PCAOB Guidance and Audits of Fair Values for Level 2 Investments

42 Pages Posted: 9 Dec 2015 Last revised: 23 Feb 2017

See all articles by Scott A. Emett

Scott A. Emett

Arizona State University (ASU) - School of Accountancy

Robert Libby

Cornell University - Samuel Curtis Johnson Graduate School of Management

Mark W. Nelson

Cornell University - Samuel Curtis Johnson Graduate School of Management

Date Written: December 30, 2016

Abstract

Investments that are classified as Level 2 within the fair value hierarchy account for approximately 92% of US banks’ fair value assets. We report an experiment that examines how experienced auditors apply current PCAOB guidance when auditing portfolios of these assets. We hypothesize and find that, depending on how overstatement is distributed within a portfolio, current PCAOB guidance leads auditors to make adjustments that are predictably too large or small relative to the aggregate overstatement in the portfolio. We also predict and find that auditors identify some patterns of overstatement as indicative of management bias, but not others. However, management-bias assessments do not affect auditors’ adjustment decisions as standards imply they should, even when auditors are prompted to consider management bias. Together, these results highlight a potential deficiency in current auditing guidance that managers could exploit by strategically locating overstatements within securities with larger book values or by spreading those overstatements across many securities within a portfolio. We suggest changes to current PCAOB guidance which should reduce these effects.

Keywords: Fair value accounting, audit adjustments, management bias, PCAOB guidance

Suggested Citation

Emett, Scott A. and Libby, Robert and Nelson, Mark W., PCAOB Guidance and Audits of Fair Values for Level 2 Investments (December 30, 2016). Available at SSRN: https://ssrn.com/abstract=2700292 or http://dx.doi.org/10.2139/ssrn.2700292

Scott A. Emett

Arizona State University (ASU) - School of Accountancy ( email )

Tempe, AZ 85287
United States

Robert Libby

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Ithaca, NY 14853
United States
607-255-3348 (Phone)
607-254-4590 (Fax)

Mark W. Nelson (Contact Author)

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

448 Sage Hall
Ithaca, NY 14853
United States
607-255-6323 (Phone)
607-254-4590 (Fax)

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