Auditing Complex Estimates: Understanding the Process Used and Problems Encountered

Abstract:     
Accounting estimates are increasingly important to companies’ financial statements; however, they require a different audit approach than accounts with verifiable historical balances. We interview 24 very experienced auditors to discover how they audit complex estimates and what problems they experience in the process. Although auditing standards allow three approaches to estimates, auditors overwhelmingly choose to audit the details of management’s estimate. They rarely choose to create an independent expectation or rely on subsequent events. The steps auditors describe and the language they use to describe the steps indicate that they follow a process of verifying individual elements of management’s assertions on a piecemeal basis, rather than engaging in a critical analysis of the overall estimate, resulting in over-reliance on management’s process. The problems that auditors identify are consistent with this view, indicating that auditors sometimes fail to understand management’s process for generating the estimate, fail to adequately test the underlying data and assumptions, fail to notice inconsistencies among the estimate and other internal data or external conditions, and over-rely on specialists to identify, evaluate, and challenge critical assumptions. We identify standards’ and firms’ emphasis on verifying management’s model and audit firms’ chosen division of knowledge between auditors and specialists as root causes of these problems. Institutional theory predicts these conventions arise from firms extending use of procedures and processes that are legitimate in one area (i.e., auditing accounts without uncertainty) to a new area (i.e., auditing complex estimates), even though they are less effective in the new area. We argue that these conventions thwart auditors’ good-faith attempts to engage in skeptical analysis of estimates, and we make suggestions for future research aimed at improving audit quality in this important area.

Number of Pages in PDF File: 66

Keywords: accounting estimates, audit quality, fair value, impairment, interview

JEL Classification: M40, M41

working papers series