About the Panelists
The panel featured Brian Croteau, CPA, partner at PricewaterhouseCoopers; Kyle Owens, CPA, professional practice standards senior manager at Crowe LLP; and Phil Wedemeyer, CPA, director at Ensco LLC. Kathleen Healy, director of the national professional services group at PricewaterhouseCoopers, moderated the panel. The following is an edited and condensed summary of the panel discussion. The views expressed are the panelists’ own personal views and not necessarily those of their employers or those employers’ boards, management, or staff.
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Healy started the discussion by asking Wedemeyer to cover the evolution of accounting estimates. In Wedemeyer’s view, “Financial engineering is now much more prevalent than it was when I started; the right-hand side of the balance sheet has certainly changed a lot. … We’ve had the move toward more fair value. It’s been the accountants who have created the move toward more subjective estimates.” He also said that PCAOB inspections have changed auditor behavior.
Next, Healy asked Owens to speak about why estimates are so subjective. Owens replied with an example from the financial services industry, noting that consideration for a transaction and fair value may not necessarily align; he gave the example of financial institutions acquired at a discount during the most recent financial crisis. In addition, he said that “in the area of expected credit losses, forward-looking assumptions going into these estimates are creating a lot of estimation uncertainty.”
Wedemeyer also spoke on subjective estimates, saying, “From my perspective, there are two dimensions to the question. As a director, I’m concerned about what auditors used to call business risk; what kind of strategic decisions are we making? Those are what really drive the critical estimates. And as an audit committee chair, I’ve got the additional responsibility of asking how we account and report on all of that.” He gave enterprise risk management as an example of something auditors should pay more attention to. In addition, he said, every accounting standard today has a control effect, and auditors and companies must be much more rigorous in the application of standards in terms of controls.
Healy then asked Croteau how management is approaching its responsibilities for preparing estimates. Croteau replied that the pervasiveness of estimates has resulted in management focusing its attention on policies, processes, controls, and documentation. “Management is increasingly focused over time on the importance of their own requirements from a books and records perspective, and maintaining contemporaneous documentation of decisions they’ve made,” he said. ”I think that’s all very positive from a controls perspective.” Croteau added that recent years have seen much attention devoted to management review controls.
Impact on Auditors
Croteau also discussed the impact estimates have had on auditors. “Some things obviously haven’t changed,” he said. “There are three ways to audit an estimate, and we may take a combination of approaches relative to auditing management’s process, developing our own estimate, or looking at subsequent information. We can’t audit away measurement uncertainty. Those things have not changed. But I do think incremental focus relative to applying professional skepticism, as we think about the role of the auditor relative to challenging management and understanding the basis for the judgments that they’re making, has been an area of focus. What we’ve done as a firm is think about developing sufficient policies, tools, and guidance for teams that help create a repeatable process.”
Healy then asked Owens to comment on applicable financial reporting frameworks and management policies in light of changes to accounting standards regarding estimates. Owens focused on the question of, “What are the actual elections allowed in GAAP? … Having appropriate disclosures around the elections you’re making with respect to GAAP is important. Policies, procedures, and controls are going to be very important over those types of disclosures. Thinking about the application of different methods, we’ve got this concept of reasonable supportable forecasts. That is an instance where management needs to make an accounting decision on how they’re going to apply that particular element of GAAP and provide robust disclosures around those types of management judgments.”
Croteau then covered auditors’ responsibility for risk assessment. “Thinking about inherent risk relative to particular assumptions is obviously where you want to start,” he said, “but you want to drill in and get the perspective of the number and nature of the significant assumptions that drive any particular estimate, and think about the reliability of potential evidence in the approach that management is taking in development of their estimates.” Regarding the evolution of auditing treatment of estimates, Croteau said that “the most important thing I’ve seen is more granular risk assessment that hones in on what’s driving the audit risk and how to address that in performing the audit.” He also noted that current regulatory efforts could help inform and improve that practice.
“The most important thing I’ve seen is more granular risk assessment that hones in on what’s driving the audit risk and how to address that in performing the audit,” Croteau said.
On risk assessment, Owens added that management review controls are a key element. “What are the control operator’s thresholds? How are they resolving the differences between different standards? Those are some very meaningful aspects of management review controls.” He continued, “There are also some things we’re seeing within practice, such as observation and participation in committees, that may help demonstrate the design and operating effectiveness of these controls.” Croteau agreed, adding that attention to the design of controls is also critical. “Thinking about the relevance and reliability of the underlying data that’s feeding into these controls is very, very important,” he said.
Wedemeyer discussed the disclosures surrounding accounting estimates, saying that “particularly with estimates that involve inherently imprecise future events, like level 3 fair value, a lot of the emphasis is on how much to record in the entry. When you get to disclosure, it’s not as clear. Some firms look at disclosure risks in terms of ‘is a required disclosure missing?” but much less in terms of “what is the nature of the disclosure?” or “is there a disclosure that’s not required by the standard explicitly that ought to be made?’ in order to be fair. This is something auditors don’t want to touch for obvious liability reasons, but it seems to me that as we get into these more subjective, volatile, and changeable estimates, it’s going to be more and more important to look at disclosures in terms of their content and the substance of what they describe around measurement uncertainty.”
Continuing, Wedemeyer stated that “the ERM [enterprise risk management] process needs to be taken seriously in terms of what the company does; not just what does the matrix look like, but actually how does it affect things. Secondly, when you’re looking at ERM, you need to understand that risks are not linear. They’re not correlated one-to-one; they interact with each other. What’s important is to understand how the company looks at the total risk picture. In the area of critical accounting estimates, management and the audit committee need to be apprised of not just the nature of the critical estimate, but how much money is in the financial statements involved around the estimate. … And auditors ought to read analyst reports because you will get a knowledge of what the market’s looking at in terms of critical variables and critical estimates.”
Croteau added that “as one thinks about critical audit matter [CAM] reporting and those disclosures that management is making, we’re seeking incremental attention by management in thinking about more granular risk assessment and description of why there might be a critical audit matter, and how that might relate to existing disclosures. That’s certainly a real benefit that management and audit committees are beginning to see.”
Professional Skepticism and Risk Assessment
Picking back up on the issue of risk assessment, Healy asked Croteau about expected changes to current practice as a result of the new PCAOB and IAASB standards. “Some will say it’s bringing the standards up to current practice,” he said, while “in other ways they will go beyond and drive some incremental changes. … As I think about a lot of the changes from an ISA [International Standards on Auditing] perspective, I think there will be some changes that drive attention or focus toward not just more work but smarter work. From a PCAOB perspective, the idea of combining the three standards into one is certainly an important point. The focus on professional skepticism, and on the assumptions that are important to driving particular risks and estimation, may be somewhat consistent with current practice, but could be somewhat incremental as well.”
Healy then asked Owens about the AICPA’s initiative to provide additional auditing guidance for the new expected credit loss standard. After giving some background on the process, Owens said that “the group is really focused is going back to overall risk, looking at it from what’s really being driven by the accounting standards. How is the auditor going to approach this risk? The guide is structured around ‘here is the accounting standard, here is the current auditing literature.’… Hopefully this guide will address some of the questions about the auditor’s expectations related to the expected credit loss model.”
Asked by Healy for other recommended guidance, Croteau referenced Financial Executives International’s publications on internal control considerations in the new credit loss and leasing standards. “These documents should be extraordinarily helpful,” he said. “They’re nonauthoritative, they’ve requested additional input, but I think a lot of great thinking has gone into them so that companies have a place to start. ”
Critical Audit Matters
Healy asked the panel for further discussion of the requirement for auditors to report on CAMs. Croteau said that there is significant overlap between CAMs and critical auditing estimates, with CAMs almost being a subset of critical estimates. “We’re finding that on average we may be identifying a couple of CAMs; that compares to companies with critical accounting estimates, on average, closer to six,” he said. “Most of them do focus on some of the most significant estimates and judgments that the company is making relative to their reporting.”
Owens noted that one particular area where investors have benefited from the inclusion of CAMs is the auditors’ responses to them. “Did the auditor,” he said, “use specialized skills to audit this area? Did they rely on controls in this particular audit matter?” Croteau added that, as auditors share draft CAMs with management and audit committees, the latter are very interested in the language the auditors use to describe the relevant area of accounting. “As we describe the area of accounting, we’re using language somewhat consistent with management’s own disclosures, but to the extent that our CAM might be more narrow and specific based on our risk assessment, we may begin to describe it in a more granular way, or refer to particular assumptions that management may not have referred to,” he said, adding that this is driving healthy discussions between auditors and management.
Healy also asked Wedemeyer about the IAASB’s similar key audit matters (KAM) and his experience with their implementation. Wedemeyer responded that he has had some difficulty engaging management on the issue, but “if the delineation is clear that we’re talking about things that the auditor has done and not things that are missing from the financial statements, which I think we agree that’s correct, then in theory, we ought to be okay. I don’t think that part of it has created any problem for us in our experience.” He added that potential litigation issues in the United States could lead to tension between auditors and lawyers over how much to disclose.
Croteau added that this tension already exists, and that CAMs should not be thought of as a substitute for getting management to make adequate disclosures in the first place. “We’ve got an obligation relative to signing the opinion and whether management’s disclosures are adequate and compliant with GAAP,” he said.
Healy then asked the panel a question from the audience, which dealt with how much guidance auditors provide for complex, highly uncertain estimates for smaller private company clients versus public companies. Croteau responded that the range of response usually depends more on the management team and what it expects from the audit team rather than the company’s size or filing status. Owens added that standards generally are equally applicable to all types of institutions, and that differences in audit strategy usually hinge on the level of documentation provided by management.