some significant expansion of audit misstatement due to fraud, how the smaller firms; however, this commenter procedures, documentation, and/or use financial statements could be also noted that many of the smaller of specialists, with limited incremental manipulated through management bias firms applying analogous requirements benefit. In addition, a few commenters in accounting estimates in significant of other standard setters (e.g., ISA 540) raised concerns that the requirements accounts and disclosures. The new would already have methodologies in could result in increased or duplicative requirement focuses the auditor’s place that addressed many of the work for issuers with no perceived attention on a risk that is particularly requirements in the new standard. benefit. The Board believes that the relevant to accounting estimates and Another commenter asserted that any scalable, risk-based approach of the new further underscores the importance of new standard would have a standard allows auditors to tailor their applying professional skepticism in this disproportionate impact on medium- procedures to respond to the risks. By area. The additional requirement could sized accounting firms and their clients, aligning with the risk assessment increase costs. as compared with larger firms and their standards and setting forth a framework The new standard’s impact on the clients. Additionally, one commenter for testing and evaluating procedures, auditor’s fixed and variable costs will noted that passing any incremental costs the new standard is designed to require likely vary depending on, among other on to clients might be especially more audit effort for accounting things, the extent to which the difficult for smaller firms. The Board estimates with higher risk of material requirements have already been believes that the new standard and misstatement, where greater benefits are incorporated in accounting firms’ audit related amendments are risk-based and expected, and less audit effort for methodologies or applied in practice by scalable for firms of all sizes, and that estimates with lower risk of material individual engagement teams. For any related cost increases are justified misstatement, where lower potential example, the new standard sets by expected improvements in audit benefits are expected. In some areas, minimum requirements when using quality. such as evaluating the relevance and pricing information obtained from third- reliability of pricing information party pricing sources, so audit firms that In addition to the auditors, companies provided by third-party pricing sources, are doing less than the minimum being audited may incur costs related to the new standard may result in requirements will likely experience the new standard and related decreased audit effort and decreased higher cost increases. In addition, the amendments, both directly and costs, where justified by lower risk of standard’s impact could vary based on indirectly. Companies could incur material misstatement. direct costs from engaging with or the size and complexity of an audit. All Unintended Consequences else equal, any incremental costs otherwise supporting the auditor generally are expected to be scalable: performing the audit. Some companies One potential unintended Higher for larger, more complex audits could face costs of providing documents consequence of replacing three existing than for smaller, less complex audits. and responding to additional auditor standards with one standard might be a The economic impact of the new requests for audit evidence, due to a perceived loss of some explanatory standard on larger accounting firms and more rigorous evaluation of the language, since the new standard is smaller accounting firms may differ. For company’s assumptions and methods. intended to eliminate redundancies in example, larger accounting firms will Companies may also incur costs if, as a the current standards. The Board likely take advantage of economies of result of the new standard, auditors believes that the new standard and scale by distributing fixed costs (e.g., need to discuss additional information related amendments, interpreted as updating audit methodologies) over a with audit committees relating to described in this release, should provide larger number of audit engagements. accounting estimates. In addition, to the adequate direction. However, the Smaller accounting firms will likely extent that auditors are able to pass on PCAOB will monitor implementation to at least part of the increased costs they determine whether additional 152 The PCAOB staff analyzed inspection data to incur by increasing audit fees, interpretive guidance is necessary. assess the baseline for auditors’ use of the work of companies and investors could incur an Another possible unintended specialists and existing practice in the application indirect cost. Some commenters on the consequence may result if an auditor of those requirements. The PCAOB observed that exploits the latitude allowed under the the firms that do not currently employ or engage proposal raised concerns that some of auditor’s specialists and use the work of company the increased costs, including the costs new standard for using information specialists tend to be smaller audit firms. The associated with requests for additional from the company’s third-party pricing PCAOB staff also found that smaller audit firms data and pricing information from third source, but does so inappropriately. The generally have comparatively few audit new standard does, however, set forth engagements in which they use the work of parties, might be passed through to company specialists. See the Specialists Release, companies in the form of increased specific direction for evaluating the supra note 2, for additional discussion. audit fees. One commenter asserted that relevance and reliability of such

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information from the third-party pricing were considered; and (3) key policy differences in these standards discussed source. choices made by the Board in herein, guidance would be an One commenter also cautioned that determining the details of the new ineffective tool and not a long-term perceived information sharing by third- standard. solution. party pricing sources beyond The Board’s approach reflects its contractual agreements could induce Alternatives to Standard Setting—Why conclusion that, in these circumstances, market data originators to stop sharing Standard Setting is Preferable to Other standard setting is needed to fully Policy-Making Alternatives their confidential market data with achieve the benefits that could result pricing services. The Board does not Among the Board’s policy tools, an from improvements in the auditing of seek to impose obligations on auditors increased focus on inspections, estimates. to obtain pricing information beyond enforcement of existing standards, or Other Standard-Setting Alternatives what is available under prevailing providing additional guidance are Considered subscriber arrangements. Clarifications alternatives to revising the standards. reflected in the requirements with The Board considered whether The Board considered certain respect to grouping of financial increasing inspections or enforcement standard-setting alternatives, including instruments also should help alleviate efforts would be effective corrective (1) developing a separate standard on concerns in this area. mechanisms to address concerns with auditing the fair value of financial Finally, a few commenters on the the audit of estimates, including fair instruments or (2) enhancing the proposal presented other potential value measurements, and concluded estimates standards through targeted unintended consequences. For example, that inspections or enforcement actions amendments. one commenter cautioned that auditors alone would be less effective in Developing a Separate Standard on may expand procedures performed achieving the Board’s objectives than in Auditing the Fair Value of Financial unnecessarily, not as a response to combination with amending auditing Instruments increased risk, but due to fear of standards. inspections. The Board believes that a Inspection and enforcement actions The Board considered developing a single, uniform set of requirements with take place after audits have occurred separate standard that would more clarity and specificity should (and potential investor harm in the case specifically address auditing the fair provide auditors with a better of insufficient audit performance). They value of financial instruments. The understanding both of their duties and reinforce future adherence to current Board chose not to pursue this of the Board’s expectations and reduce auditing standards. Given the alternative because the addition of a the risk that auditors would perform differences in the estimates standards separate standard could result in unnecessary procedures due to fear of discussed previously, devoting confusion and potential inconsistencies inspections. additional resources to inspections and in the application of other standards. Another commenter pointed to the enforcement activities without Additionally, the auditing issues risk of cost spillover to private company improving the relevant performance pertinent to accounting estimates, audits, where PCAOB standards are not requirements for auditors would including financial instruments, legally required but may nevertheless be increase auditors’ compliance with what inherently overlap. Instead, the new applied. Pursuant to its statutory the Board and many stakeholders view standard includes a special topics mandate under the Sarbanes-Oxley Act, as standards that could be improved. appendix, which separately discusses the Board sets standards for audits of The PCAOB has issued seven Staff certain matters relevant to financial issuers and SEC-registered brokers and Audit Practice Alerts between 2007 and instruments without repeating dealers based on considerations of 2014 that address, to varying degrees, requirements that relate more broadly to investor protection and the public auditing accounting estimates.153 The all estimates, such as evaluating audit interest in the preparation of PCAOB has considered issuing evidence. informative, accurate, and independent additional practice alerts or other staff Enhancing the Estimates Standards audit reports. The Board does not have guidance specific to the use of third 154 Through Targeted Amendments authority either to require or to prohibit parties such as pricing services. The application of its standards in other Board believes guidance specific to the The Board considered, but contexts, and cannot predict or control use of third parties would be limited to determined not to pursue, amending the extent to which private companies discussing the auditor’s application of rather than replacing the three estimates and their auditors may elect to apply the existing standards and, given the standards. Retaining multiple standards PCAOB standards. with similar requirements would not The Board expects that the overall 153 See, e.g., Matters Related to Auditing Fair eliminate redundancy and could result Value Measurements of Financial Instruments and in confusion and potential benefits of the proposed standard will the Use of Specialists, Staff Audit Practice Alert No. justify any potential unintended 2 (Dec. 10, 2007); Auditor Considerations Regarding inconsistencies in the application of the negative effects. Fair Value Measurements, Disclosures, and Other- standards. The approach presented in Than-Temporary Impairments, Staff Audit Practice the new standard is designed to be Alternatives Considered, Including Alert No. 4 (Apr. 21, 2009); Assessing and clearer and to result in more consistent Policy Choices Responding to Risk in the Current Economic Environment, Staff Audit Practice Alert No. 9 (Dec. application and more effective audits. The development of the new standard 6, 2011); Maintaining and Applying Professional Commenters on the proposal were involved considering a number of Skepticism in Audits, Staff Audit Practice Alert No. generally supportive of a single, uniform alternative approaches to address the 10 (Dec. 4, 2012); and Matters Related to Auditing standard with a consistent set of Revenue in an Audit of Financial Statements, Staff problems described above. This section Audit Practice Alert No. 12 (Sept. 9, 2014). requirements. One commenter said that explains (1) why standard setting is 154 Other standard setters have issued guidance they believed that audit quality would preferable to other policy-making relating to their existing standards. For example, the be promoted with a single framework. alternatives, such as providing IAASB issued International Auditing Practice Note On the other hand, one commenter, 1000, Special Considerations in Auditing Financial interpretive guidance or enhancing Instruments (Dec. 16, 2011), to provide guidance to citing the differences between fair value inspection or enforcement efforts; (2) auditors when auditing fair value measurements of measurements and derivatives and other standard-setting approaches that financial instruments. hedging accounting, expressed concerns

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about combining multiple standards Require the Auditor To Develop an • Including a requirement, similar to into one, but did not specify how the Independent Expectation those in AU–C Section 540, Auditing auditing approach could or should Given the variety of types of Accounting Estimates, Including Fair differ. Another commenter cautioned Value Accounting Estimates, And accounting estimates and the ways in 156 that a single standard would lead to a which they are developed, the Board is Related Disclosures (‘‘AU–C 540’’), one-size-fits-all audit approach and not retaining the three common approaches for the auditor to evaluate how allow the tailoring of audit procedures. from the existing standards for auditing management has considered alternative However, by aligning with the risk accounting estimates, including fair assumptions or outcomes and why it has rejected them when significant assessment standards and describing the value measurements. In addition, the measurement uncertainty exists. basic requirements for testing and new standard continues to require the evaluating estimates, the new standard Including additional requirements auditor to determine what substantive when an estimate gives rise to a is designed to allow the auditors to procedures are responsive to the tailor their procedures in order to significant risk would mandate the assessed risks of material misstatement. auditor to direct additional attention to respond to specific risks of material The Board considered, but misstatement. that risk. AS 2301, however, already determined not to pursue, requiring the requires an auditor to perform Key Policy Choices auditor to develop an independent substantive procedures, including tests expectation for certain estimates, or of details that are specifically Given a preference for a single, when an estimate gives rise to a responsive to the assessed risks of comprehensive standard applicable to significant risk. Some members of the material misstatement. This includes all accounting estimates, including fair Board’s advisory groups advocated for a circumstances when the degree of value measurements, in significant requirement for the auditor to develop complexity or judgment in the accounts and disclosures, the Board an independent expectation in addition recognition or measurement of financial considered different approaches to to testing management’s process. In information related to the risk, addressing key policy issues. addition, some SAG members suggested especially those measurements a requirement for the auditor to develop Include a Reporting Requirement in the involving a wide range of measurement an independent expectation rather than New Standard uncertainty, give rise to a significant test management’s process. Finally, a risk.157 Further, with respect to critical Measurement uncertainty cannot be few commenters on the proposal stated accounting estimates,158 the new eliminated entirely through audit that auditors should develop standard and related amendments procedures. This raises a question of independent estimates in addition to require the auditor to obtain an whether reporting of additional testing management’s process. Although understanding of how management information about such procedures in requiring an independent expectation analyzed the sensitivity of its significant the auditor’s report is necessary. could help reduce the risk of anchoring assumptions to change, based on other bias, it may not always be feasible. For However, the Board also considered reasonably likely outcomes that would some accounting estimates, the data and whether requiring communication in have a material effect on its financial significant assumptions underlying the 159 the auditor’s report relating to estimates condition or operating performance, estimate often depend on internal would be duplicative of the new and to take that understanding into company information. Also, developing requirement to communicate critical account when evaluating the a customized method or model for a audit matters (‘‘CAMs’’); any matters reasonableness of the significant particular company’s estimate may not arising from the audit of the financial assumptions and potential for be practical, and a more general method statements that were communicated or management bias. or model could be less precise than the Thus, requiring specific procedures required to be communicated to the company’s own model. In those for accounting estimates that give rise to audit committee and that (1) relate to situations, the auditor may not have a significant risks would be duplicative in accounts or disclosures that are material reasonable alternative to testing the some ways of the existing requirement to the financial statements and (2) company’s process. in AS 2301 as well as those set forth by involved especially challenging, the new standard, and could result in subjective, or complex auditor Require Additional Audit Procedures additional audit effort without judgments.155 Under the new auditor’s When an Accounting Estimate Gives significantly improving audit quality. reporting standard, auditors will Rise to Significant Risk Additionally, including prescriptive identify each CAM, describe the The Board considered including requirements for significant risks could principal considerations that led them additional requirements when an result in the auditor performing only the to determine it was a CAM, briefly accounting estimate gives rise to a required procedures when more describe how the CAM was addressed in significant risk, either more broadly or effective procedures exist, or could the audit, and refer to the relevant specifically when a wide range of provide disincentives for the auditor to accounts or disclosures in the financial measurement uncertainty exists. deem a risk significant in order to avoid statements. Because these reporting Alternatives considered included: performing the additional procedures. requirements will apply to financial • Establishing that certain estimates Accordingly, the Board did not adopt statement estimates, including fair value are presumed to give rise to a significant these alternatives in favor of retaining measurements, if they meet the risk (e.g., the allowance for loan losses). the existing requirement in AS 2301. definition of CAM, AS 2501 (Revised) • Establishing specific procedures does not include any additional that would depend on the risk 156 See paragraph 15a of AU–C 540. reporting requirements. determined to be significant (e.g., the 157 See AS 2301.11 and AS 2110.71f. use of a complex model determined to 158 See paragraph .A3 of AS 1301, 155 See The Auditor’s Report on an Audit of give rise to a significant risk would Communications with Audit Committees. Financial Statements When the Auditor Expresses 159 See Commission Guidance Regarding an Unqualified Opinion and Related Amendments result in the auditor being required to Management’s Discussion and Analysis of Financial to PCAOB Standards, PCAOB Release No. 2017–001 perform specific procedures on that Condition and Results of Operations, Release No. (June 1, 2017). model). 33–8350.

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Special Considerations for Audits of also notes that any new PCAOB one or more of these properties, there Emerging Growth Companies standards and amendments to existing may be a greater degree of information Pursuant to Section 104 of the standards determined not to apply to asymmetry for EGCs than for the Jumpstart Our Business Startups the audits of EGCs would require broader population of companies, (‘‘JOBS’’) Act, rules adopted by the auditors to address the differing increasing the importance of the Board subsequent to April 5, 2012, requirements within their external audit to investors in enhancing generally do not apply to the audits of methodologies, which would create the the credibility of management 163 EGCs unless the SEC ‘‘determines that potential for confusion. This would disclosure.166 The new standard and the application of such additional run counter to the objective of related amendments, which are requirements is necessary or appropriate improving audit practice by setting forth intended to enhance audit quality, in the public interest, after considering a more uniform, risk-based approach to could increase the credibility of the protection of investors, and whether auditing accounting estimates, financial statement disclosures by EGCs. the action will promote efficiency, including fair value measurements. When confronted with information competition, and capital formation.’’ 160 Overall, the above discussion of asymmetry, investors may require a As a result of the JOBS Act, the rules benefits, costs, and unintended larger risk premium, and thus increase and related amendments to PCAOB consequences is generally applicable to the cost of capital to companies.167 standards the Board adopts are generally audits of EGCs. Since EGCs tend to be Reducing information asymmetry, subject to a separate determination by smaller public companies, their therefore, can lower the cost of capital accounting estimates may be less likely to companies, including EGCs, by the SEC regarding their applicability to 164 audits of EGCs. to involve complex processes, decreasing the risk premium required by The proposal sought comments on the although those estimates may constitute investors.168 Therefore, investors in applicability of the proposed some of the largest accounts in EGCs’ EGCs may benefit as much as, if not requirements to the audits of EGCs. financial statements. Furthermore, EGCs more than, investors in other types of Commenters on the issue supported may generally be more subject to issuers as a result of the new standard applying the proposed requirements to information asymmetry problems and related amendments. audits of EGCs, citing benefits to the associated with accounting estimates PCAOB staff gathered data from 2012– users of EGC financial statements and than other issuers. EGCs generally tend 2016 reported inspection findings for the risk of confusion and inconsistency to have shorter financial reporting issuer audits that were identified to be histories than other exchange-listed if different methodologies were required EGCs in the relevant inspection year.169 companies and as a result, there is less for EGC and non-EGC audits. One The chart below shows the number of information available to investors commenter suggested ‘‘phasing’’ the EGC audits with deficiencies related to regarding such companies relative to the implementation of the requirements for the accounting estimates standard and broader population of public audits of EGCs to reduce the compliance fair value standard 170 based on the companies. Although the degree of burden. 2012–2016 reported inspection information asymmetry between To inform consideration of the findings.171 The data help demonstrate application of auditing standards to investors and company management for audits of EGCs, the staff has also a particular issuer is unobservable, researchers have developed a number of Venkatesh, Insider Holdings and Perceptions of published a white paper that provides Information Asymmetry: A Note, 43 Journal of general information about proxies that are thought to be correlated Finance 1041 (1988). characteristics of EGCs.161 As of the with information asymmetry, including 166 See, e.g., Molly Mercer, How Do Investors November 15, 2017 measurement date, small issuer size, lower analyst Assess the Credibility of Management Disclosures?, coverage, larger insider holdings, and 18 Accounting Horizons 185, 189 (2004) the PCAOB staff identified 1,946 (‘‘[Academic studies] provide archival evidence that companies that had identified higher research and development external assurance from auditors increases 165 themselves as EGCs in at least one SEC costs. To the extent that EGCs exhibit disclosure credibility . . . These archival studies filing since 2012 and had filed audited suggest that bankers believe audits enhance the banks; (iv) crude petroleum and natural gas; and (v) credibility of financial statements . . .’’). financial statements with the SEC in the pharmaceutical preparations. Id. at 14–15. The 167 See, e.g., Lambert et al., Information 18 months preceding the measurement financial statements of companies operating in Asymmetry, Information Precision, and the Cost of date. these industries would likely have accounting Capital 21. The Board believes that accounting estimates that include, for example, asset 168 For a discussion of how increasing reliable estimates are common in the financial impairments and allowances for loan losses. public information about a company can reduce 163 risk premium, see Easley and O’Hara, Information 162 Approximately 99% of EGCs were audited by statements of many EGCs. The Board accounting firms that also audit issuers that are not and the Cost of Capital 1553. EGCs and 40% of EGC filers were audited by firms 169 See EGC White Paper for the methodology 160 See Public Law 112–106 (Apr. 5, 2012). See that are required to be inspected on an annual basis used to identify EGCs. Section 103(a)(3)(C) of the Sarbanes-Oxley Act, as by the PCAOB because they issued audit reports for 170 Deficiencies related to the derivatives standard added by Section 104 of the JOBS Act. Section 104 more than 100 issuers in the year preceding the were infrequent over the inspection period of the JOBS Act also provides that any rules of the measurement date. See EGC White Paper at 3. reviewed, and therefore considered insignificant for Board requiring (1) mandatory audit firm rotation 164 See, e.g., the note to AS 2201.09, which purposes of this analysis. or (2) a supplement to the auditor’s report in which provides that many smaller companies have less 171 The chart identifies the audits of EGCs with the auditor would be required to provide additional complex operations and that less complex business deficiencies reported in the public portion of information about the audit and the financial processes and financial reporting systems are a inspection reports. It shows the relative frequency statements of the issuer (auditor discussion and factor indicating less complex operations. of EGC audits with deficiencies citing the existing analysis) shall not apply to an audit of an EGC. The 165 See, e.g., David Aboody and Baruch Lev, accounting estimates standard or the existing fair new standard and related amendments do not fall Information Asymmetry, R&D, and Insider Gains, value standard compared to the total EGC audits within either of these two categories. 55 Journal of Finance 2747 (2000); Michael J. with deficiencies for that year. It also shows the 161 See PCAOB white paper, Characteristics of Brennan and Avanidhar Subrahmanyam, frequency of inspected EGCs audits that had a Emerging Growth Companies as of November 15, Investment Analysis and Price Formation in deficiency. For example, in inspection year 2013, 2017 (Oct. 11, 2018) (‘‘EGC White Paper’’), available Securities Markets, 38 Journal of Financial 50% of the EGC audits that were inspected had a on the Board’s website. Economics 361 (1995); Varadarajan V. Chari, Ravi deficiency and 60% of the audits with deficiencies 162 The five SIC codes with the highest total assets Jagannathan, and Aharon R. Ofer, Seasonalities in included at least one deficiency citing the as a percentage of the total assets for the EGC Security Returns: The Case of Earnings accounting estimates standard or the fair value population are (i) real estate investment trusts; (ii) Announcements, 21 Journal of Financial Economics standard (total 2016 reported inspection findings state commercial banks; (iii) national commercial 101 (1988); and Raymond Chiang, and P.C. are based on preliminary results).

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the high frequency of deficiencies appropriately applied and about overall audits that had deficiencies (including related to the existing estimates and fair audit quality in this area. The EGC deficiencies in internal control over value standards in the audits of EGCs, audits that had deficiencies related to financial reporting) have remained raising questions about whether the existing estimates and fair value relatively high (45%–60%) for the professional skepticism is being standards as a proportion of total EGC 2012–2016 period.

The Board has provided this analysis on these matters during the The information asymmetry between to assist the SEC in its consideration of Commission’s public comment process. the management and the customers of brokers and dealers about the brokers’ whether it is ‘‘necessary or appropriate Applicability to Audits of Brokers and in the public interest, after considering Dealers and dealers’ financial condition may be the protection of investors and whether significant and of particular interest to the action will promote efficiency, The proposal indicated that the customers, as the brokers or dealers may competition, and capital formation,’’ to proposed standard and amendments have custody of customers assets, which apply the new standard and related would apply to audits of brokers and could become inaccessible to the amendments to audits of EGCs. dealers, as defined in Sections 110(3)– customers in the event of an insolvency. (4) of the Sarbanes-Oxley Act. The In addition, unlike the owners of For the reasons explained above, the Board solicited comment on any factors brokers and dealers, who themselves Board believes that the new standard specifically related to audits of brokers may be managers and thus may be and related amendments are in the and dealers that may affect the subject to minimal or no information public interest and, after considering the application of the proposed asymmetry, customers of brokers and protection of investors and the amendments to those audits. dealers may, in some instances, be large promotion of efficiency, competition, Commenters that addressed the issue in number and may not be expert in the and capital formation, recommends that agreed that the proposal should apply to management or operation of brokers and the new standard and related these audits, citing benefits to users of dealers. Such information asymmetry amendments apply to audits of EGCs. financial statements of broker and between the management and the Accordingly, the Board recommends dealers and the risk of confusion and customers of brokers and dealers that the Commission determine that it is inconsistency if different methodologies increases the role of auditing in necessary or appropriate in the public were required under PCAOB standards enhancing the reliability of financial interest, after considering the protection for audits of different types of entities. information, especially given that the of investors and whether the action will After considering comments, the use of estimates, including fair value promote efficiency, competition, and Board determined that the new standard measurements, is prevalent among capital formation, to apply the new and related amendments, if approved by brokers and dealers. The provision to standard and related amendments to the SEC, will be applicable to all audits regulatory agencies of reliable and audits of EGCs. The Board stands ready performed pursuant to PCAOB accurate accounting estimates on to assist the Commission in considering standards, including audits of brokers brokers’ and dealers’ financial any comments the Commission receives and dealers. statements may enable these agencies to

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more effectively monitor these of the Exchange Act is appropriate in post all comments on the Commission’s important market participants. light of the PCAOB’s request that the internet website (http://www.sec.gov/ Improved audits may help prevent Commission, pursuant to Section rules/pcaob.shtml). Copies of the accounting fraud that affects brokers’ 103(a)(3)(C) of the Sarbanes-Oxley Act, submission, all subsequent and dealers’ customers and that may be determine that the proposed rules apply amendments, all written statements perpetrated, for example, through to the audits of EGCs, the Commission with respect to the proposed rules that manipulated valuations of securities. has determined to extend to July 3, 2019 are filed with the Commission, and all Therefore, the new standard should the date by which the Commission written communications relating to the benefit customers and regulatory should take action on the proposed proposed rules between the Commission authorities of brokers and dealers by rules. and any person, other than those that increasing confidence that brokers and IV. Solicitation of Comments may be withheld from the public in dealers are able to meet their obligations accordance with the provisions of 5 Interested persons are invited to to their customers and are in U.S.C. 552, will be available for website submit written data, views and compliance with regulatory viewing and printing in the arguments concerning the foregoing, requirements. Commission’s Public Reference Room, Accordingly, the discussion above of including whether the proposed rules on official business days between the the need for the new standard and are consistent with the requirements of related amendments, as well as the Title I of the Act. Comments may be hours of 10:00 a.m. and 3:00 p.m. costs, benefits, alternatives considered, submitted by any of the following Copies of such filing will also be and potential unintended consequences methods: available for inspection and copying at to auditors and the companies they the principal office of the PCAOB. All Electronic Comments audit, also applies to audits of brokers comments received will be posted and dealers. In addition, with respect to • Use the Commission’s internet without charge. Persons submitting the impact of the new standard on comment form (http://www.sec.gov/ comments are cautioned that we do not customers of brokers and dealers, the rules/pcaob.shtml); or redact or edit personal identifying expected improvements in audit quality • Send an email to rule-comments@ information from comment submissions. described above would benefit such sec.gov. Please include File Number You should submit only information customers, along with investors, capital PCAOB–2019–02 on the subject line. that you wish to make available publicly. All submissions should refer markets and auditors, while the final Paper Comments to File Number PCAOB–2019–02 and requirements are not expected to result • in any direct costs or unintended Send paper comments in triplicate should be submitted on or before April consequences to customers of brokers to Secretary, Securities and Exchange 25, 2019. and dealers. Commission, 100 F Street NE, Washington, DC 20549–1090. For the Commission, by the Office of the Chief , by delegated authority.172 III. Date of Effectiveness of the All submissions should refer to File Proposed Rules and Timing for Number PCAOB–2019–02. This file Eduardo A. Aleman, Commission Action number should be included on the Deputy Secretary. Pursuant to Section 19(b)(2)(A)(ii) of subject line if email is used. To help the [FR Doc. 2019–06426 Filed 4–3–19; 8:45 am] the Exchange Act, and based on its Commission process and review your BILLING CODE 8011–01–P determination that an extension of the comments more efficiently, please use period set forth in Section 19(b)(2)(A)(i) only one method. The Commission will 172 17 CFR 200.30–11(b)(1) and (3).

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