PCAOB targets management bias with new auditing proposals

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The Public Company Accounting Oversight Board’s recently proposed rules on auditing accounting estimates and using the work of specialists indicate the PCAOB wants auditors to view management bias more skeptically.

At a meeting earlier this month, the PCAOB issued a pair of proposals to strengthen its requirements for an auditor’s use of the work of specialists, and for auditing accounting estimates such as fair value measurements (see PCAOB proposes new requirements for use of specialists and accounting estimates). The proposals were issued the same day the board approved its long-awaited standard for changing the auditor’s reporting model to provide more information on critical audit matters (see PCAOB makes major changes to auditor’s report). While the new audit reporting standard is garnering more attention, the new proposals could also have a big impact on auditing firms and the work they do for public companies.

“The PCAOB is certainly increasing the requirement for auditors to enhance professional skepticism as well as make a determination of eliminating management biases and estimates, especially in fair value measurements,” said Mark L. Zyla, managing director of the Atlanta-based business valuation firm Acuitas and chairman of the International Valuation Standards Council’s Standards Review Board.

Like the audit report standard, the PCAOB has been working on the proposals for several years, and Zyla didn’t find them surprising. “It’s pretty much what we had been expecting,” he said. “It just increases the auditor’s responsibility. The interesting thing is that it’s based on what the PCAOB is seeing from their inspection reports—areas of concern of theirs—and they’re addressing those concerns.”

The proposals will require auditors to more carefully scrutinize the work of the outside specialists who are hired by companies and audit firms to come up with figures such as fair value measurements and other types of valuations.

“I think there is going to be more time involved in auditing the work of outside specialists, and some of the areas of focus are going to be the methodologies and assumptions used by the specialists and their acceptance, or how they tested all of those for reasonableness,” said Zyla.

Not only auditing firms, but also valuation firms like Acuitas, are likely to see an impact from the proposals. “We expect that this new standard, combined with something the profession came up with, known as the Mandatory Performance Framework, is likely to increase the level of documentation as to the assumptions and methodologies for the reasonableness of the fair value measurements,” said Zyla.

Auditors and specialist alike will need to better document how they arrived at their valuations and not just trust the estimates coming from company managers.

“You would have to increasingly connect the dots between the measurement and the original sources of data,” said Zyla. “Valuation specialist audits typically relied on management assertions for a lot of the information. That’s no longer the case.”

The PCAOB hopes to curb management bias on the part of auditors to make sure they view the information more objectively.

“It requires the auditors to explicitly consider any potential management biases, so that becomes ingrained as part of the audit process for fair value measurements and other estimates,” said Zyla.

What the standard won’t do is discourage the increasing use of accounting estimates on financial statements. “They’re becoming more and more common, particularly in the area of fair value measurements,” said Zyla.

Nevertheless, he believes the estimates generally improve overall audit quality and the quality of the financial reporting process. The use of outside specialists is likely to grow as a result of the new proposals, not decline.

“I think it’s likely to increase the use of outside specialists because the experience and know-how of the specialists with the Mandatory Performance Framework would allow for greater audit efficiencies rather than trying to do it internally,” said Zyla.

The International Valuation Standards Council has its own set of valuation standards. Zyla chairs the IVSC’s Standards Review Board, and he noted that the IVSC is currently in the process of soliciting suggestions for future revisions to its standards (see IVSC plans future agenda for valuation standards). The standards will likely need to take into account the PCAOB proposals.

“The IVSC has an invitation to comment on their agenda for the upcoming year,” said Zyla. “As far as the stakeholders would like to see an increased focus on that, the IVSC is certainly receptive to consideration and comments from stakeholders in this area, to be considered as part of their agenda.”

The PCAOB’s other proposed standard on the use of valuation specialists by firms increases the requirements for supervision of the work of the auditor’s own valuation specialist, Zyla noted. “Typically on an audit the auditors will bring in a member of their firm that’s a valuation specialist to review the work of management’s outside specialist, which is the audit evidence in the fair value measurements,” he said. “This new standard also increases the scrutiny of the work of the audit firm’s internal valuation specialist.”

Zyla anticipates the proposal will enhance the quality of the audit process, but the work of outside specialists is also likely to increase as a result.

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