Extreme Estimation Uncertainty in Fair Value Estimates: Implications for Audit Assurance

Abstract

SUMMARY The overall complexity and estimation uncertainty inherent in financial statements have increased in recent decades; however, the related reports and services have changed very little, including the format of the balance sheet and income statement, the content in the auditor's report, and the level and nature of assurance provided on estimates. We examine estimates reported by public companies and find that fair value and other estimates based on management's subjective models and inputs contain estimation uncertainty or imprecision that is many times greater than materiality. Importantly, changes in the estimates often impact net income; consequently, the extreme estimation uncertainty also resides in measures such as earnings per share. We do not question the value audits provide to the marketplace, the importance of fair value reporting, or the ability of auditors to deploy up-to-date valuation and auditing techniques. Rather, we suggest that the convergence of relatively recent events is placing an increasingly difficult, and perhaps in some cases unrealistic, burden on auditors. We consider whether the convergence of events in regulation and standard setting may have outstripped auditors' ability to provide the level and nature of assurance currently required on estimates with extreme estimation uncertainty by auditing standards and regulators. We discuss potential changes to financial reporting and auditing standards that may improve the information provided to users and also address the concerns we raise. Finally, we suggest avenues for future research that may be fruitful in addressing how changes to standards would influence the behavior of preparers, auditors, and users. JEL Classifications: M4; M40; M41; M42. Data Availability: All data are publicly available.

Current Practices and Challenges in Auditing Fair Value Measurements and Complex Estimates: Implications for Auditing Standards and the Academy

“…Auditing FVMs is a challenging task given the high degree of subjectivity and extreme measurement uncertainty associated with some FVMs (e.g., Christensen et al 2012;PCAOB 2012a;Glover et al 2016). The challenge is exacerbated when auditing standards provide limited and, at times, vague guidance.…”

“…The challenge is exacerbated when auditing standards provide limited and, at times, vague guidance. Current standards related to auditing FVMs and use of specialists provide lists of possible audit procedures with relatively little guidance (e.g., PCAOB 2001PCAOB , 2002Bell and Griffin 2012;Christensen et al 2012;Glover et al 2016). For instance, AS 2502 allows auditors to select from three substantive approaches: (1) testing management's assumptions, valuation model, and underlying data; (2) developing an independent estimate; and (3) reviewing subsequent events and transactions.…”

“…T he subjectivity inherent in estimating future events, coupled with the potential high degree of measurement uncertainty, makes auditing fair value measurements and other complex estimates (hereafter, collectively, FVMs) challenging for auditors (Public Company Accounting Oversight Board [PCAOB] 2007a, 2007bBratten, Gaynor, McDaniel, Montague, and Sierra 2013;Christensen, Glover, and Wood 2012;Glover, Taylor, and Wu 2016). 1 The challenging nature of auditing FVMs is consistent with repeated and frequent PCAOB reported inspection deficiencies identified for both financial and nonfinancial FVMs (e.g., PCAOB 2008a, 2010a, 2012a.…”

Budgeting Audit Time: Effects of Audit Step Frame and Verifiability

“…These prior studies suggest that auditors view the risks of material misstatement in fair values as being very high (e.g., see Christensen et al 2012;Griffith et al 2015) and potentially irreducible (e.g., see Bell and Griffin 2012;Cannon and Bedard 2017). Given the auditors' widespread view that the risk of misstatement in fair-value estimates is very high, auditors may tend to develop large time budgets that are not sensitive to frame variations in the audit steps.…”

“…We propose that two key features fundamental to the auditing context-the framing of audit steps and the perceived verifiability of the performance quality of audit steps-may affect audit budgeting judgments. We examine the effect of audit step frame and verifiability in the setting of auditing fair values, which is an area where step verifiability tends to be low (Bell and Griffin 2012;Christensen, Glover, and Wood 2012;Cannon and Bedard 2017) and auditors are vulnerable to providing insufficient effort (PCAOB 2015b(PCAOB , 2015c(PCAOB , 2015d.…”