Public Company Accounting Oversight Board; Notice of Filing of Proposed Rules on Auditing Accounting Estimates, Including Fair Value Measurements, and Amendments to PCAOB Auditing Standards

Federal RegisterApr 4, 2019

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-85434; File No. PCAOB-2019-02]

Public Company Accounting Oversight Board; Notice of Filing of Proposed Rules on Auditing Accounting Estimates, Including Fair Value Measurements, and Amendments to PCAOB Auditing Standards

March 28, 2019.

Pursuant to Section 107(b) of the Sarbanes-Oxley Act of 2002 (the “Act” or “Sarbanes-Oxley Act”), notice is hereby given that on March 20, 2019, the Public Company Accounting Oversight Board (the “Board” or “PCAOB”) filed with the Securities and Exchange Commission (the “Commission” or “SEC”) the proposed rules described in Items I and II below, which items have been prepared by the Board. The Commission is publishing this notice to solicit comments on the proposed rules from interested persons.

I. Board's Statement of the Terms of Substance of the Proposed Rules

On December 20, 2018, the Board adopted a new rule and amendments to auditing standards (collectively, the “proposed rules”), under which the three existing standards related to auditing estimates, including fair value measurements, will be replaced with a single, updated standard. The text of the proposed rules appears in Exhibit A to the SEC Filing Form 19b-4 and is available on the Board's website at

https://pcaobus.org/Rulemaking/Pages/docket-043-auditing-accounting-estimates-fair-value-measurements.aspx

and at the Commission's Public Reference Room.

II. Board's Statement of the Purpose of, and Statutory Basis for, the Proposed Rules

In its filing with the Commission, the Board included statements concerning the purpose of, and basis for, the proposed rules and discussed any comments it received on the proposed rules. The text of these statements may be examined at the places specified in Item IV below. The Board has prepared summaries, set forth in sections A, B, and C below, of the most significant aspects of such statements. In addition, the Board is requesting that, pursuant to Section 103(a)(3)(C) of the Sarbanes-Oxley Act, the Commission approve the proposed rules for application to audits of emerging growth companies (“EGCs”).

The Board's request is set forth in section D.

The term “emerging growth company” is defined in Section 3(a)(80) of the Securities Exchange Act of 1934 (the “Exchange Act”) (15 U.S.C. 78c(a)(80)).

See also Inflation Adjustments and Other Technical Amendments Under Titles I and III of the JOBS Act,

Release No. 33-10332 (Mar. 31, 2017), 82 FR 17545 (Apr. 12, 2017).

A. Board's Statement of the Purpose of, and Statutory Basis for, the Proposed Rules

(a) Purpose

Summary

The Board has adopted amendments to its standards for auditing accounting estimates and fair value measurements, under which three existing standards will be replaced with a single, updated standard (“AS 2501 (Revised)” or the “new standard”). As discussed in more detail below, in the Board's view, the new standard and related amendments will further investor protection by strengthening audit requirements, applying a more uniform, risk-based approach to an area of the audit that is of increasing prevalence and significance, and updating the standards in light of recent developments.

The financial statements of most companies reflect amounts in accounts and disclosures that require estimation, which may include fair value measurements or other types of estimates. These estimates appear in items like revenues from contracts with customers, valuations of certain financial and non-financial assets, impairments of long-lived assets, allowances for credit losses, and contingent liabilities. As financial reporting frameworks evolve toward greater use of estimates, accounting estimates are becoming more prevalent and more significant, often having a significant impact on a company's reported financial position and results of operations.

By their nature, accounting estimates, including fair value measurements, generally involve subjective assumptions and measurement uncertainty, making them susceptible to management bias. Some estimates involve complex processes and methods. As a result, accounting estimates are often some of the areas of greatest risk in an audit, requiring additional audit attention and appropriate application of professional skepticism. The challenges of auditing estimates may be compounded by cognitive bias, which could lead auditors to anchor on management's estimates and inappropriately weight confirmatory over contradictory evidence.

The Board's oversight activities, which have revealed a recurring pattern of deficiencies in this area, also raise concerns about auditors' application of professional skepticism, including addressing potential management bias, in this area of the audit. Over the years, PCAOB staff has provided guidance for auditors related to auditing accounting estimates, but this area remains challenging and practices among firms vary.

Currently, three PCAOB auditing standards primarily relate to accounting estimates, including fair value measurements. These three standards, which were originally adopted between 1988 and 2003, include common approaches for substantive testing but vary in the level of detail in describing the auditor's responsibilities with respect to those approaches. In addition, because the three standards predate the Board's risk assessment standards, they do not fully integrate risk assessment requirements that relate to identifying, assessing, and responding to the risks of material misstatement in accounting estimates.

The new standard builds on the common approaches in the three existing standards and will strengthen PCAOB auditing standards in the following respects:

• Providing direction to prompt auditors to devote greater attention to addressing potential management bias in accounting estimates, as part of applying professional skepticism.

• Extending certain key requirements in the existing standard on auditing fair value measurements, the newest and most comprehensive of the three existing standards, to other accounting estimates in significant accounts and disclosures, reflecting a more uniform approach to substantive testing for estimates.

• More explicitly integrating requirements with the Board's risk assessment standards to focus auditors on estimates with greater risk of material misstatement.

• Making other updates to the requirements for auditing accounting estimates to provide additional clarity and specificity.

• Providing a special topics appendix to address certain aspects unique to auditing fair values of financial instruments, including the use of pricing information from third parties such as pricing services and brokers or dealers.

The Board has adopted the new standard and related amendments after substantial outreach, including two

rounds of public comment. Commenters generally supported the Board's objective of improving the quality of audits involving accounting estimates, and suggested areas where the proposed requirements could be modified or clarified. The Board has taken all of these comments, as well as observations from PCAOB oversight activities and the relevant academic literature, into account.

In a separate PCAOB release, the Board also adopted amendments to its standards for using the work of specialists, which are often involved in developing, or assisting in the evaluation of, accounting estimates.

Certain provisions of the new standard include references to AS 1210,

Using the Work of an Auditor-Engaged Specialist;

AS 1201,

Supervision of the Audit Engagement;

and AS 1105,

Audit Evidence,

as amended.

See Amendments to Auditing Standards for Auditor's Use of the Work of Specialists,

PCAOB Release No. 2018-006 (Dec. 20, 2018) (“Specialists Release”).

In its consideration of the new standard and related amendments, the Board is mindful of the significant advances in technology that have occurred in recent years, including increased use of data analysis tools and emerging technologies. An increased use of technology-based tools, together with future developments in the use of data and technology, could have a fundamental impact on the audit process. The Board is actively exploring these potential impacts through ongoing staff research and outreach.

In the context of this rulemaking, the Board considered how changes in technology could affect the processes companies use to develop accounting estimates, including fair value measurements, and the tools and techniques auditors apply to audit them. The Board believes that the new standard and related amendments are sufficiently principles-based and flexible to accommodate continued advances in the use of data and technology by both companies and auditors. The Board will continue to monitor advances in this area and any effect they may have on the application of the new standard.

The new standard and related amendments apply to all audits conducted under PCAOB standards. Subject to approval by the Commission, the new standard and related amendments will take effect for audits for fiscal years ending on or after December 15, 2020.

(b) Statutory Basis

The statutory basis for the proposed rules is Title I of the Act.

B. Board's Statement on Burden on Competition

Not applicable. The Board's consideration of the economic impacts of the proposed rules is discussed in section D below.

C. Board's Statement on Comments on the Proposed Rules Received From Members, Participants or Others

The Board released the proposed rules for public comment in

Proposed Auditing Standard—Auditing Accounting Estimates, Including Fair Value Measurements, and Proposed Amendments to PCAOB Auditing Standards,

PCAOB Release No. 2017-002 (June 1, 2017) (“proposal” or “Estimates Proposing Release”). The PCAOB also issued for public comment a Staff Consultation Paper,

Auditing Accounting Estimates and Fair Value Measurements

(Aug. 19, 2014) (“SCP”). Copies of Release No. 2017-002, the SCP, and the comment letters received in response to the PCAOB's requests for comment are available on the PCAOB's website at

https:/pcaobus.org/Rulemaking/Pages/docket-043-auditing-accounting-estimates-fair-value-measurements.aspx.

The PCAOB received 81 written comment letters. The Board's response to the comments received and the changes made to the rules in response to the comments received are discussed below.

Background

Accounting estimates are an essential part of financial statements. Most companies' financial statements reflect accounts or amounts in disclosures that require estimation. Accounting estimates are pervasive to financial statements, often substantially affecting a company's financial position and results of operations. Examples of accounting estimates include certain revenues from contracts with customers, valuations of financial and non-financial assets, impairments of long-lived assets, allowances for credit losses, and contingent liabilities.

The evolution of financial reporting frameworks toward greater use of estimates includes expanded use of fair value measurements that need to be estimated. For purposes of this rulemaking, a fair value measurement is considered a form of accounting estimate because it generally shares many of the same characteristics with other estimates, including subjective assumptions and measurement uncertainty.

Rulemaking History

The PCAOB has engaged in extensive outreach to explore the views of market participants and others on the potential for improvement of the auditing standards related to accounting estimates. This includes discussions with the Board's Standing Advisory Group (“SAG”) and the Pricing Sources Task Force. In addition, in August 2014, the PCAOB issued the SCP, to solicit comments on various issues, including the potential need for standard setting and key aspects of a potential new standard and related requirements.

In June 2017, the Board proposed to replace three auditing standards that primarily relate to accounting estimates, including fair value measurements, with a single standard. The proposal included a special topics appendix addressing certain matters relevant to auditing the fair value of financial instruments and amendments to several PCAOB standards to align them with the single standard. A number of commenters across many affiliations supported the Board's efforts to strengthen auditing practices and update its standards in this area.

In addition to this outreach, the Board's approach has been informed by, among other things, observations from PCAOB oversight activities and SEC enforcement actions and consideration of academic research, the standard on auditing accounting estimates recently adopted by the International Auditing and Assurance Standards Board (“IAASB”), and the extant standard on auditing accounting estimates of the Auditing Standards Board (“ASB”) of the American Institute of Certified Public Accountants.

Overview of Existing Requirements

The primary PCAOB standards that apply specifically to auditing accounting estimates, including fair value measurements are:

• AS 2501,

Auditing Accounting Estimates

(originally issued in April 1988) (“accounting estimates standard”)—applies to auditing accounting estimates in general.

• AS 2502,

Auditing Fair Value Measurements and Disclosures

(originally issued in January 2003) (“fair value standard”)—applies to auditing the measurement and disclosure of assets, liabilities, and specific components of equity presented or disclosed at fair value in financial statements.

• AS 2503,

Auditing Derivative Instruments, Hedging Activities, and Investments in Securities

(originally issued in September 2000) (“derivatives

standard”)—applies to auditing financial statement assertions for derivative instruments, hedging activities, and investments in securities. Its scope includes requirements for auditing the valuation of derivative instruments and securities, including those measured at fair value.

The accounting estimates standard, fair value standard, and derivatives standard are referred to collectively as the “estimates standards.”

In addition, the Board's risk assessment standards,

which set forth requirements for the auditor's assessment of and response to risk in an audit, include requirements that relate to accounting estimates. These requirements involve procedures regarding identifying and assessing risks of material misstatement in accounting estimates,

identifying and evaluating misstatements in accounting estimates,

and evaluating potential management bias associated with accounting estimates.

PCAOB standards also set forth requirements for the auditor to plan and perform his or her work with due professional care, which includes the application of professional skepticism.

The Board's “risk assessment standards” include AS 1101,

Audit Risk;

AS 1105; AS 1201; AS 2101,

Audit Planning;

AS 2105,

Consideration of Materiality in Planning and Performing an Audit;

AS 2110,

Identifying and Assessing Risks of Material Misstatement;

AS 2301,

The Auditor's Responses to the Risks of Material Misstatement;

and AS 2810,

Evaluating Audit Results.

See generally

AS 2110.13.

See

AS 2810.13.

See

AS 2810.27.

See generally

paragraph .07 of AS 1015,

Due Professional Care in the Performance of Work.

Both the accounting estimates standard and the fair value standard provide that the auditor may apply one or a combination of three approaches to substantively test an accounting estimate:

•

Testing management's process.

This generally involves:

• Evaluating the reasonableness of assumptions used by management that are significant to the estimate, and testing and evaluating the completeness, accuracy, and relevance of data used;

and

See generally

AS 2501 and AS 2502.26-.39.

• Evaluating the consistency of management's assumptions with other information.

Id.

•

Developing an independent estimate.

This generally involves using management's assumptions, or alternative assumptions, to develop an independent estimate or an expectation of an estimate.

See generally

AS 2501.12 and AS 2502.40.

•

Reviewing subsequent events or transactions.

This generally involves using events or transactions occurring subsequent to the balance sheet date, but prior to the date of the auditor's report, to provide evidence about the reasonableness of the estimate.

See generally

AS 2501.13 and AS 2502.41-.42.

In general, the fair value standard, which is the most recent of the estimates standards, sets forth more detailed procedures for the common approaches described above. The level of detail within the fair value standard, however, varies.

For example, the fair value standard sets forth a number of different requirements for testing management's process but only a few general requirements for developing an independent estimate.

See generally

AS 2502.26-.40.

See generally

AS 2502.40.

The derivatives standard primarily addresses auditing derivatives. This standard also includes requirements for auditing the valuation of derivatives and investment securities, including valuations based on an investee's financial results, and testing assertions about securities based on management's intent and ability.

See generally

AS 2503.28-.34 and .56-.57.

Existing Practice

The PCAOB's understanding of audit practice at both larger and smaller audit firms under existing PCAOB standards has been informed by, among other things, the collective experience of PCAOB staff, observations from oversight activities of the Board, enforcement actions of the SEC, comments received on the SCP and proposal, and discussions with the SAG and audit firms.

Overview of Existing Practice

The PCAOB has observed through its oversight activities that some audit firms' policies, procedures, and guidance (“methodologies”) use approaches that apply certain of the basic procedures for auditing fair value measurements to other accounting estimates (

e.g.,

evaluating the method used by management to develop estimates).

The PCAOB has also observed that when testing management's process, some auditors have developed expectations of certain significant assumptions as an additional consideration in evaluating the reasonableness of those assumptions.

Notably, most of those firms base their methodologies largely on the standards of the IAASB or the ASB, both of which have adopted one standard for auditing both fair value measurements and other accounting estimates.

Over the past few years, some audit firms have updated their methodologies, often in response to identified inspection deficiencies. For example, in the area of auditing the fair value of financial instruments, some firms have directed resources to implement more rigorous procedures to evaluate the process used by third-party pricing sources to determine the fair value of financial instruments.

The PCAOB has observed diversity in how audit firms use information obtained from third-party sources in auditing fair value measurements. Such third-party sources include pricing services and brokers or dealers, which provide pricing information related to the fair value of financial instruments.

Another type of third-party source—specialists who develop independent estimates or assist in evaluating a company's estimate or the work of a company's specialist—is addressed separately in the Specialists Release.

See supra

note 2.

Some larger audit firms have implemented centralized approaches to developing independent estimates of the fair value of financial instruments. These firms may use centralized, national-level pricing desks or groups to assist in performing procedures relating to testing the fair value of financial instruments. The level of information provided by these centralized groups to engagement teams varies. In some cases, the national-level pricing desk obtains pricing information from pricing services at the request of the engagement team. Additionally, national-level pricing desks may periodically provide information about a pricing service's controls and methodologies, and provide information on current market conditions for different types of securities to inform an engagement team's risk assessment. In other cases, the national-level pricing desk itself may develop estimates of fair value for certain types of securities, assist audit teams with evaluating the specific methods and assumptions related to a particular instrument, or evaluate differences between a company's price and price from a pricing source. Smaller audit firms that do not have a national pricing group may engage valuation specialists to perform some or all of these functions. Some smaller firms use a combination of external valuation specialists and internal pricing groups.

Commenters generally did not disagree with the description of current practice in the proposal. A few commenters pointed to additional areas where company and firm size and available resources can result in diverse audit approaches (

e.g.,

impairment testing, estimates of environmental

liabilities, and obtaining evidence related to complex transactions).

Observations From Audit Inspections

Through its oversight activities, the PCAOB has historically observed numerous deficiencies in auditing accounting estimates. Audit deficiencies have been observed in both larger and smaller audit firms.

See, e.g., Annual Report on the Interim Inspection Program Related to Audits of Brokers and Dealers,

PCAOB Release No. 2018-003 (Aug. 20, 2018);

PCAOB Staff Inspection Brief, Preview of Observations from 2016 Inspections of Auditors of Issuers

(Nov. 2017); and

Annual Report on the Interim Inspection Program Related to Audits of Brokers and Dealers,

PCAOB Release No. 2017-004 (Aug. 18, 2017).

See also

Estimates Proposing Release at 12, footnote 39.

PCAOB inspections staff has observed audit deficiencies in issuer audits related to a variety of accounting estimates, including revenue-related estimates and reserves, the allowance for loan losses, the fair value of financial instruments, the valuation of assets and liabilities acquired in a business combination, goodwill and long-lived asset impairments, inventory valuation allowances, and equity-related transactions. Examples of such deficiencies include failures to (1) sufficiently test the accuracy and completeness of company data used in fair value measurements or other estimates, (2) evaluate the reasonableness of significant assumptions used by management, and (3) understand information provided by third-party pricing sources. In audits of brokers or dealers, deficiencies include failures to (1) obtain an understanding of the methods and assumptions internally developed or obtained by third parties that were used by the broker or dealer to determine fair value of securities, and (2) perform sufficient procedures to test valuation of securities. The observed deficiencies are frequently associated with, among other things, a failure to appropriately apply professional skepticism in auditing the estimates.

Audit deficiencies have also been observed by other regulators internationally. For example, an International Forum of Independent Audit Regulators (“IFIAR”) survey released in 2018 reported that accounting estimates was one of the audit areas with the highest rate and greatest number of findings. The most commonly observed deficiencies related to failures to assess the reasonableness of assumptions, including consideration of contrary or inconsistent evidence where applicable; sufficiently test the accuracy of data used; perform sufficient risk assessment procedures; take relevant variables into account; evaluate how management considered alternative assumptions; and adequately consider indicators of bias.

See

IFIAR,

Report on 2017 Survey of Inspection Findings

(Mar. 9, 2018), at 10 and B-6.

More recently, there are some indications in PCAOB inspections of issuer audits that observed deficiencies in this area are decreasing, as compared to earlier years. Some audit firms have updated their audit practices in light of deficiencies identified through inspections. Not all firms have improved their practices in this area, however, and PCAOB inspections staff has continued to observe deficiencies similar to those described above. Inspection observations continue to raise concerns about auditors' application of professional skepticism, including addressing potential management bias, in auditing accounting estimates.

Observations From Enforcement Cases

Over the years, there have been a number of enforcement actions by the PCAOB and SEC for violations of PCAOB standards in auditing accounting estimates, demonstrating the importance of this aspect of the audit. Enforcement actions have been brought against larger and smaller firms, with domestic and international practices.

PCAOB enforcement cases related to auditing estimates have generally involved one or more of the following violations (1) failure to perform any procedures to determine the reasonableness of significant assumptions; (2) failure to test the relevance, sufficiency, and reliability of the data supporting the accounting estimates; (3) failure to perform a retrospective review of a significant accounting estimate to determine whether management's judgments and assumptions relating to the estimate indicated a possible bias; and (4) failure to adequately consider contradictory evidence or perform procedures to obtain corroboration for management representations regarding accounting estimates.

See, e.g., Deloitte & Touche LLP,

PCAOB Release No. 105-2018-008 (May 23, 2018);

Tarvaran Askelson & Company, LLP, Eric Askelson, and Patrick Tarvaran,

PCAOB Release No. 105-2018-001 (Feb. 27, 2018);

David M. Burns, CPA,

PCAOB Release No. 105-2017-055 (Dec. 19, 2017);

Grant Thornton LLP,

PCAOB Release No. 105-2017-054 (Dec. 19, 2017);

Anthony Kam & Associates Limited, and Anthony KAM Hau Choi, CPA,

PCAOB Release No. 105-2017-043 (Corrected Copy) (Nov. 28, 2017);

BDO Auditores, S.L.P., Santiago Sañé Figueras, and José Ignacio Algás Fernández,

PCAOB Release No. 105-2017-039 (Sept. 26, 2017);

Kyle L. Tingle, CPA, LLC and Kyle L. Tingle, CPA,

PCAOB Release No. 105-2017-027 (May 24, 2017);

Wander Rodrigues Teles,

PCAOB Release No. 105-2017-007 (Mar. 20, 2017);

KAP Purwantono, Sungkoro & Surja, Roy Iman Wirahardja, and James Randall Leali,

PCAOB Release No. 105-2017-002 (Feb. 9, 2017);

HJ & Associates, LLC, S. Jeffrey Jones, CPA, Robert M. Jensen, CPA, and Charles D. Roe, CPA,

PCAOB Release No. 105-2017-001 (Jan. 24, 2017);

Arshak Davtyan, Inc. and Arshak Davtyan, CPA,

PCAOB Release No. 105-2016-053 (Dec. 20, 2016);

David C. Lee, CPA,

PCAOB Release No. 105-2016-052 (Dec. 20, 2016);

Arturo Vargas Arellano, CPC,

PCAOB Release No. 105-2016-045 (Dec. 5, 2016); and

Goldman Kurland and Mohidin, LLP and Ahmed Mohidin, CPA,

PCAOB Release No. 105-2016-027 (Sept. 13, 2016).

See also

Estimates Proposing Release at 13, footnote 41.

Similarly, the SEC has brought Rule 102(e) proceedings against auditors for substantive failures in auditing accounting estimates, including failures to obtain sufficient appropriate audit evidence for significant accounting estimates in an entity's financial statements and failures to exercise due professional care, including professional skepticism, throughout the audit.

In some cases, the auditor (1) obtained little, if any, reliable or persuasive evidence with respect to management's adjustments to stale appraised values; (2) failed to identify and address bias in management's estimates; or (3) failed to evaluate the results of audit procedures performed, including whether the evidence obtained supported or contradicted estimates in the financial statements.

See, e.g., Paritz & Company, P.A., Lester S. Albert, CPA, and Brian A. Serotta, CPA,

SEC Accounting and Auditing Enforcement Release (“AAER”) No. 3899 (Sept. 21, 2017);

KPMG LLP and John Riordan, CPA,

SEC AAER No. 3888 (Aug. 15, 2017);

William Joseph Kouser Jr., CPA, and Ryan James Dougherty, CPA,

AAER No. 3864 (Apr. 4, 2017);

Grassi & Co., CPAs, P.C.,

SEC AAER No. 3826 (Nov. 21, 2016).

See also

Estimates Proposing Release at 14, footnote 42.

See, e.g., Miller Energy Resources, Inc.,

Paul W. Boyd, CPA, David M. Hall, and Carlton W. Vogt, III, CPA,

SEC AAER Nos. 3780 (June 7, 2016) and 3673 (Aug. 6, 2015);

Grant Thornton, LLP,

SEC AAER No. 3718 (Dec. 2, 2015).

Reasons To Improve Auditing Standards

The Board believes that its standards for auditing accounting estimates, including fair value measurements, can be improved to provide better direction to auditors with respect to both the application of professional skepticism, including addressing potential management bias, and the use of third-party pricing information.

First, the differences in requirements among the three estimates standards suggest that revising PCAOB standards to set forth a more uniform, risk-based approach to auditing estimates can lead to improvements in auditing practices for responding to the risks of material misstatement in accounting estimates, whether due to error or fraud.

Second, because the subjective assumptions and measurement uncertainty of accounting estimates make them susceptible to management bias, the Board believes that PCAOB standards related to auditing accounting estimates will be improved by emphasizing the application of professional skepticism, including addressing potential management bias.

Although the risk assessment standards and certain other PCAOB standards address professional skepticism and management bias, the estimates standards provide little or no specific direction on how to address those topics in the context of auditing accounting estimates.

Third, existing requirements do not provide specific direction about how to evaluate the relevance and reliability of pricing information from third parties. PCAOB standards should be improved by revising the requirements in this area to drive a level of work effort commensurate with both the risks of material misstatement in the valuation of financial instruments and the relevance and reliability of the evidence obtained.

The Board received 38 comment letters on the proposal. A number of commenters supported the Board's efforts to strengthen auditing practices and update its standards related to estimates and fair value measurements. For example, investor groups asserted that the proposal will strengthen auditor responsibilities, improve audit quality, and further investor protection. Other commenters pointed to better integration and alignment with the risk assessment standards, noting, for example, that a risk-based approach to auditing estimates will help to resolve the differences in requirements among the current standards. Some commenters supported combining the three existing standards into a single standard, for example, because it would make the requirements easier to navigate and comply with. Some commenters also expressed support for the incremental direction in the proposal on matters related to financial instruments, including the use of pricing information from third parties as audit evidence.

Some commenters on the proposal challenged the relevance of inspection experience to the Board's consideration of the new standard. For example, two commenters questioned whether the existence of audit deficiencies related to estimates warrant revision to the estimates standards. Another commenter suggested that development of standards should be based on areas where audit quality can be improved in order to protect the public interest, not just through areas that have been identified during the inspection process. In contrast, other commenters expressed concern over continued audit deficiencies observed in this area and supported the development of the proposal. Another commenter argued that a lack of clarity in the estimates standards might be a contributing factor to the persistence of audit deficiencies associated with auditing estimates and fair value measurements.

The Board believes that a pattern of deficiencies over time raises questions about whether professional skepticism is being appropriately applied and about overall audit quality in this area, and supports the view that estimates are a challenging area of the audit. More specific direction should contribute to more consistent, risk-based execution and improved audit quality.

Some commenters questioned the need for the proposal citing, among other things, insufficient evidence that existing standards are deficient and the loss of certain content from the estimates standards that the commenters considered to be useful. One commenter argued that the standards for fair value measurements should be differentiated from the standards for other accounting estimates because the goals of the standards are fundamentally different.

The Board believes it is appropriate to apply a more uniform approach to the audit of accounting estimates, including fair value measurements, including by bringing the requirements together into a single standard. The estimates standards already reflect common approaches to substantive testing. While the level of detail varies across the three standards, these differences do not derive from differences in the assessed risks of material misstatement. The Board believes that a single standard will promote auditor performance that is more consistently responsive to risk. The new standard also includes an appendix on valuation of financial instruments that provides specific direction in that area.

Some commenters asserted that the proposal would lead to unnecessary expansion of procedures and thus increased costs. For example, one of those commenters contended that the proposed requirements could affect the ability of smaller accounting firms to audit certain types of issuers. Another commenter cautioned against a one-size-fits-all audit approach, expressing concern about expecting the same level of rigor in developing accounting estimates from both the largest and smallest public companies. One commenter challenged the scalability of the proposal, arguing that auditors will assume that all listed factors and considerations will have to be addressed in every audit, and that nothing in the proposal directed the auditor to consider cost-benefit implications or whether further testing and analysis would meaningfully improve the auditor's ability to assess the reasonableness of an estimate. Other commenters, however, asserted that the standard is sufficiently scalable.

The Board believes that the new standard is well-tailored to address an increasingly significant and challenging area of the audit. The new standard is designed to be scalable because the necessary audit evidence depends on the corresponding risks of material misstatement. The new standard does not prescribe detailed procedures or the extent of procedures, beyond the requirement to respond to risk, including significant risk, and direction for applying the primary approaches to testing. Rather, it builds on the existing requirements of AS 2301 under which the auditor designs procedures that take into account the types of potential misstatements that could result from the identified risks and the likelihood and magnitude of potential misstatement.

Specific risk factors associated with the estimates—for example, subjective assumptions, measurement uncertainty, or complex processes or methods

—affect the auditor's risk assessment and in turn, the required audit effort.

AS 2301.09.

See

paragraph AS 2110.60A, as amended, for examples of specific risk factors.

Aligning the new standard and related amendments with the risk assessment standards directs auditors to focus on estimates with greater risk of material misstatement. The new standard allows auditors to tailor their approach to best respond to identified risks and effectively obtain sufficient appropriate evidence. To the extent the new standard results in increased audit effort, that effort should be scaled in relation to the relevant risks, and any associated costs should be justified in light of the benefits of appropriate audit attention and the appropriate application of professional skepticism.

Some commenters also challenged the anticipated benefits of the proposal, arguing that additional audit work would not improve the quality of financial reporting, given the inherent uncertainty and subjectivity surrounding estimates.

The new standard and related amendments acknowledge that estimates have estimation uncertainty and that it affects the risks of material misstatement. Neither the Board nor auditors are responsible for placing limits on the range of estimation uncertainty. That uncertainty is a function of the estimate's measurement requirements under the applicable financial reporting framework, the economic phenomena affecting that estimate, and the fact that it involves assessments of future outcomes. Under

the new standard and related amendments, the auditor will consider estimation uncertainty in assessing risk and performing procedures in response to risk, which involves evaluating whether the accounting estimates are reasonable in the circumstances and in conformity with the applicable financial reporting framework, as well as evaluating potential management bias in accounting estimates, and its effect on the financial statements. These responsibilities align with the auditor's overall responsibility for planning and performing financial statement audits.

Commenters generally acknowledged the Board's efforts to emphasize professional skepticism, including addressing management bias, in the proposal and provided varying views on related aspects of the proposal. Some commenters, for example, indicated that the proposal should place even more emphasis on the need to challenge management or the consideration of management bias, noting the existence of overly optimistic or skewed estimates in financial statements. One commenter advocated for more discussion within the standard of the various types of bias that can affect auditing estimates.

In contrast, other commenters asserted that the proposal overemphasized the need for professional skepticism, or had a negative tone that assumed a predisposition to management bias. One commenter pointed out other practices and requirements that, in the commenter's view, mitigate the risk of management bias, among them CEO and CFO certification, management reporting and auditor attestation on internal control over financial reporting, internal audit, and audit committee oversight. Some of these commenters expressed concern that the emphasis on professional skepticism would lead to unnecessary expansion of audit procedures.

A few commenters also argued that management bias is inherent in accounting estimates and cannot be eliminated. One of the commenters added that, for those reasons, the proposed requirements addressing management bias should not apply to estimates made pursuant to the new accounting standard on credit losses.

Another commenter suggested that the proposal should differentiate between limitations that an auditor can address (

e.g.,

analytical ability), those that can be partially addressed (

e.g.,

some features of management bias), and those that cannot be addressed (

e.g.,

time constraints, limits on available information).

See

Financial Accounting Standards Board (“FASB”) Accounting Standards Update No. 2016-13,

Financial Instruments—Credit Losses

(Topic 326):

Measurement of Credit Losses on Financial Instruments

(June 2016).

The Board acknowledges that given the subjective assumptions and measurement uncertainty inherent in many estimates, bias cannot be eliminated entirely. However, a standard that reinforces the importance of professional skepticism, including addressing the potential for management bias, when auditing estimates will remind auditors of their existing responsibilities to evaluate contradictory evidence and to address the effects of bias on the financial statements.

Some commenters suggested that the standard include guidance on identifying and testing relevant controls over accounting estimates. For example, one commenter suggested guidance related to auditor consideration of management's controls over selection and supervision of a company specialist. Another commenter suggested additional guidance on identification and testing of relevant controls, and identification and response to risks of material misstatement due to fraud in relation to auditing estimates.

The auditor's responsibilities for testing controls are already addressed in AS 2110, AS 2301, and AS 2201,

An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.

These requirements apply to controls over accounting estimates. Those responsibilities are not altered by the new standard and related amendments. However, after considering the comments, an amendment was made to provide additional direction on testing controls related to auditing estimates.

Overview of Final Rules

The Board has adopted a single standard to replace the accounting estimates standard, the fair value standard, and the derivatives standard. As described in more detail below, AS 2501 (Revised) includes a special topics appendix that addresses certain matters relevant to auditing the fair value of financial instruments. In addition, several PCAOB auditing standards will be amended to align them with the new standard on auditing accounting estimates. The new standard and related amendments will make the following changes to existing requirements:

• Provide direction to prompt auditors to devote greater attention to addressing potential management bias in accounting estimates, as part of applying professional skepticism. In this regard, the new standard and related amendments will:

• Amend AS 2110 to require a discussion among the key engagement team members of how the financial statements could be manipulated through management bias in accounting estimates in significant accounts and disclosures.

• Emphasize certain key requirements to focus auditors on their obligations, when evaluating audit results, to exercise professional skepticism, including evaluating whether management bias exists.

• Remind auditors that audit evidence includes both information that supports and corroborates the company's assertions regarding the financial statements and information that contradicts such assertions.

• Require the auditor to identify significant assumptions used by the company and describe matters the auditor should take into account when identifying those assumptions.

• Provide examples of significant assumptions (important to the recognition or measurement of the accounting estimate), such as assumptions that are susceptible to manipulation or bias.

• Emphasize requirements for the auditor to evaluate whether the company has a reasonable basis for the significant assumptions used and, when applicable, for its selection of assumptions from a range of potential assumptions.

• Explicitly require the auditor, when developing an independent expectation of an accounting estimate, to have a reasonable basis for the assumptions and method he or she uses.

• Require that the auditor obtain an understanding of management's analysis of critical accounting estimates and take that understanding into account when evaluating the reasonableness of significant assumptions and potential management bias.

• Recast certain existing requirements using terminology that encourages maintaining a skeptical mindset, such as “evaluate” and “compare” instead of “corroborate.”

• Strengthen requirements for evaluating whether data was appropriately used by a company that build on requirements in the fair value standard, and include a new requirement for evaluating whether a company's change in the source of data is appropriate.

• Clarify the auditor's responsibilities for evaluating data that build on the existing requirements in AS 1105.

• Amend AS 2401,

Consideration of Fraud in a Financial Statement Audit,

to clarify the auditor's responsibilities when performing a retrospective review of accounting estimates and align them with the requirements in the new standard.

• Extend certain key requirements in the fair value standard to other accounting estimates in significant accounts and disclosures to reflect a more uniform approach to substantive testing. For estimates not currently subject to the fair value standard, this will:

• Refine the three substantive approaches common to the accounting estimates standard to include more specificity, similar to the fair value standard.

• Describe the auditor's responsibilities for testing the individual elements of the company's process used to develop the estimate (

i.e.,

methods, data, and significant assumptions).

• Set forth express requirements for the auditor to evaluate the company's methods for developing the estimate, including whether the methods are:

• In conformity with the requirements of the applicable financial reporting framework; and

• Appropriate for the nature of the related account or disclosure, taking into account the auditor's understanding of the company and its environment.

• Require the auditor to take into account certain factors in determining whether significant assumptions that are based on the company's intent and ability to carry out a particular course of action are reasonable.

• Further integrate requirements with the risk assessment standards to focus auditors on estimates with greater risk of material misstatement. The new standard and related amendments incorporate specific requirements relating to accounting estimates into AS 2110 and AS 2301 to inform the necessary procedures for auditing accounting estimates. Specifically, the new standard and related amendments would:

• Amend AS 2110 to include risk factors specific to identifying significant accounts and disclosures involving accounting estimates.

• Align the scope of the new standard with AS 2110 to apply to accounting estimates in significant accounts and disclosures.

• Amend AS 2110 to set forth requirements for obtaining an understanding of the company's process for determining accounting estimates.

• Require auditors to respond to significantly differing risks of material misstatement in the components of accounting estimates, consistent with AS 2110.

• Remind auditors of their responsibility to evaluate conformity with the applicable financial reporting framework, reasonableness, and potential management bias and its effect on the financial statements when responding to the risks of material misstatement in accounting estimates in significant accounts and disclosures.

• Require the auditor, when identifying significant assumptions, to take into account the nature of the accounting estimate, including related risk factors, the applicable financial reporting framework, and the auditor's understanding of the company's process for developing the estimate.

• Include matters relevant to identifying and assessing risks of material misstatement related to the fair value of financial instruments.

• Add a note in AS 2301 to emphasize that performing substantive procedures for the relevant assertions of significant accounts and disclosures involves testing whether the significant accounts and disclosures are in conformity with the applicable financial reporting framework.

• Add a note to AS 2301 providing that for certain estimates involving complex models or processes, it might be impossible to design effective substantive tests that, by themselves, would provide sufficient appropriate evidence regarding the assertions.

• Make other updates to the requirements for auditing accounting estimates, including:

• Update the description of what constitutes an accounting estimate to encompass the general characteristics of the variety of accounting estimates, including fair value measurements, in financial statements.

• Set forth specific requirements for evaluating data and pricing information used by the company or the auditor that build on the existing requirements in AS 1105.

• Establish more specific requirements for developing an independent expectation that vary depending on the source of data, assumptions, or methods used by the auditor and build on AS 2810 to provide a requirement when developing an independent expectation as a range.

• Relocate requirements in the derivatives standard for obtaining audit evidence when the valuation of investments is based on investee results as an appendix to AS 1105.

• Provide specific requirements and direction to address auditing the fair value of financial instruments, including:

• Establish requirements to determine whether pricing information obtained from third parties, such as pricing services and brokers or dealers, provides sufficient appropriate evidence, including:

• Focus auditors on the relevance and reliability of pricing information from third-party sources,

regardless of whether the pricing information was obtained by the company or the auditor.

The requirements in this area focus primarily on pricing information from pricing services and brokers or dealers, but also cover pricing information obtained from other third-party pricing sources, such as exchanges and publishers of exchange prices.

• Establish factors that affect relevance and reliability of pricing information obtained from a pricing service.

• Require the auditor to perform additional audit procedures to evaluate the process used by the pricing service when fair values are based on transactions of similar financial instruments.

• Require the auditor to perform additional procedures on pricing information obtained from a pricing service when no recent transactions have occurred for either the financial instrument being valued or similar financial instruments.

• Establish conditions under which less information is needed about particular methods and inputs of individual pricing services in circumstances where prices are obtained from multiple pricing services.

• Establish factors that affect the relevance and reliability of quotes from brokers or dealers.

• Require the auditor to understand, if applicable, how unobservable inputs were determined and evaluate the reasonableness of unobservable inputs.

The Board seeks to improve the quality of auditing in this area and believes these changes strengthen and enhance the requirements for auditing accounting estimates.

Commenters largely supported a single, more uniform standard to address auditing accounting estimates, including fair value measurements. For example, one commenter observed that the existence of three related standards in this area made it difficult for auditors to navigate to be certain that all requirements were met. A few commenters, however, asserted that fair value measurements and derivatives are unique and involve different functions. One of those commenters also expressed concern about applying audit procedures in the fair value standard to other accounting estimates. The new standard takes into account the unique

aspects of auditing fair value measurements, such as the use of observable and unobservable inputs. Further, the new standard includes a separate appendix that addresses auditing the fair value of financial instruments.

Some commenters requested supplemental or implementation guidance for various requirements presented in the proposed standard and the related amendments. Several commenters also advocated for retaining portions of the derivatives standard that, in their view, provided helpful guidance. Two commenters suggested that the Board consider issuing guidance specific to the audits of brokers and dealers.

See

below for further discussion of the comments received on specific requirements and additional guidance on the implementation of the requirements in the new standard.

A few commenters observed that the proposal did not explicitly address how advances in technology, including use of data analytics, could affect audit procedures. In its consideration of the new standard and related amendments, the Board is mindful of the significant advances in technology that have occurred in recent years, including increased use of data analysis tools and emerging technologies. An increased use of these technology-based tools, together with future developments in the use of data and technology, could have a fundamental impact on the audit process. The Board is actively exploring these potential impacts through ongoing staff research and outreach.

For example, the staff is currently researching the effects on the audit of, among other things, data analytics, artificial intelligence, and distributed ledger technology, assisted by a task force of the SAG.

See

Data and Technology Task Force overview page, available on the Board's website.

In the context of this rulemaking, the Board considered how changes in technology could affect the approaches to auditing accounting estimates. The Board believes that the new standard and related amendments are sufficiently principles-based and flexible to accommodate continued advances in the use of data and technology by both companies and auditors. The Board will continue to monitor advances in this area and any implications related to the standard.

See

PCAOB,

Changes in Use of Data and Technology in the Conduct of Audits, available at https://pcaobus.org/Standards/research-standard-setting-projects/Pages/technology.aspx.

Some commenters advocated for greater alignment of the proposal with the IAASB's exposure draft on International Standard on Auditing 540 (“ISA 540”)

to achieve greater consistency in practice, and suggested continued coordination of efforts in this area. The Board considered the IAASB's ISA 540 project while developing the new standard. While there is some commonality between the new standard and ISA 540 Revised, the new standard is aligned with the Board's risk assessment standards and designed for audits of issuers and SEC-registered brokers and dealers.

See

IAASB Exposure Draft, Proposed ISA 540 (Revised),

Auditing Accounting Estimates and Related Disclosures,

(Apr. 20, 2017). In October 2018, the IAASB released the final standard (“ISA 540 Revised”).

Following is a discussion of significant comments received on the proposal along with revisions made by the Board after consideration of those comments and additional guidance on the implementation of the requirements of the new standard. The subsections also include a comparison of the final requirements with the analogous requirements of the following standards issued by the IAASB and the Auditing Standards Board (“ASB”) of the American Institute of Certified Public Accountants:

• ISA 540 Revised, adopted by the IAASB; and

• AU-C Section 540,

Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures

(“AU-C Section 540”), adopted by the ASB of the American Institute of Certified Public Accountants.

The comparison does not necessarily represent the views of the IAASB or ASB regarding the interpretation of their standards. Additionally, the information presented in the subsections does not include the application and explanatory material in the IAASB standards or ASB standards.

Paragraph A59 of ISA 200,

Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing,

and paragraph .A64 of AU-C Section 200,

Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Generally Accepted Auditing Standards,

indicate that the related application and other explanatory material “does not in itself impose a requirement” but “is relevant to the proper application of the requirements” of the respective standards.

AS 2501 (Revised)

Scope of the Standard

See Paragraphs .01-.02

As in the proposal, the new standard applies when auditing accounting estimates in significant accounts and disclosures. Commenters on this topic supported the scope set forth in the standard.

Comparison With Standards of Other Standard Setters

The scope and nature of accounting estimates described in ISA 540 Revised, AU-C Section 540, and the new standard share some common concepts. However, the accounting estimates covered by the new standard are expressly linked to significant accounts and disclosures.

Objective of the Standard

See Paragraph .03

In the proposal, the standard included a detailed objective expressly addressing the fundamental aspects of auditing accounting estimates under the estimates standards: Testing and evaluating whether accounting estimates (1) are reasonable in the circumstances, (2) have been accounted for and disclosed in conformity with the applicable financial reporting framework, and (3) are free from bias that results in material misstatement.

Commenters asserted that including the phrase “free from bias that results in material misstatement” as a distinct element of the audit objective was not clear, could imply absolute assurance, or could be interpreted as a broader obligation than what is required under the existing standards. Some commenters recommended deleting the reference to bias from the objective, and others suggested revisions in order to clarify the intent of including the reference to bias in the objective. One commenter suggested that the objective should be for auditors to determine whether accounting estimates and disclosures are reasonable in the context of the applicable financial reporting framework, which in the commenter's view would be broader than the proposed objective.

After consideration of comments, the Board has (1) revised the objective to describe the overall purpose of the procedures required under the new standard and other relevant procedures under the risk assessment standards (specifically, to determine whether accounting estimates in significant accounts and disclosures are properly accounted for and disclosed in financial statements);

(2) relocated the description of more specific auditor responsibilities—evaluating conformity with the applicable financial reporting framework, reasonableness, and potential management bias—from the

objective to the requirements;

and (3) provided additional context in the requirements to enhance clarity, including citing corresponding requirements in other PCAOB standards. In addition, for conciseness, the new standard and amendments have been revised to consistently use the phrase “sufficient appropriate evidence,” which has the same meaning in PCAOB standards as the phrase “sufficient appropriate audit evidence.”

This approach to formulating an objective is similar to the approach in other PCAOB standards.

See, e.g.,

paragraph .02 of AS 2410,

Related Parties.

See

first note to paragraph .05 of the new standard.

As discussed in more detail below, the revised objective links more closely with the requirements of the risk assessment standards

and continues to focus auditors on their existing obligations to evaluate potential management bias in the context of auditing accounting estimates.

See supra

note 3. The risk assessment standards set forth requirements relating to the auditor's assessment of, and response to, the risks of material misstatement in the financial statements.

Comparison With Standards of Other Standard Setters

The objective of ISA 540 Revised is to obtain sufficient appropriate audit evidence about whether accounting estimates and related disclosures in the financial statements are reasonable in the context of the applicable financial reporting framework. The objective of AU-C Section 540 is substantially the same but also includes whether related disclosures in the financial statements are adequate.

Identifying and Assessing Risks of Material Misstatement

See Paragraph .04

The proposed standard discussed how the auditor's responsibilities regarding the process of identifying and assessing risks of material misstatement, as set forth in AS 2110 apply to auditing accounting estimates. The proposed requirement provided that, among other things, identifying and assessing risks of material misstatement related to accounting estimates includes determining whether the components of estimates in significant accounts and disclosures are subject to significantly differing risks, and which estimates are associated with significant risks.

See

AS 2110.70-.71.

One commenter asserted that the term “components” should be defined and another commenter observed that “components of estimates” could be interpreted to mean inputs used to develop the estimate, or individual accounts that roll up into a financial statement line item.

AS 2501 (Revised) retains paragraph .04 as proposed, including the reference to components of estimates. This reference is not new and derives from the concept in the risk assessment standards that components of a potential significant account or disclosure might be subject to significantly differing risks

which would need to be taken into account in designing and performing audit procedures. For example, a valuation allowance in the company's financial statements may include a general component and a specific component with differing risks.

See

AS 2110.63.

Comparison With Standards of Other Standard Setters

In identifying and assessing the risks of material misstatement, ISA 540 Revised requires the auditor to separately assess inherent risk and control risk. The auditor is required to take into account, in assessing inherent risk (a) the degree to which the accounting estimate is subject to estimation uncertainty, and (b) the degree to which (i) the selection and application of the method, assumptions and data in making the accounting estimate; or (ii) the selection of management's point estimate and related disclosures for inclusion in the financial statements, are affected by complexity, subjectivity, or other inherent risk factors.

ISA 540 Revised and AU-C Section 540 also include requirements related to identification of significant risks related to accounting estimates. AS 2110 sets forth requirements for identifying significant risks under PCAOB standards.

AU-C Section 540 requires the auditor to evaluate the degree of estimation uncertainty associated with an accounting estimate in identifying and assessing the risks of material misstatement.

Responding to the Risks of Material Misstatement

See Paragraphs .05-.07

The proposed standard explained how the basic requirement in AS 2301 to respond to the risks of material misstatement applies when performing substantive procedures for accounting estimates in significant accounts and disclosures. Additionally, the proposal provided that responding to risks of material misstatement in the context of accounting estimates involves, among other things, (1) testing whether estimates in significant accounts and disclosures are in conformity with the applicable financial reporting framework, (2) responding to significantly differing risks of material misstatement in the components of an accounting estimate, and (3) applying professional skepticism in gathering and evaluating audit evidence, particularly when responding to fraud risks. The proposed standard also reminded auditors that, as the assessed risk of material misstatement increases, the evidence that the auditor should obtain also increases. The evidence provided by substantive procedures depends on the mix of the nature, timing, and extent of those procedures.

Commenters provided views on various aspects of the proposed requirements. One commenter asked for clarification on the role of professional skepticism in relation to fraud risks and management bias. Another commenter advocated for a framework against which auditor skepticism can be evaluated. Other commenters suggested including requirements to evaluate both corroborative and contradictory audit evidence similar to AS 1105.02. A few commenters also requested clarification of how substantive procedures related to accounting estimates can be performed at an interim date.

The new standard retains the discussion of the auditor's responsibilities for responding to risks associated with estimates substantially as proposed. The statements in the new standard related to responding to the risks of material misstatement are rooted in the Board's risk assessment standards and drew no critical comments.

The new standard reflects two changes from the proposal. As noted above, the description of more specific auditor responsibilities—evaluating conformity with the applicable accounting framework, reasonableness, and potential management bias—has been relocated from the objective to paragraph .05 to provide additional context for responding to risks of material misstatement. Specifically, the new standard states that responding to risks of material misstatement involves evaluating whether the accounting estimates are in conformity with the applicable financial reporting framework and reasonable in the circumstances, as well as evaluating potential management bias in accounting estimates and its effect on the financial statements. Notably, the added language regarding potential management bias is aligned with paragraphs AS 2810.24-.27 to remind auditors of existing requirements.

Additionally, the new standard now includes a reference to AS 1105.02, as suggested by some commenters, reminding auditors that audit evidence consists of both information that

supports and corroborates management's assertions regarding the financial statements and information that contradicts such assertions.

With respect to the comments regarding guidance on professional skepticism and performing procedures at interim dates, other PCAOB standards already address the auditor's responsibilities in those areas, and the new standard does not change that direction with respect to auditing estimates. For example, paragraphs .07-.09 of AS 1015,

Due Professional Care in the Performance of Work,

paragraph .13 of AS 2401, and AS 2301.07 address the appropriate application of professional skepticism, and AS 2301.43-.46 discusses the auditor's responsibilities when performing substantive procedures at an interim date. Those standards apply when auditing accounting estimates.

Scalability of the Standard

In response to questions in the proposal, commenters expressed mixed views on the scalability of the proposed requirements. Some commenters indicated that the proposed requirements were sufficiently scalable, while others identified challenges in scaling the auditor's response to identified risks in accounting estimates and requested additional guidance. For example, some commenters opined that it was not clear how auditors would tailor their response to an estimate that represented a significant risk of material misstatement compared with a lower risk estimate. One commenter advocated for further guidance to address situations where an estimate is deemed to have a low inherent risk. Another commenter indicated that it is important to recognize that the amount of evidence may not necessarily increase, but the persuasiveness and sufficiency of the evidence should increase.

The new standard is designed to be scalable because the necessary audit evidence depends on the corresponding risk of material misstatement. The standard does not prescribe detailed procedures or the extent of procedures, beyond the requirement to respond to the risk, including significant risk, and the direction for applying the primary approaches for testing. Rather, it builds on the requirements of AS 2301 to design procedures that take into account the types of potential misstatements that could result from the identified risks and the likelihood and magnitude of potential misstatement.

Specific risk factors associated with the estimates—for example, subjective assumptions, measurement uncertainty, or complex processes or methods

—would affect the auditor's risk assessment and in turn, the required audit effort. For example:

AS 2301.09.

See

AS 2110.60A, as amended, for examples of specific risk factors.

• Testing a simple calculation of depreciation expense, including evaluating remaining useful lives, for a group of assets of the same type with similar usage and condition would generally require less audit effort than testing asset retirement obligations that involve significant assumptions about costs not yet incurred based on estimation of the probability of future events.

• In testing the valuation of assets acquired and liabilities assumed in a business combination, more audit effort would need to be directed to assets and liabilities whose valuation involves more subjective assumptions, such as identifiable intangible assets and contingent consideration, than to assets with readily determinable values.

Additionally, the new standard echoes language from AS 2301.37 in stating that, as the assessed risk of material misstatement increases, the evidence from substantive procedures that the auditor should obtain also increases. Consistent with AS 2301, for an individual accounting estimate, different combinations of the nature, timing, and extent of testing might provide sufficient appropriate evidence to respond to the assessed risk of material misstatement for the relevant assertion.

Selection of Approaches

The proposed standard retained the requirement to test accounting estimates using one or a combination of three basic approaches from the estimates standards: (1) Testing the company's process, (2) developing an independent expectation, and (3) evaluating audit evidence from events or transactions occurring after the measurement date. The proposed standard also included a note reminding auditors that their understanding of the process the company used to develop the estimate, along with results of tests of relevant controls, should inform the auditor's decisions about the approach he or she takes to auditing an estimate.

Several commenters expressed support for retaining the three common approaches, as set forth in the proposal. Other commenters indicated that the proposal should emphasize that testing the company's process may not always be the best audit approach; with one commenter noting that the proposed requirement may lead auditors to test management's process substantively, regardless of whether another approach will provide the same or more persuasive audit evidence. Two commenters stressed the importance of developing an independent expectation and suggested this approach be selected in addition to testing the company's process. None of these commenters, however, suggested that the selection of substantive approaches should be limited.

Some commenters sought further direction on how the auditor would obtain sufficient evidence when using a combination of approaches, with some commenters asserting that, for example, the proposed requirement might result in inconsistent application or auditors unnecessarily performing all procedures under each approach. One commenter asked the Board to clarify whether documentation of a specific testing approach is expected.

Some commenters also requested guidance on the application of specific testing approaches. For instance, one commenter suggested that the Board consider directing auditors to always evaluate audit evidence from events or transactions occurring after the measurement date related to the accounting estimate, as, in their view, there would be limited circumstances in which this approach would not provide appropriate audit evidence to determine whether accounting estimates are reasonable. Another commenter added that events occurring after the measurement date may effectively eliminate estimation uncertainty, which affects risk assessment and the audit response related to valuation. This commenter suggested the proposal clarify the extent of additional procedures required, if any, when such events are considered and tested.

One commenter suggested more guidance be provided about how an auditor's understanding of management's process affects the auditor's planned response to assessed risk in accordance with AS 2301. This commenter also observed that the note to paragraph .07 may be read to mean that relevant controls are expected to be tested in all audits and suggested a footnote reference to relevant requirements of AS 2301.

The new standard retains the requirements for testing accounting estimates substantially as proposed, allowing the auditor to determine the approach or combination of approaches appropriate for obtaining sufficient appropriate evidence to support a conclusion about the particular accounting estimate being audited. The

new standard takes into account that accounting estimates vary in nature and in how they are developed. Therefore, mandating a particular testing approach may not be feasible or practical in the circumstances. For example, in some cases, data and significant assumptions underlying the estimate may be largely based on a company's internal information (

e.g.,

sales projections or employee data), or the estimate may be generated using a customized company-specific model. In those situations, the auditor may not have a reasonable alternative to testing the company's process. Similarly, there may not be any events or transactions occurring after the measurement date related to certain estimates (

e.g.,

the outcome of a contingent liability might not be known for a number of years). Rather than imposing limits on the selection of approaches, the new standard describes the auditor's responsibilities for appropriately applying the selected approach, or combination of approaches, to obtain sufficient appropriate evidence and performing an appropriate evaluation of the evidence obtained.

As under the estimates standards, the new standard allows for the auditor to use a combination of approaches to test an estimate. For example, some estimates consist of multiple components (

e.g.,

valuation allowances) and the auditor may vary the approaches used for the individual components. The auditor may also choose to develop an independent expectation of a significant assumption used by the company in conjunction with testing the company's process for developing the estimate. Whether using a combination of approaches or a single approach, the auditor is required to have a reasonable basis for using alternative methods or deriving his or her own assumptions, as discussed in more detail below. Similarly, when using information produced by the company as audit evidence, the auditor is required to evaluate whether that information is sufficient and appropriate for the purposes of the audit, regardless of the approach the auditor uses to test the estimate.

See

AS 1105.10.

The new standard also carries forward the point from the accounting estimate standard that the auditor's understanding of the company's process for developing the estimate, and, if relevant controls are tested, the results of those tests, informs the auditor's decision about which approach or approaches to take. AS 2301 describes the auditor's responsibilities for testing controls in a financial statement audit. The new standard does not change those responsibilities, including the circumstances under which the auditor is required to test controls. Rather, the standard emphasizes that the results of the auditor's tests of controls can affect the nature, timing and extent of planned substantive procedures. Further, the auditor's understanding of the company's process related to an estimate can provide insight into the nature and extent of available audit evidence, and thus inform the auditor's selection of approaches.

Lastly, the new standard does not set forth requirements for audit documentation. The auditor's responsibilities with respect to audit documentation are addressed in AS 1215,

Audit Documentation.

Accordingly, audit documentation relevant to selection of approaches should be evident to an experienced auditor, having no previous connection with the engagement.

See

AS 1215.06.

Comparison With Standards of Other Standard Setters

ISA 540 Revised requires the auditor's procedures to be responsive to the assessed risks of material misstatement at the assertion level, considering the reasons for the assessment given to those risks, and include one or more of the three approaches to substantive testing (similar to the new standard).

ISA 540 Revised also includes requirements for tests of controls. AS 2301 sets forth requirements for tests of controls in financial statement audits under PCAOB standards.

ISA 540 Revised also includes a requirement for the auditor to take into account that the higher the assessed risk of material misstatement, the more persuasive the audit evidence needs to be. The auditor is required to design and perform further audit procedures in a manner that is not biased towards obtaining audit evidence that may be corroborative or towards excluding audit evidence that may be contradictory.

AU-C Section 540 requires the auditor to determine whether management has appropriately applied the requirements of the applicable financial reporting framework relevant to the accounting estimate. In responding to the assessed risks of material misstatement, AU-C Section 540 also requires the auditor to undertake one or more of the three approaches discussed above, as well as providing an approach to perform a combination of tests of controls over the estimate along with substantive procedures.

Testing the Company's Process Used To Develop the Accounting Estimate

See Paragraph .09

The proposed standard included an introductory statement explaining the purpose of and steps involved in testing the company's process. Specifically, the standard explained that testing the company's process involves performing procedures to test and evaluate the methods, data, and significant assumptions used to develop the company's estimate in order to form a conclusion about whether the estimate is reasonable in the circumstances, in conformity with the applicable financial reporting framework, and free from bias that results in material misstatement.

Similar to the comments received on the proposed objective, some commenters expressed concerns about the phrase “free from bias that results in material misstatement” when describing the auditor's responsibilities in this area. One commenter also asked whether these requirements would apply to assumptions, models, and data provided by a company specialist. Another commenter sought clarification on the meaning of the terms “test,” “data,” and “assumptions.”

As with the objective of the standard, paragraph .09 of the new standard was revised to describe an overarching concept for testing the company's process—that is, to form a conclusion about whether the estimate is properly accounted for and disclosed in financial statements. These revisions are responsive to comments and link the auditor's responsibilities more closely to the requirements of the Board's risk assessment standards.

As discussed in more detail below, the new standard directs the auditor to look to the requirements in Appendix A of AS 1105

for the auditor's responsibilities with respect to using the work of a company's specialist in the audit. This direction has been modified from the proposal to align with changes to the Specialists Release.

The auditor's responsibilities with respect to using the work of a company specialist are presented as Appendix A of AS 1105.

See supra

note 2.

Finally, the meaning of the terms “test,” “data,” and “assumptions” in the new standard is consistent with the meaning of these terms used in the estimates standards and other PCAOB standards.

Comparison With Standards of Other Standard Setters

ISA 540 Revised provides that, as part of testing how management made the accounting estimate, the auditor is

required to perform procedures to obtain sufficient appropriate audit evidence regarding the risks of material misstatement relating to (a) selection and application of the methods, significant assumptions and the data used by management in making the accounting estimate, and (b) how management selected the point estimate and developed related disclosures about estimation uncertainty.

The Board's risk assessment standards address the auditor's responsibilities for responding to risks of material misstatement and obtaining sufficient appropriate evidence.

AU-C Section 540 provides that as part of testing how management made the accounting estimate and the data on which it is based, the auditor should evaluate whether the method of measurement used is appropriate in the circumstances, the assumptions used by management are reasonable in light of the measurement objectives of the applicable financial reporting framework, and the data on which the estimate is based is sufficiently reliable for the auditor's purposes.

Evaluating the Company's Methods

See Paragraphs .10-.11

The proposed standard provided that the auditor should evaluate whether the methods used by the company are (1) in conformity with the applicable financial reporting framework, including evaluating whether the data and significant assumptions are appropriately applied; and (2) appropriate for the nature of the related account or disclosure and the company's business, industry, and environment. The proposed requirements were similar to certain requirements of the fair value standard.

See

AS 2502.15 and .18.

A number of commenters expressed concerns about the requirement to evaluate whether the company's methods are appropriate for the company's “business, industry, and environment” because in their view, the requirement seemed to suggest all companies within a particular industry use, or should use, the same method. Two commenters also suggested adding specific requirements—to evaluate models used by the company and test the mathematical accuracy of the calculations used by the company to translate its assumptions into the accounting estimate. One commenter sought clarification on the intent of the requirement to evaluate whether the data and significant assumptions are appropriately applied under the applicable financial reporting framework.

The new standard retains substantially as proposed the requirement to evaluate whether the methods used by the company are in conformity with the applicable financial reporting framework, including evaluating whether the data is appropriately used and significant assumptions are appropriately applied under the framework. The applicable financial reporting framework may prescribe a specific method to develop an estimate or allow for alternative methods, or provide guidance on how to apply the method, including guidance on the selection or use of assumptions or data. Evaluating whether the company's method is in conformity with the financial reporting framework involves evaluating whether the data is appropriately used and significant assumptions are appropriately applied by the method, which, if applicable, would include testing the mathematical accuracy of the calculations under the method.

The methods used by the company may involve the use of a model (

e.g.,

expected future cash flows). The new standard does not prescribe specific procedures for testing models, as suggested by one commenter.

The Board believes that requirements specific to models are not necessary because evaluating the method, as discussed above, includes consideration of models to the extent necessary to reach a conclusion on the appropriateness of the method. Under the new standard, the necessary audit procedures to evaluate the method used by the company (which, as appropriate, include models involved in the method) are commensurate with the assessed risks associated with the estimate. For example, the risks associated with a method that uses a commercially available valuation model may relate to whether the model is appropriate for the related estimate under the applicable financial reporting framework, whereas the risks associated with a method that uses an internally-developed company model may include additional risks associated with how the model was developed. In this example, the internally-developed model scenario would require greater audit effort to respond to the broader range of risks, as compared to the commercially available model scenario. In either case, the auditor would evaluate whether the method was used appropriately, including whether adjustments, if any, to the output of the model were appropriate.

This commenter advocated for the approach taken by the IAASB regarding models. ISA 540 Revised requires that, when management's application of the method involves complex modeling, the auditor's procedures address whether judgments have been applied consistently and, when applicable, whether (1) the design of the model meets the measurement objective of framework, is appropriate in the circumstances, and changes from the prior period's model are appropriate in the circumstances; and (2) adjustments to the output of the model are consistent with the measurement objective and are appropriate in circumstances.

After consideration of comments, the requirement regarding evaluating the appropriateness of the method was revised to remove the reference to the company's business and industry. Under the new standard, the auditor is required to evaluate whether the company's method is appropriate for the nature of the related account or disclosure, taking into account the auditor's understanding of the company and its environment. This revised requirement is consistent with the risk assessment standards because the auditor's evaluation of the method (a substantive procedure) is informed by the auditor's understanding of the company and its environment (obtained through the auditor's risk assessment procedures).

Notably, part of the auditor's procedures for obtaining an understanding of the company and its environment include obtaining an understanding of relevant industry, regulatory, and other external factors, and evaluating the company's selection and application of accounting principles.

Additionally, AS 2301.05d requires the auditor to evaluate whether the company's selection and application of significant accounting principles, particularly those related to subjective measurements and complex transactions, are indicative of bias that could lead to material misstatement of the financial statements.

AS 2110.09 and .12-.13.

The proposed standard also addressed circumstances in which a company has changed its method for developing an accounting estimate by requiring the auditor to determine the reasons for and evaluate the appropriateness of such change.

One commenter asserted that it would be more appropriate to require the auditor to evaluate whether the company's reasons for making the change are appropriate. This commenter also sought clarification on what constitutes a change in method and on the auditor's responsibility when the company has not made a determination about whether different methods result in significantly different estimates. Another commenter expressed concern that, because of a lack of clarity about the definition of “method” and what

constitutes a change, the proposed requirement could result in potentially onerous documentation necessary to support changes to methods. Finally, one commenter suggested adding a requirement for the auditor to evaluate whether the company failed to revise its method to recognize changes in facts and circumstances.

The new standard retains as proposed the requirements for the auditor to (1) determine the reasons for changes to the method used by the company and evaluate the appropriateness of such change, and (2) evaluate the appropriateness of methods selected by the company in circumstances where the company has determined that different methods could result in significantly different estimates. The requirements in the new standard are similar to those in the fair value standard

and consistent with the auditor's responsibilities to obtain an understanding of the company's process used to develop the estimate, including the methods used.

These requirements also take into account that, in some cases, more than one method may be used to develop a particular estimate. It is important for the auditor to understand the basis for the company's change to its method, as changes that are not based on new information or other changes in the company's circumstances could be indicative of management bias (

e.g.,

changing the method to achieve a favorable financial result).

AS 2502.19.

See

AS 2110.28, as amended.

See

AS 2810 for requirements related to evaluating bias in accounting estimates.

With respect to other comments raised above, a separate requirement to evaluate whether the company failed to revise its method to recognize changes in facts and circumstances is unnecessary as auditors would make this determination when evaluating appropriateness of the method for the nature of the account or disclosure, taking into account the auditor's understanding of the company and its environment. That understanding should inform the auditor about conditions which might indicate that a change in method is needed. For example, the use of a discounted cash flow method to value a financial instrument may no longer be appropriate once an active market is introduced for the instrument. Moreover, changes to the method could result in a change to the corresponding estimate and affect the consistency of the financial statements (as discussed in AS 2820,

Evaluating Consistency of Financial Statements

In addition, contrary to the views of one commenter, the new standard does not impose any new documentation requirements to the existing provisions of AS 1215.

See also

FASB Accounting Standards Codification Topic 250,

Accounting Changes and Error Corrections.

Comparison With Standards of Other Standard Setters

ISA 540 Revised provides that the auditor's procedures shall address (a) whether the method selected is appropriate in the context of the applicable financial reporting framework, and, if applicable, whether changes from the method used in prior periods are appropriate; (b) whether judgments made in selecting the method give rise to indicators of possible management bias; (c) whether the calculations are applied in accordance with the method and are mathematically accurate; and (d) whether the integrity of the significant assumptions and the data has been maintained in applying the method.

See supra

note 45 for additional requirements related to models.

AU-C Section 540 requires the auditor to determine whether the methods for making the accounting estimate are appropriate and have been applied consistently, and whether changes, if any, in accounting estimates or in the method for making them from the prior period are appropriate in the circumstances. Further, AU-C Section 540 provides that as part of testing how management made the accounting estimate, and the data on which it is based, the auditor evaluates whether the method of measurement used is appropriate in the circumstance.

Testing Data Used

See Paragraphs .12-.14

The proposed standard discussed the auditor's responsibilities for testing and evaluating both internal and external data. This included (1) reiterating existing requirements in AS 1105 to test the accuracy and completeness of information produced by the company, or to test the controls over the accuracy and completeness of that information;

and (2) requiring the auditor to evaluate the relevance and reliability

of data from external sources.

AS 1105.10.

AS 1105.07-.08.

The proposed standard also provided that the auditor should evaluate whether the data is used appropriately by the company, including whether (1) the data is relevant to the measurement objective for the accounting estimate; (2) the data is internally consistent with its use by the company in other estimates tested; and (3) the source of the company's data has changed from the prior year and, if so, whether the change is appropriate.

A few commenters called for clarification of various aspects of the proposed requirements pertaining to data. For example, one commenter suggested the requirements clarify that company data supplied to a third party or company specialist is not considered to be data from an external source. This commenter also asked for a framework for evaluating whether the source of the company's data has changed from the prior year and, if so, whether the change is appropriate. Another commenter sought more clarity on whether the requirement applies to all data or may be limited to significant data.

Some commenters also suggested additional requirements in this area. For example, one commenter asserted that the existing requirements related to completeness and accuracy of data in AS 1105 do not themselves constitute a procedure that addresses risks of material misstatement and instead, suggested an express requirement to evaluate whether the data used in the estimate is accurate and complete. Another commenter pointed to the existence of data analytics tools as an alternative to sampling, and advocated for some acknowledgement in the requirements of the importance of the integrity of these tools and the controls over their development. One commenter suggested a requirement to assess whether management has appropriately understood or interpreted significant data.

The new standard retains the requirements for testing and evaluating data substantially as proposed, including requirements to evaluate whether the data is relevant to the measurement objective, internally consistent, and whether the source of the company's data has changed from the prior year and if so, whether the change is appropriate. The new standard builds on the auditor's responsibilities established by AS 1105, including requirements to test the accuracy and completeness of information produced by the company. Contrary to the views of one commenter, AS 1105 currently includes an obligation for the auditor to test company-produced data. Accordingly, an additional requirement to evaluate whether the data used in the estimate is accurate and complete is not necessary. Furthermore, the determination of the data to be tested—and the nature, timing, and extent of that testing—

should be based on and responsive to the assessed risks of material misstatement.

Consistent with the proposed standard, AS 2501 (Revised) makes a distinction between procedures to be performed regarding internal data and procedures regarding data from external sources used by the company to develop accounting estimates. Examples of internal data include the company's historical warranty claims and historical losses on defaulted loans. Examples of external data include economic, market, or industry data. Company data supplied by the company to a third party or company specialist is not data from an external source. The new standard also points auditors to Appendix B of AS 1105 for situations in which the valuation of an investment is based on the investee's financial results.

The new standard also retains substantially as proposed requirements to evaluate whether the data was used appropriately by the company. Evaluating the manner in which data was used by the company necessarily builds on the auditor's understanding of the company's process used to develop the estimate. This includes evaluating whether the company's selection and use of data is in conformity with the requirements of the financial reporting framework. Further, devoting audit attention to changes in the data source might reveal potential contradictory evidence and help the auditor identify potential management bias. For example, while a new source of data might result in an estimate that better reflects a company's specific circumstances, a change in data source could also be used by a company to achieve a desired financial result. The new standard has been modified to clarify that evaluating whether the data is used appropriately includes evaluating whether the data is internally consistent with its use by the company in other significant accounts and disclosures based on similar example procedures in the fair value standard.

See

AS 2502.39.

As noted by one commenter, significant advances in technology have occurred in recent years, including increased use of data analysis tools. The Board considered how changes in technology could affect the approaches to auditing accounting estimates and believes that the new standard and related amendments are sufficiently principles-based and flexible to accommodate continued advances in the use of data and technology by both companies and auditors.

Comparison With Standards of Other Standard Setters

ISA 540 Revised provides that the auditor's procedures shall address (a) whether the data is appropriate in the context of the applicable financial reporting framework, and, if applicable, changes from prior periods are appropriate; (b) whether judgments made in selecting the data give rise to indicators of possible management bias; (c) whether the data is relevant and reliable in the circumstances; and (d) whether the data has been appropriately understood or interpreted by management, including with respect to contractual terms.

AU-C Section 540 provides that in testing how management made the accounting estimate, and the data on which it is based, the auditor should evaluate whether the data on which the estimate is based is sufficiently reliable for the auditor's purposes.

Identification of Significant Assumptions

See Paragraph .15

The proposed standard provided that the auditor should identify which of the assumptions used by the company are significant assumptions to the estimate and provided criteria to assist the auditor in making this determination. Furthermore, the proposed standard provided that, if the company has identified significant assumptions used in an estimate, the auditor's identification of significant assumptions should also include those assumptions.

Some commenters expressed concern about one of the factors to be considered in identifying significant assumptions—whether an assumption relates to an identified and assessed risk of material misstatement. The commenters opined that the factor was too broad and could result in an excessive number of assumptions being identified as significant. Some of those commenters suggested adding a note to describe how all of the factors set forth in the proposal work together. A few commenters made other suggestions with respect to this requirement including (1) incorporating the requirement to identify assumptions used by the company which are important to the recognition or measurement of the accounting estimate in the financial statements into AS 2110.28e, as amended; (2) adding a qualifying phrase, such as “as applicable,” to the factors because some factors may not always be relevant or may vary in significance; and (3) incorporating the concept described in AS 2502.33 that significant assumptions cover matters that materially affect the estimate.

Some commenters also voiced concerns that the proposed requirement to include as significant those assumptions that the company has identified as significant may not be appropriate because (1) management is not required to designate assumptions as significant, and (2) auditors and company management may reach different conclusions about which assumptions are significant. One commenter expressed the view that the omission of a requirement to identify assumptions beyond what management identified may be inconsistent with the requirements of AS 2110, and suggested the Board clarify the auditor's responsibilities when, for example, management has not considered a specific assumption needed to correctly apply the applicable accounting framework. Another commenter suggested that assumptions identified by the company as significant should be reflected as an additional factor relevant to identifying significant assumptions rather than a requirement.

After consideration of comments received, the requirement was revised. Specifically, the factor regarding whether an assumption relates to an identified and assessed risk of material misstatement was removed. Instead, the new standard requires the auditor to take into account the nature of the accounting estimate, including related risk factors,

the requirements of the applicable financial reporting framework, and the auditor's understanding of the company's process for developing the estimate when identifying significant assumptions. Further, the remaining factors from the proposal—sensitivity to variation, susceptibility to manipulation and bias, unobservable data or adjustments, and dependence on the company's intent and ability to carry out specific courses of action—have been reframed in the new standard as examples of assumptions that would ordinarily be significant. The examples provided are not intended to be an exhaustive list of significant assumptions or a substitute for taking into account the auditor's understanding of the nature of the estimate, including risk factors, the requirements of the applicable financial reporting framework, and his or her understanding of the company's process for developing the estimate. Rather, the examples are provided to illustrate how the concepts in the new standard can be applied to identify significant assumptions that are important to the

recognition or measurement of an accounting estimate. The revised formulation provides better context for the application of the requirement, as suggested by some commenters, and prompts auditors to consider those assumptions that drive or are associated with identified risks of material misstatement.

See

AS 2110.60-.60A, as amended.

The auditor is not expected to document a detailed comparison of each assumption used in the estimate to each factor or example described above. Instead, consistent with AS 1215, the auditor should document the significant assumptions identified and the auditor's rationale for that determination.

In addition, the proposed note—requiring auditors to include as significant those assumptions that the company has identified as significant assumptions—was not included in the new standard. As discussed above, the new standard requires the auditor, in identifying significant assumptions, to take into account the auditor's understanding of the company's process for developing the estimate, which would include understanding the assumptions used by the company in that estimate (whether expressly identified or implicit in the nature of the estimate or method used). This approach addresses commenter concerns about whether the Board was imposing a responsibility on management to identify significant assumptions.

The intent of the proposed requirement to include significant assumptions identified by the company was to provide the auditor with a starting point for the auditor's evaluation (consistent with the fair value standard). However, since the revised requirement already focuses the auditor on understanding the assumptions used by the company to develop the estimate and the associated risk factors, the new standard does not include a new factor for assumptions identified as significant by management, as suggested by a commenter.

Lastly, the requirement to identify significant assumptions was not relocated to AS 2110.28, as suggested by one commenter, because identifying significant assumptions is an inherent part of testing the company's process for developing estimates.

Evaluation of Significant Assumptions

See Paragraphs .16-.18

The proposed standard set forth requirements to evaluate the reasonableness of significant assumptions used by the company, both individually and in combination, including evaluating whether (1) the company has a reasonable basis for those assumptions and, when applicable, the company's selection of assumptions from a range of potential assumptions; and (2) significant assumptions are consistent with, among other things, the company's objectives, historical data, the economic environment, and market information. In circumstances when the auditor develops an expectation of an assumption to evaluate its reasonableness, the proposed standard also provided that the auditor should have a reasonable basis for that expectation.

Some commenters asked for clarification of certain aspects of the requirement. For example, a few commenters asked for clarification on the requirement to assess whether management has a reasonable basis for its assumptions. Another commenter asked for an explanation of what “reasonable” is intended to mean in the context of accounting estimates. One commenter sought clarification on how to evaluate differences between management's assumption and the auditor's expectation in circumstances where the auditor develops an expectation of an assumption to evaluate its reasonableness. Another commenter requested that the requirement address factors relevant to evaluating reasonableness of forward-looking information in anticipation of the new accounting standard on credit losses.

See

FASB Accounting Standards Update No. 2016-13,

Financial Instruments—Credit Losses

(Topic 326):

Measurement of Credit Losses on Financial Instruments

(June 2016).

With respect to evaluating consistency with baseline information described in the standard, one commenter asked for clarification of how the requirement to evaluate factors in paragraph .16 works with the requirement to “test” in paragraph .09. This commenter also asked for clarification of the extent of the procedures to be performed when evaluating the consistency of significant assumptions with the contextual information set forth in the standard, where relevant, asserting that the requirement may be difficult to apply in practice. Another commenter suggested that the auditor be required to

consider

whether the assumptions are consistent with the information provided in order to better align the provision with language used by the IAASB.

One commenter suggested inclusion of a specific requirement to assess significant assumptions for management bias.

The new standard retains the requirements for evaluating reasonableness of significant assumptions substantially as proposed. The requirements recognize that estimates are generally developed using a variety of assumptions and focus the auditor on how the company selects its assumptions.

The auditor's assessment of whether the company has a reasonable basis for a significant assumption (including an assumption based on forward-looking information) relates to whether the assumption used by the company is based on an analysis of relevant information, or determined arbitrarily, with little or no such analysis. The auditor's assessment also involves considering whether the company considered relevant evidence, regardless of whether it corroborates or contradicts the company's assumption.

Under the new standard, the auditor should evaluate whether the significant assumptions are consistent with relevant information such as the company's objectives; historical experience (

e.g.,

prior years' assumptions and past practices), taking into account changes in conditions affecting the company; and other significant assumptions in other estimates tested (

e.g.,

assumptions are consistent with each other and other information obtained). This requirement is consistent with requirements in the fair value standard.

In making this evaluation, the auditor uses his or her understanding of the company and its environment, the assessed risks of material misstatement, and his or her understanding of the process used to develop the estimates.

See generally

AS 2502.29-.36.

In circumstances where the auditor develops an expectation of an assumption to evaluate reasonableness, the auditor is required to have a reasonable basis for that expectation (consistent with the requirements regarding developing independent expectations), taking into account relevant information, including the information set forth in the requirement. The new standard does not prescribe specific follow-up procedures when there are differences between the auditor's expectation and the company's significant assumptions. The nature and extent of procedures would depend on relevant factors such as the reason for the difference and the potential effect of the difference on the accounting estimate.

See

AS 2501.30-.31 (Revised).

With respect to the comment regarding management bias, the new standard was revised to provide that responding to risks of material misstatement involves, among other things, evaluating potential management bias in accounting estimates, and its effect on the financial statements (in paragraph .05). Furthermore, the requirements in paragraphs .30-.31 of the new standard, as well as AS 2810.27 address the evaluation of bias in accounting estimates. Therefore, an explicit requirement to evaluate bias as part of evaluating reasonableness of significant assumptions is not necessary.

Intent and Ability

As part of evaluating the reasonableness of significant assumptions, the proposed standard provided that the auditor take into account factors (

e.g.,

company's past history of carrying out stated intentions, written plans or other documentation, stated reasons for course of action, and the company's ability to carry out action based on financial resources, legal restrictions, etc.) that affect the company's intent and ability to carry out a particular course of action when such action is relevant to the significant assumption.

One commenter asserted that compliance with the proposed requirements would not be possible when information described in factors does not exist and suggested adding the phrase “as applicable” to the requirement.

The new standard retains, as proposed, the requirement to take into account specific factors in evaluating the reasonableness of significant assumptions when the significant assumption is based on the company's intent and ability to carry out a particular course of action. As in other PCAOB standards, the auditor takes factors into account to the extent they are relevant.

Critical Accounting Estimates

With respect to critical accounting estimates, the proposed standard provided that the auditor should obtain an understanding of how management analyzed the sensitivity of its significant assumptions

to change, based on other reasonably likely outcomes that would have a material effect, and to take that understanding into account when evaluating the reasonableness of the significant assumptions and potential for management bias.

For the purposes of this requirement, significant assumptions identified by the company may not necessarily include all of those identified by the auditor as significant.

Some commenters expressed concern that the proposed requirement may place undue emphasis on, or create an inappropriate linkage with, a company's management discussion and analysis (“MD&A”) disclosure. One commenter also suggested that the requirement may not always apply (if, for example, management were unable to perform a sensitivity analysis), and suggested clarification that the intent was for the auditor to understand whether, and if so, how, management analyzed the sensitivity of significant assumptions to change.

Some commenters suggested the proposed requirement be recast or aligned as a risk assessment procedure. For example, one commenter observed that the auditor's and management's judgment can differ with respect to critical accounting estimates. That commenter also stated that it was unclear whether the auditor should obtain this understanding if choosing a substantive-only testing strategy. One commenter suggested limiting the proposed requirement to critical accounting estimates with significant risks. Another commenter sought clarification that the requirement does not alter the auditor's responsibilities under AS 2710,

Other Information in Documents Containing Audited Financial Statements.

The new standard retains the requirement substantially as proposed. In consideration of comments, the requirement was clarified to better align with the SEC's requirement for critical accounting estimates

by describing that the sensitivity of management's significant assumptions to change is based on other reasonably likely outcomes that would have a material effect on the company's financial condition or operating performance.

See Commission Guidance Regarding Management's Discussion and Analysis of Financial Condition and Results of Operations,

Release No. 33-8350 (Dec. 19, 2003), 68 FR 75056 (Dec. 29, 2003), at Section V (“Critical Accounting Estimates”) for management's responsibilities related to critical accounting estimates.

Under the new standard, the auditor is not expected to evaluate the company's compliance with the SEC's MD&A requirements, but rather to obtain an understanding of management's analysis of critical accounting estimates and to use this understanding in evaluating the reasonableness of the significant assumptions and potential for management bias in accordance with AS 2810.27. In the Board's view, the sensitivity analysis used by the company in developing the critical accounting estimates disclosures for the year under audit can provide important information about the significant assumptions underlying those estimates.

The Board considered recasting the requirement to obtain an understanding of management's analysis of its critical accounting estimates as a risk assessment procedure, as suggested by some commenters. However, this understanding is a necessary part of evaluating the reasonableness of significant assumptions and the potential for management bias in critical accounting estimates, which is a substantive procedure. Moreover, MD&A disclosures regarding critical accounting estimates might not be available until late in the audit, and therefore could affect the timing of related audit procedures.

The requirements in the new standard with respect to critical accounting estimates would not change the auditor's responsibilities under AS 2710 regarding other information in documents containing audited financial statements.

Although there may be significant overlap between estimates with significant risks identified by the auditor and the critical accounting estimates identified by management, the requirements for auditors under paragraph .18 of the new standard are not limited to estimates with significant risks as suggested by one commenter. Rather, the paragraph is consistent with the requirements to evaluate the reasonableness of assumptions in significant accounts and disclosures. The MD&A disclosures regarding critical accounting estimates can provide relevant information to inform the auditor's evaluation of the reasonableness of the significant assumptions and potential for management bias.

Comparison With Standards of Other Standard Setters

ISA 540 Revised provides that the auditor's procedures shall address (a) whether the significant assumptions are appropriate in the context of the applicable financial reporting framework, and, if applicable, changes from prior periods are appropriate; (b) whether judgments made in selecting the significant assumptions give rise to indicators of management bias; (c) whether the significant assumptions are consistent with each other and with those used in other accounting estimates, or with related assumptions used in other areas of the entity's business activities, based on the auditor's knowledge obtained in the

audit; and (d) when applicable, whether management has the intent to carry out specific courses of action and has the ability to do so.

ISA 540 Revised also requires the auditor to address whether, in the context of the applicable financial reporting framework, management has taken appropriate steps to (a) understand estimation uncertainty; and (b) address estimation uncertainty by selecting an appropriate point estimate and by developing related disclosures about estimation uncertainty. When, in the auditor's judgment based on the audit evidence obtained, management has not taken appropriate steps to understand or address estimation uncertainty, ISA 540 Revised requires the auditor to, among other things, request management to perform additional procedures to understand estimation uncertainty or to address it by reconsidering the selection of management's point estimate or considering providing additional disclosures relating to the estimation uncertainty, and evaluate management's response. If the auditor determines that management's response to the auditor's request does not sufficiently address estimation uncertainty, to the extent practicable, the auditor is required to develop an auditor's point estimate or range.

AU-C Section 540 provides that as part of testing how management made the accounting estimate, and the data on which it is based, the auditor shall evaluate whether the assumptions used by management are reasonable in light of the measurement objectives of the applicable financial reporting framework. Further, for accounting estimates that give rise to significant risks, AU-C Section 540 requires the auditor to evaluate: (a) How management considered alternative assumptions or outcomes and why it rejected them, or how management has otherwise addressed estimation uncertainty in making accounting estimates; (b) whether the significant assumptions used by management are reasonable; and (c) where relevant to the reasonableness of the significant assumptions used by management or the appropriate application of the applicable financial reporting framework, management's intent to carry out specific courses of action and its ability to do so.

AU-C Section 540 further provides that if, in the auditor's professional judgment, management has not addressed adequately the effects of estimation uncertainty on the accounting estimates that give rise to significant risks, the auditor should, if considered necessary, develop a range with which to evaluate the reasonableness of the accounting estimate.

Company's Use of a Specialist or Third-Party Pricing Information

See Paragraphs .19-.20

The proposed standard would have required the auditor to also take into account the work of a company's specialist used in developing an accounting estimate when determining the evidence needed in testing the company's process. The proposed standard also referenced Appendix B of AS 1105

for testing and evaluating the work of a company's specialist when that work is used to support a conclusion regarding a relevant assertion, such as a relevant assertion related to an accounting estimate.

In a separate proposal, the Board proposed to amend its standards regarding the auditor's use of the work of specialists, including specialists employed or engaged by the company (“company's specialist”).

See Proposed Amendments to Auditing Standards for the Auditor's Use of the Work of Specialists,

PCAOB Release No. 2017-003 (“Specialists Proposal”). The Specialists Proposal set forth these amendments in Appendix B of AS 1105.

In addition, when third-party pricing information used by the company is significant to the valuation of financial instruments, the proposed standard required the auditor to evaluate whether the company has used that information appropriately and whether it provides sufficient appropriate evidence.

One commenter expressed concern that the proposed requirement would result in practical challenges as it would require the auditor to test the methods, data, and significant assumptions used or developed by a company specialist in the same manner that the auditor would if the accounting estimate was developed without the assistance of a company specialist. Another commenter advocated for closer alignment with the proposed requirements of Appendix B of AS 1105, citing, for example, requirements for testing the accuracy and completeness of company-produced data used by the specialists and evaluating the relevance and reliability of data obtained from external sources.

One commenter advocated for requiring auditors to consider whether company specialists possess specific credentials as part of auditing estimates under the proposed standard.

With respect to circumstances when third-party pricing information used by the company is significant to the valuation of financial instruments, one commenter requested additional guidance or criteria for evaluating whether the company has used third-party pricing information “appropriately” when assessing whether the information provides sufficient appropriate evidence.

In consideration of comments (including those received on the Specialists Proposal), the new standard requires the auditor to look to the requirements of Appendix A of AS 1105 that discuss the auditor's responsibilities for using the work of company specialists.

Appendix A of AS 1105 sets forth, among other things, procedures to be performed in evaluating the data, assumptions, and methods used by a company's specialist. Further, rather than addressing specific credentials of the specialist, Appendix A of AS 1105 requires the auditor to assess the knowledge, skill, and ability of the company's specialist.

The auditor's responsibilities with respect to using the work of a company's specialist are presented as Appendix A of AS 1105.

See

Specialists Release,

supra

note 2. The analogous proposed requirements were originally presented as Appendix B of AS 1105 in the Specialists Proposal.

The new standard retains as proposed the requirement to evaluate, when third-party pricing information used by the company is significant to the valuation of financial instruments, whether the company has used third-party pricing information appropriately and whether it provides sufficient appropriate evidence. The auditor's determination as to whether third-party pricing information was used appropriately by the company includes whether the information is in conformity with the applicable financial reporting framework.

Comparison With Standards of Other Standard Setters

ISA 540 Revised provides that when using the work of a management's expert, the requirements in paragraphs 21-29 of ISA 540 Revised

may assist the auditor in evaluating the appropriateness of the expert's work as audit evidence for a relevant assertion in accordance with paragraph 8(c) of ISA 500,

Audit Evidence.

In evaluating the work of the management's expert, the nature, timing, and extent of the further audit procedures are affected by the auditor's

evaluation of the expert's competence, capabilities and objectivity, the auditor's understanding of the nature of the work performed by the expert, and the auditor's familiarity with the expert's field of expertise.

Paragraphs 21-29 of ISA 540 Revised describe the requirements for obtaining audit evidence from events occurring up to the date of the auditor's report; testing how management made the accounting estimate; and developing an auditor's point estimate or range.

ISA 540 Revised provides that in obtaining audit evidence regarding the risks of material misstatement relating to accounting estimates, irrespective of the sources of information to be used as audit evidence, the auditor shall comply with the relevant requirements in ISA 500.

Developing an Independent Expectation of the Estimate

See Paragraph .21

The proposal sought to retain the general approach in the estimates standards for developing an independent expectation,

and more explicitly tailored the requirements to the different sources of the methods, data, and assumptions used by the auditor. Those sources include (1) independent assumptions and methods of the auditor, (2) data and assumptions obtained from a third party, and (3) the company's data, assumptions, or methods.

See

AS 2501.12, AS 2502.40, and AS 2503.40.

Additionally, while seeking to retain the requirement under the fair value standard for an auditor to understand management's assumptions to ensure that his or her independent estimate takes into consideration all significant variables,

the proposal expressly required the auditor to take into account the requirements of the applicable financial reporting framework.

See

AS 2502.40.

The proposal also replaced certain terms used in the estimates standards to describe audit procedures with more neutral language (such as replacing “corroborate” with “compare”) to reduce the risk of confirmation bias or anchoring bias when auditing accounting estimates.

Commenters on this topic were generally supportive of the proposed requirement for developing an independent expectation, indicating that the requirement is clear and sufficient. One commenter asked the Board to clarify situations where developing an independent expectation of the estimate would be appropriate. Another commenter indicated that using the phrase “developing an independent expectation” implies that the auditor would reach this expectation independently, without reference to management's methods, data, and assumptions, and recommended that the Board consider changing this phrasing to developing a “comparative estimate” or a “point estimate” to better reflect the procedures described.

After consideration of these comments, the requirement is adopted substantially as proposed. The determination of when to use an approach or a combination of approaches is at the auditor's discretion based on the relevant facts and circumstances. In addition, the use of the phrase “developing an independent expectation of the estimate” is consistent with the concept in the estimates standards. The intention of the requirement is not to imply that the auditor could (or should) develop an expectation of the estimate without reference to the company's methods, data, and assumptions, but rather to more explicitly acknowledge that, in developing an independent expectation of the estimate, an auditor could use methods, data, and assumptions obtained from different sources.

Consistent with the proposal, the new standard tailors the requirements to develop an independent expectation to the different sources of the methods, data, and assumptions used by the auditor as set forth in the table below and discussed further in the sections 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 direction to auditors in light of the various ways in which auditors develop an independent expectation of accounting estimates.

The new standard also expressly prompts the auditor to take into account the requirements of the applicable financial reporting framework when developing an independent expectation. By taking into account the requirements of applicable financial reporting framework, the auditor might identify additional considerations relevant to the estimate that the company did not take into account in its own process for developing the estimate. As with the proposal, the new standard also uses more neutral terms, such as “evaluate” and “compare” to mitigate the risk of confirmation bias or anchoring bias when auditing accounting estimates. For example, the new standard requires the auditor to compare the auditor's independent expectation to the company's accounting estimate instead of developing an independent fair value estimate “for corroborative purposes.”

See

AS 2502.40.

Independent Assumptions and Methods of the Auditor

See Paragraph .22

The proposal recognized that, when developing an independent expectation of an estimate, the auditor can independently derive assumptions or use a method that differs from the company's method. In those situations, the auditor should have a reasonable basis for his or her assumptions and methods used.

Commenters on this topic were generally supportive of the proposed requirement that the auditor have a reasonable basis for the assumptions and methods used when developing an independent expectation of the estimate. The requirement is adopted as proposed.

Under the new requirement, the auditor is required to have a reasonable basis for the assumptions and methods used to develop an independent expectation. Having a reasonable basis would reflect consideration of, among other things, the nature of the estimate; relevant requirements of the applicable financial reporting framework; the auditor's understanding of the company, its environment, and the company's process for developing the estimate; and other relevant audit evidence, regardless of whether the evidence corroborates or contradicts the company's assumptions.

Data and Assumptions Obtained From a Third Party

See Paragraph .23

The proposal directed the auditor to the existing requirements in AS 1105 when evaluating the relevance and reliability of data or assumptions obtained from a third party. This approach is consistent with the requirements for evaluating data from external sources as described above.

The proposal also directed the auditor to comply with the requirements of proposed AS 1210 when the third party

is a specialist engaged by the auditor.

The proposal did not set forth specific requirements related to methods obtained from a third party that is not a specialist.

See

paragraph .08 of the proposed standard.

One commenter expressed concern that the proposed requirements were too restrictive and somewhat impractical and that it may not be possible or necessary to obtain data and assumptions from a third party and to create assumptions independent of those of the company. The commenter recommended that the Board retain the extant direction allowing the auditor to use management's assumptions when developing independent expectations.

After consideration of the comment, the requirement is adopted as proposed. As described below, consistent with the estimates standards and the proposal, the new requirement continues to allow the use of company data, assumptions, or methods while also allowing the auditor to use other sources.

Appendix A of AS 2501 (Revised) applies when the auditor develops an independent expectation of the fair value of financial instruments using pricing information from a third party. These requirements are discussed further below.

Also consistent with the proposal, the new standard does not set forth specific requirements related to methods obtained from a third party, as the Board understands that auditors typically use either the company's methods or their own (which may include specialists' methods) in developing an independent expectation.

Use of Company Data, Assumptions, or Methods

See Paragraph .24

The proposal sought to retain the existing requirements for the auditor to test data from the company and evaluate the company's significant assumptions for reasonableness, when used by the auditor to develop an independent estimate.

The proposal also required the auditor to evaluate the company's method, if the auditor uses that method to develop an independent expectation. The proposal recognized that auditors may use a portion or a combination of data, assumptions, and method provided by the company in developing their expectations. If the company's data, assumptions, or methods are those of a company's specialist, the proposal also directed the auditor to comply with the requirements in proposed Appendix B of AS 1105 for using the work of a company specialist as audit evidence.

See

AS 2502.40.

One commenter suggested that the Board clarify that when developing an independent expectation of an estimate, the auditor's testing of management's process is limited to those areas on which the auditor intends to rely for purposes of developing the expectation.

This provision is adopted substantially as proposed. Under the new standard, when an auditor chooses to develop an independent expectation using certain of the company's data, significant assumptions, or methods, the auditor is required to test such data or evaluate such assumptions or methods, using the corresponding procedures that apply when the auditor tests the company's process. In response to comments, the text was revised from the proposal to clarify the scope of the obligation to test. The new standard also includes a note referring the auditor to look to the requirements in Appendix A of AS 1105 in situations where the company's data, assumptions or methods were those of a company's specialist.

See

Specialists Release,

supra

note 2.

Comparison With Standards of Other Standard Setters

When the auditor develops a point estimate or a range to evaluate management's point estimate and related disclosures about estimation uncertainty, ISA 540 Revised provides that the auditor's further audit procedures include procedures to evaluate whether the methods, assumptions or data used are appropriate in the context of the applicable financial reporting framework. ISA 540 Revised also provides that regardless of whether the auditor uses management's or the auditor's own methods, assumptions or data, further audit procedures be designed and performed to address the matters in paragraphs 23-25 of ISA 540 Revised.

Paragraphs 23-25 of ISA 540 Revised describe the auditor's further procedures for addressing methods, significant assumptions, and data.

AU-C Section 540 provides that if the auditor uses assumptions or methods that differ from management's, the auditor shall obtain an understanding of management's assumptions or methods sufficient to establish that the auditor's point estimate or range takes into account relevant variables and to evaluate any significant differences from management's point estimate.

Developing an Independent Expectation as a Range

See Paragraph .25

The proposal provided that, if the auditor's independent expectation consisted of a range rather than a point estimate, the auditor should determine that the range was appropriate for identifying a misstatement of the company's accounting estimate and was supported by sufficient appropriate audit evidence.

The estimates standards provide for the development of an independent point estimate as one approach for testing accounting estimates, but these standards do not discuss developing an independent expectation as a range of estimates. AS 2810 provides for developing a range of possible estimates for purposes of the auditor's evaluation of misstatements relating to accounting estimates.

Some commenters asked for clarification or guidance on how to determine that a range is appropriate for identifying a misstatement. Some commenters stated that the proposed requirement implied a level of precision within a range that may not be feasible. Some commenters suggested expressly acknowledging situations where the range is greater than the materiality threshold by including, for example, language similar to IAASB's Exposure Draft, Proposed ISA 540 (Revised) (“ED 540”), paragraph A134.

One of these commenters argued that for certain highly judgmental estimates, additional audit work cannot reduce the size of the range below the materiality threshold, and that the proposed requirement could lead to excessive work. Another commenter suggested that the proposed standard did not sufficiently address estimation uncertainty, including what constitutes a reasonable range of estimation uncertainty and how auditors are to address and disclose such uncertainty.

ED 540, paragraph A134 stated that “In certain circumstances, the auditor's range for an accounting estimate may be multiples of materiality for the financial statements as a whole, particularly when materiality is based on operating results (for example, pre-tax income) and this measure is relatively small in relation to assets or other balance sheet measures. In these circumstances, the auditor's evaluation of the reasonableness of the disclosures about estimation uncertainty becomes increasingly important. Considerations such as those included in paragraphs A133, A144, and A145 may also be appropriate in these circumstances.” Substantially similar guidance appears in paragraph A125 of ISA 540 Revised.

After considering the comments, the requirement has been revised to clarify that, when establishing an independent expectation as a range, the auditor should determine that the range encompasses only reasonable outcomes, in conformity with applicable financial reporting framework, and is supported by sufficient appropriate evidence.

Also, a footnote has been added to paragraph .26 of the new standard reminding auditors that, under AS 2810.13, if a range of reasonable estimates is supported by sufficient appropriate evidence and the recorded estimate is outside of the range of

reasonable estimates, the auditor should treat the difference between the recorded accounting estimate and the closest reasonable estimate as a misstatement.

The requirement that the range should be supported by sufficient appropriate evidence is consistent with the principle in the new standard that the auditor should have a reasonable basis for the data, assumptions, and methods used in developing an independent expectation. The sufficiency and appropriateness of the evidence needed will depend on the relevant circumstances, including the nature of the accounting estimate, the requirements of the applicable financial reporting framework, and the number and nature of significant assumptions and data used in the independent expectation.

Notably, the new standard does not restrict the size of the auditor's range to the level of materiality for the financial statements as a whole determined under AS 2105 (“financial statement materiality”). An appropriate range in accordance with paragraph .25 of the new standard might be very large, even exceeding financial statement materiality. For example, under certain market conditions, comparable transactions for some assets, even after appropriate adjustment, might indicate a wide range of fair value measurements. As another example, some accounting estimates are highly sensitive to one or more assumptions, such that a small change in an assumption can result in a large change in the value of the estimate. In those situations, the auditor's responsibility is to determine an appropriate range based on the criteria set forth in the new standard.

The Board considered the comments asking for a statement in the standard acknowledging that an independent expectation as a range could exceed the materiality level determined under AS 2105. However, such a statement was not added because it would not have changed the auditor's responsibility under the new standard.

Finally, with respect to estimation uncertainty, the new standard and related amendments acknowledge that estimates have estimation uncertainty, which affects the risks of material misstatement. Neither the Board nor auditors are responsible for placing limits on the range of estimation uncertainty. That uncertainty is a function of the estimate's measurement requirements under the applicable financial reporting framework, the economic phenomena affecting that estimate, and the fact that estimates involve assessments of future outcomes. Under the new standard, the auditor's responsibility is to consider estimation uncertainty in assessing risk and performing procedures in response to risk, which involves evaluating whether the accounting estimates are reasonable in the circumstances and in conformity with the applicable financial reporting framework, as well as evaluating management bias in accounting estimates, and its effect on the financial statements. These responsibilities are better aligned with the auditor's overall responsibility for planning and performing financial audits.

Auditors may also have disclosure and reporting responsibilities in relation to these matters.

See

AS 3101,

The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion,

and AS 1301,

Communications with Audit Committees.

Comparison With Standards of Other Standard Setters

ISA 540 Revised provides that if the auditor develops an auditor's range, the auditor shall (a) determine that the range includes only amounts that are supported by sufficient appropriate audit evidence and have been evaluated by the auditor to be reasonable in the context of the measurement objectives and other requirements of the applicable financial reporting framework; and (b) design and perform further audit procedures to obtain sufficient appropriate audit evidence regarding the assessed risks of material misstatement relating to the disclosures in the financial statements that describe the estimation uncertainty.

AU-C Section 540 provides that if the auditor concludes that it is appropriate to use a range, the auditor should narrow the range, based on audit evidence available, until all outcomes within the range are considered reasonable.

Comparing the Auditor's Independent Expectation to the Company's Accounting Estimate

See Paragraph .26

The proposal set forth the requirement for the auditor to compare the auditor's independent expectation to the company's estimate and evaluate the differences in accordance with AS 2810.13.

See

additional discussion of evaluating audit results below.

No comments were received on this topic. The requirement is adopted substantially as proposed, with an expanded footnote reminding auditors that under AS 2810.13, if a range of reasonable estimates is supported by sufficient appropriate evidence and the recorded estimate is outside of the range of reasonable estimates, the auditor should treat the difference between the recorded accounting estimate and the closest reasonable estimate as a misstatement.

Evaluating Audit Evidence From Events or Transactions Occurring After the Measurement Date

See Paragraphs .27-.29

The proposal noted that events and transactions that occur after the measurement date can provide relevant evidence to the extent they reflect conditions at the measurement date. The proposal provided that the auditor should evaluate whether the audit evidence from events or transactions occurring after the measurement date is sufficient, reliable, and relevant to the company's accounting estimate and whether the evidence supports or contradicts the company's estimate.

Commenters were generally supportive of the proposed requirements, indicating they were clear and sufficient. Two commenters requested additional clarity regarding the assessment of whether the audit evidence is sufficient, reliable, and relevant to the company's accounting estimate, one in the context of subsequent events and one more generally. Another commenter suggested including cautionary language with respect to fair value estimates indicating that fair value measurements are derived from information that would be known or knowable to a market participant at the measurement date.

The Board considered these comments and determined that the requirements in the proposal are sufficiently clear and has adopted the requirements as proposed.

The new standard, as with the proposal, requires the auditor to evaluate whether audit evidence from events or transactions occurring after the measurement date is sufficient, reliable, and relevant to the company's accounting estimate and whether the evidence supports or contradicts the company's estimate. This would include evaluating pertinent information that is known or knowable at the measurement date. For example, the sale of a bond shortly after the balance-sheet date (which in this case is also the measurement date) may provide relevant evidence regarding the company's fair value measurement of the bond as of the balance sheet date if the intervening market conditions remain the same. As another example, when a business combination occurred during the year, events occurring

subsequent to the measurement date, such as the cash settlement of short-term receivables, may provide relevant evidence about the accounting estimate as of the measurement date if they reflect conditions at the measurement date. In those situations, the audit procedures would be focused on evaluating the relevance and reliability of the evidence provided by the subsequent event, including the extent to which the subsequent event reflects conditions existing at the measurement date.

Additionally, the new standard requires the auditor to take into account changes in the company's circumstances and other relevant conditions between the event or transaction date and the measurement date. It also notes that as the length of time from the measurement date increases, the likelihood that events and conditions have changed during the intervening period also increases.

Comparison With Standards of Other Standard Setters

The corresponding ISA 540 Revised requirement provides that when the auditor's further audit procedures include obtaining audit evidence from events occurring up to the date of the auditor's report, the auditor shall evaluate whether such audit evidence is sufficient and appropriate to address the risks of material misstatement relating to the accounting estimate, taking into account that changes in circumstances and other relevant conditions between the event and the measurement date may affect the relevance of such audit evidence in the context of the applicable financial reporting framework.

AU-C Section 540 provides that the auditor should determine whether events occurring up to the date of the auditor's report provide audit evidence regarding the accounting estimate.

Evaluating Audit Results

See Paragraphs .30-.31

The proposed standard incorporated existing requirements of AS 2810 for evaluating the results of audit procedures performed on accounting estimates, including evaluating bias in accounting estimates (both individually and in the aggregate).

One commenter noted that the requirements could be interpreted as a presumption that bias always exists in accounting estimates or a requirement to determine whether actual bias exists, and suggested that the standard include the word “potential” when referencing bias, similar to the requirements of AS 2810. Another commenter sought clarification as to whether the proposed standard required the auditor to evaluate bias in individual assumptions.

The new standard retains paragraphs .30 and .31 regarding evaluating audit results substantially as proposed. In consideration of comments, paragraphs .30 and .31 were revised to include a reference to potential bias, consistent with AS 2810.24-.27. The requirements in the new standard are intended to remind auditors of their existing responsibilities to evaluate potential bias in accounting estimates (both individually and in the aggregate) and its effect on the financial statements. For example, indicators of management bias may affect the assessed risk of material misstatement and the auditor's conclusions about whether accounting estimates are reasonable in the circumstances. As discussed above, individual assumptions that are susceptible to manipulation or bias are ordinarily considered significant and evaluated for reasonableness.

See

discussion of identification of significant assumptions above.

Comparison With Standards of Other Standard Setters

ISA 540 Revised requires the auditor to evaluate whether judgments and decisions made by management in making the accounting estimates included in the financial statements, even if they are individually reasonable, are indicators of possible management bias. When indicators of possible management bias are identified, the auditor shall evaluate the implications for the audit. Where there is intention to mislead, management bias is fraudulent in nature.

ISA 540 Revised further requires the auditor to evaluate, based on the audit procedures performed and audit evidence obtained, whether (a) the assessments of the risks of material misstatement at the assertion level remain appropriate, including when indicators of possible management bias have been identified; (b) management's decisions relating to the recognition, measurement, presentation and disclosure of these accounting estimates in the financial statements are in accordance with the applicable financial reporting framework; and (c) sufficient appropriate audit evidence has been obtained.

AU-C Section 540 requires the auditor to review the judgments and decisions made by management in the making of accounting estimates to identify whether indicators of possible management bias exist.

Both ISA 540 Revised and AU-C Section 540 provide that the auditor should determine whether the accounting estimates and related disclosures are reasonable in the context of the applicable financial reporting framework, or are misstated.

Appendix A—Special Topics

Introduction

Appendix A of the proposed standard set forth requirements for the auditor to perform specific procedures when auditing the fair value of financial instruments, focusing on the use of pricing information from third parties such as pricing services and brokers or dealers. The proposal also incorporated and built on topics discussed in the derivatives standard, including certain procedures for auditing the valuation of derivatives and securities measured at fair value. The proposed requirements were informed by outreach, including the Pricing Sources Task Force, and publications of other standard setters.

Paragraph .A1 of Appendix A prompts the auditor to obtain an understanding of the nature of the financial instruments being valued in order to identify and assess risks of material misstatement related to the fair value of those instruments. Paragraph .A2 provides the general framework, specifically, the auditor's responsibility to determine whether the pricing information from a third party

provides sufficient appropriate evidence to respond to the risks of material misstatement.

Appendix A focuses primarily on pricing information from pricing services and brokers or dealers, but paragraph .A2 also covers pricing information obtained from other third-party sources, such as exchanges and publishers of exchange prices.

Paragraphs .A3-.A9 provide more specific direction for cases where pricing information from pricing services and brokers or dealers are used. Paragraph .A10 sets forth factors for the auditor to take into account when obtaining an understanding of how unobservable inputs were determined and evaluating the reasonableness of unobservable inputs when the unobservable inputs are significant to the valuation of financial instruments.

A number of commenters expressed general support for the proposed Appendix A but commented on specific aspects of the proposed requirements. These comments are addressed below in a section-by-section discussion of the proposal and the new standard. In addition, there were two areas of comment that relate to several aspects of the proposed Appendix: (1) The extent to which audit procedures could be performed over groups or classes of financial instruments, rather than individual instruments; and (2) the role played by centralized groups within an accounting firm, such as a pricing desk, in performing procedures related to

testing the fair value of financial instruments.

On the first area of comment, commenters asked for clarification on whether all of the required procedures in Appendix A were to be applied to financial instruments individually; expressing concerns that doing so would lead to excessive work. Some commenters suggested clarifying changes to the proposed Appendix, such as inserting “type of” or “types of” before the term “financial instrument” in various requirements in the appendix. One commenter suggested adding a note indicating that the procedures in paragraphs .A4-.A8 of the proposal were not required to be applied to each individual financial instrument. Another commenter suggested that auditors be allowed to understand and evaluate the methods and inputs used by pricing services at the level of the asset class for financial instruments with lower estimation uncertainty.

The Board did not intend that all required procedures in Appendix A be applied to individual financial instruments in all cases. Rather, the Board intended that financial instruments with similar characteristics and risks of material misstatement could be grouped for purposes of applying substantive procedures. In some circumstances, however, it may not be appropriate to group financial instruments (for example, where financial instruments are dissimilar, or where the auditor does not have a reasonable basis upon which to base the grouping). As discussed in greater detail below, Appendix A of the new standard has been revised to clarify areas where it may be appropriate for procedures to be performed over groups of financial instruments rather than individual financial instruments.

On the second area, commenters asked for additional guidance about the role of centralized groups that the largest accounting firms often use to assist in performing procedures related to testing the fair value of financial instruments. The specific services performed and the nature and level of detail of information provided by centralized groups to engagement teams can vary. Some commenters suggested that the proposal further address how the requirements apply when a centralized pricing desk is used and raised specific issues regarding the use of centralized groups under the proposed requirements. One commenter advocated for more precise requirements about the degree to which procedures may be executed by a centralized group. The new standard does not prescribe the role or responsibilities of centralized pricing groups in audits, and Appendix A does not provide specific direction in that regard. Instead, the new standard allows engagement teams to continue seeking assistance from centralized groups when performing the procedures required under the new standard. This approach gives audit firms the flexibility to determine the most appropriate way to use their centralized pricing groups on an audit to satisfy the requirement of the new standard.

As under the proposal, centralized groups within the firm that assist engagement teams with evaluating the specific methods and assumptions related to a particular instrument, identifying and assessing risks of material misstatement, or evaluating differences between a company's price and a pricing service's price generally would be subject to the supervision requirements of AS 1201.

Additionally, centralized groups may periodically provide general information within the firm about a pricing service's controls and methodologies or general information on current market conditions for different types of securities. Such general information may inform engagement teams' risk assessments, to the extent that the information is reliable and relevant to their engagements. The activities of centralized groups to obtain and communicate such general information are different in nature from the engagement-specific services provided by the centralized groups, which are subject to supervision. Thus, it is important for firm quality control systems to have policies and procedures related to the accuracy of such general information from centralized groups.

Identifying and Assessing Risks of Material Misstatement Related to the Fair Value of Financial Instruments

See Paragraph .A1

Under the proposal, the auditor was to obtain an understanding of the nature of the financial instruments being valued to identify and assess the risks of material misstatement related to their fair value, taking into account specified matters.

Commenters were generally supportive of the proposed requirement. One commenter suggested that the auditor should be permitted to stratify financial instruments into groups as part of identifying and assessing risks of material misstatement, and suggested reframing one of the required procedures to refer to the type of financial instruments. Paragraph .A1 is not intended to require auditors to obtain an understanding of each financial instrument one-by-one. The language has been revised to refer to financial instruments (plural) or type of financial instruments to make this clear. The new standard allows auditors, where appropriate, to stratify financial instruments into groups with similar characteristics for purpo

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