C2-1 Griffith Hammersley Kadous Isar 2011

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Auditing Complex Estimates: Process, Problems, and Preliminary Recommendations for Improving Auditor Performance

Emily E. Griffith University of Georgia eegriff@uga.edu

Jacqueline S. Hammersley University of Georgia jhammers@uga.edu

Kathryn Kadous Emory University kkadous@bus.emory.edu

April 2011

Preliminary Draft

We are grateful to John Fogarty for helpful discussions about this project. We also thank Wendy Bailey, Dan Stone, Arnie Wright, Hal Zeidman, and workshop participants at Notre Dame, Kentucky, and the Northeast Behavioral Accounting Research Seminar for comments on prior drafts of this paper. Additionally, we thank the auditors and their firms who have given their time assisting with the interviews. Jackie Hammersley is grateful for the support provided by a Terry Sanford Research Award.

Auditing Complex Estimates: Process, Problems, and Preliminary Recommendations for Improving Auditor Performance We perform a task analysis of auditing estimates with the ultimate goal of improving auditor performance at this increasingly important task. First, we analyze auditing standards and interview 24 audit partners and senior managers to assess how auditors perform the task and how well their performance matches the required process. Next, we rely on the interviews and a content analysis of recent PCAOB inspection reports to shed light on the difficulties auditors experience in auditing estimates. We find that while auditors’ reported processes generally match standards, auditors tend to evaluate estimates by focusing on auditing the details of management’s estimate instead of creating an independent one. Further, they do not report considering whether any important conditions were omitted from management’s model. We also find that both auditors and regulators report auditor difficulties with over-reliance on management’s process. That is, auditors sometimes fail to understand management’s process for generating the estimate, fail to adequately test the underlying data and assumptions, and fail to notice inconsistencies among the estimate and other internal data or external conditions. We identify underlying causes of these problems and make recommendations for changes to auditing standards, practices, and auditor training to improve the audits of estimates. Key Words: Accounting estimates, audit quality, fair value, impairment, interview

Auditing Complex Estimates: Process, Problems, and Preliminary Recommendations for Improving Auditor Performance 1. Introduction Estimates are items included in financial statements for which the measurement or valuation of some amounts is uncertain. Relatively simple accruals, such as accrued expenses, are included in this category as are accounts requiring more sophisticated estimation procedures such as fair value measurements and impairments. The uncertainty in the account may depend on the outcome of future events or on data that cannot be accumulated on a timely, cost-effective basis (American Institute of Certified Public Accountants (AICPA) 1988). Recent changes in accounting principles have increased the importance of estimates, including values of post-retirement benefits, impairments of goodwill, and fair values of financial assets and liabilities, to the financial statements. The proposed implementation of International Financial Reporting Standards (IFRS) in the U.S. will likely continue this trend. In addition, economic pressures have further increased the importance of valuation allowances and impairments and have increased the difficulty in assessing the reasonableness of fair values. During the recent economic crisis, critics asserted that fair value accounting exacerbated or even caused the crisis by increasing the magnitude of reported losses (Isaac 2008). This discussion highlights the importance of estimates of fair value to the capital markets (SEC) 2008). While estimates are of increasing importance to the interpretation of financial...
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