[Federal Register Volume 84, Number 65 (Thursday, April 4, 2019)]
[Notices]
[Pages 13396-13439]
[FR Doc No: 2019-06426]

Vol. 84

Thursday,

No. 65

April 4, 2019

Part II

 Securities and Exchange Commission

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 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; Notice

Federal Register / Vol. 84 , No. 65 / Thursday, April 4, 2019 /
Notices

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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'').\1\ The Board's request is set forth in section D.
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    \1\ 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).
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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.\2\ 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.
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    \2\ See Amendments to Auditing Standards for Auditor's Use of
the Work of Specialists, PCAOB Release No. 2018-006 (Dec. 20, 2018)
(``Specialists Release'').
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    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,\3\ 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,\4\
identifying and evaluating misstatements in accounting estimates,\5\
and evaluating potential management bias associated with accounting
estimates.\6\ 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.\7\
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    \3\ 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.
    \4\ See generally AS 2110.13.
    \5\ See AS 2810.13.
    \6\ See AS 2810.27.
    \7\ See generally paragraph .07 of AS 1015, Due Professional
Care in the Performance of Work.
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    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; \8\
and
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    \8\ See generally AS 2501 and AS 2502.26-.39.
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     Evaluating the consistency of management's assumptions
with other information.\9\
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    \9\ Id.
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     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.\10\
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    \10\ See generally AS 2501.12 and AS 2502.40.
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     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.\11\
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    \11\ See generally AS 2501.13 and AS 2502.41-.42.
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    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.\12\ 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.\13\
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    \12\ See generally AS 2502.26-.40.
    \13\ See generally AS 2502.40.
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    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.\14\
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    \14\ See generally AS 2503.28-.34 and .56-.57.
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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).\15\ 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.
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    \15\ 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.
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    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.\16\
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    \16\ 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.
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    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.\17\
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    \17\ 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.
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    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.\18\
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    \18\ 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.
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    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.\19\
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    \19\ 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 Sa[ntilde][eacute] Figueras,
and Jos[eacute] Ignacio Alg[aacute]s Fern[aacute]ndez, 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.
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    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.\20\ 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.\21\
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    \20\ 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.
    \21\ 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).
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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.\22\
Specific risk factors associated with the estimates--for example,
subjective assumptions, measurement uncertainty, or complex processes
or methods\23\--affect the auditor's risk assessment and in turn, the
required audit effort.
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    \22\ AS 2301.09.
    \23\ 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.\24\ 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).
---------------------------------------------------------------------------

    \24\ 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,\25\ regardless of whether the
pricing information was obtained by the company or the auditor.
---------------------------------------------------------------------------

    \25\ 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.\26\
---------------------------------------------------------------------------

    \26\ 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.\27\
---------------------------------------------------------------------------

    \27\ 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.\28\
---------------------------------------------------------------------------

    \28\ 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'') \29\ 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.
---------------------------------------------------------------------------

    \29\ 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'').
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    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.\30\
---------------------------------------------------------------------------

    \30\ 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); \31\ (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; \32\ 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.''
---------------------------------------------------------------------------

    \31\ 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.
    \32\ See first note to paragraph .05 of the new standard.
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    As discussed in more detail below, the revised objective links more
closely with the requirements of the risk assessment standards \33\ and
continues to focus auditors on their existing obligations to evaluate
potential management bias in the context of auditing accounting
estimates.
---------------------------------------------------------------------------

    \33\ 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.\34\
---------------------------------------------------------------------------

    \34\ 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 \35\ 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.
---------------------------------------------------------------------------

    \35\ 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.\36\
---------------------------------------------------------------------------

    \36\ 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.\37\ Specific
risk factors associated with the estimates--for example, subjective
assumptions, measurement uncertainty, or complex processes or methods
\38\--would affect the auditor's risk assessment and in turn, the
required audit effort. For example:
---------------------------------------------------------------------------

    \37\ AS 2301.09.
    \38\ 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.\39\
---------------------------------------------------------------------------

    \39\ 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.\40\
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    \40\ See AS 1215.06.
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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).\41\
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    \41\ 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 \42\ 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.
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    \42\ 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.\43\
---------------------------------------------------------------------------

    \43\ 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.\44\
---------------------------------------------------------------------------

    \44\ 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.\45\ 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.
---------------------------------------------------------------------------

    \45\ 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).\46\ 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.\47\
---------------------------------------------------------------------------

    \46\ 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.
    \47\ 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 \48\
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.\49\ 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).\50\
---------------------------------------------------------------------------

    \48\ AS 2502.19.
    \49\ See AS 2110.28, as amended.
    \50\ 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).\51\ 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.
---------------------------------------------------------------------------

    \51\ 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.\52\
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    \52\ 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; \53\
and (2) requiring the auditor to evaluate the relevance and reliability
\54\ of data from external sources.
---------------------------------------------------------------------------

    \53\ AS 1105.10.
    \54\ 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.\55\
---------------------------------------------------------------------------

    \55\ 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,\56\ 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.
---------------------------------------------------------------------------

    \56\ 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.\57\
---------------------------------------------------------------------------

    \57\ 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.\58\ 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.
---------------------------------------------------------------------------

    \58\ 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.\59\
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    \59\ See AS 2501.30-.31 (Revised).

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    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
\60\ 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.
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    \60\ 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.
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    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 \61\
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.
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    \61\ 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.
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    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