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5160 Auditing Accounting Estimates,including Fair Value Accounting Estimates,and

Related Disclosures
An accounting estimate is an approximation of a financial statement element, item or account absent a precise means of measurement. The term
is also used with respect to an amount measured at fair value where there is measurement or estimation uncertainty. Accounting estimates are
generally pervasive in financial statements. Certain examples of accounting estimates include net realizable values of inventory and accounts
receivable, valuation of certain types of financial instruments, property and casualty insurance loss reserves, revenues from contracts accounted
for by the percentage-of-completion method, and pension and warranty expenses. PCAOB AU 342.16 identifies other examples.
In our audit, the overall objective is to obtain sufficient appropriate audit evidence about whether accounting estimates are reasonable and the
related disclosures are adequate and in conformity with GAAP (AICPA AU-C 540.06, PCAOB AU 342.07(b)-(c)) We are responsible for evaluating
the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole.
In evaluating and testing the reasonableness of an estimate, we normally concentrate on key factors and assumptions that are:
1. Significant to the accounting estimate.
2. Sensitive to variations.
3. Deviations from historical patterns.
4. Subjective and susceptible to misstatement and bias.
We normally should consider the historical experience of the entity in making past estimates as well as our experience in the industry. However,
changes in facts, circumstances, or entity's procedures may cause factors different from those considered in the past to become significant to the
accounting estimate. (PCAOB AU 342.09)
Perform Risk Assessment Procedures
As estimates are based on subjective as well as objective factors, it may be difficult for management to establish controls over them. Even when
management's estimation process involves competent personnel using relevant and reliable data, there is potential for bias in the subjective
factors. Accordingly, when planning and performing procedures to evaluate accounting estimates, we should consider, with an attitude of
professional skepticism, both the subjective and objective factors.
The risk of material misstatement of accounting estimates normally varies with the complexity and subjectivity associated with the process for
developing the estimate, the availability and reliability of relevant data, the number and significance of assumptions that are made, and the degree
of uncertainty associated with the assumptions. (PCAOB AU 342.05, PCAOB AU 328.13)
Audit risk generally increases when transactions or account balances involve significant judgmental matters because there may be a greater risk of
material misstatement associated with such judgments and less likelihood of them being subject to routine control systems. During planning, we
should obtain an understanding of the following in order to provide a basis for the identification and assessment of the risks of material
misstatement for accounting estimates:
l The requirements of GAAP relevant to accounting estimates, including related disclosures (AICPA AU-C 540.08(a))
l How management identifies those transactions, events and conditions that may give rise to the need to recognize or disclose an accounting
estimate, by: (AICPA AU-C 540.08(b))
Making inquiries of management about changes in circumstances (such as new types or changes in terms of transactions,
assumptions, accounting policy changes, regulatory or other changes or new conditions or events) that may give rise to new, or the
need to revise existing, accounting estimates (AICPA AU-C 540.08(b), PCAOB AU 342.08(c))
Considering assertions embodied in the financial statements (PCAOB AU 342.08(a))
Evaluating information obtained in performing other procedures, such as:
n Information about changes made or planned in our client's business, including changes in operating strategy, and the industry
in which our client operates that may indicate the need to make an accounting estimate
n Changes in the methods of accumulating information
n Information concerning identified litigation, claims, and assessments and other contingencies
n Information from reading available minutes of meetings of stockholders, directors, and appropriate committees
Information contained in regulatory or examination reports, supervisory correspondence, and similar materials from applicable
n
regulatory agencies (PCAOB AU 342.08(b))
l The process management follows in developing accounting estimates, and an understanding of the data on which they are based, including:
The method, including where applicable the model, used in making the accounting estimate
Relevant controls
Whether management has used an expert
The assumptions underlying the accounting estimates
Whether there has been or ought to have been a change from the prior period in the methods for making the accounting estimates,
and if so, why
Whether and, if so, how management has assessed the effect of measurement or estimation uncertainty (AICPA AU-C 540.08(c),
PCAOB AU 328.09)
Review Outcome of Prior Period Accounting Estimates
The outcome of an accounting estimate will often differ from the accounting estimate recognized in the prior period financial statements. By
performing risk assessment procedures to identify and understand the reasons for such differences, we may obtain:
l Information regarding the effectiveness of management's prior period estimation process, from which we can judge the likely effectiveness
of management's current process
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l Audit evidence that is pertinent to the re-estimation, in the current period, of prior period accounting estimates
l Audit evidence of matters, such as estimation uncertainty, that may be required to be disclosed in the financial statements (AICPA AU-C
540.A39)
We should review the outcome of accounting estimates included in the prior period financial statements or, where applicable, their subsequent re-
estimation in the current period. The nature and extent of our review takes account of the nature of the accounting estimates and whether the
information obtained from the review would be relevant to identifying and assessing risks of material misstatement of accounting estimates made in
the current period financial statements. However, the review is not intended to call into question the judgments made in the prior periods that were
based on information available at the time. (AICPA AU-C 540.09, PCAOB AU 316.64) As a practical matter, our review of prior period accounting
estimates as a risk assessment procedure may be carried out in conjunction with the retrospective review of significant accounting estimates
required by PwC Audit 4250. (AICPA AU-C 540.A41)
The review of prior period accounting estimates may also assist us, in the current period, in identifying circumstances or conditions that increase
the susceptibility of accounting estimates to, or indicate the presence of, possible management bias. Our professional skepticism assists in
identifying such circumstances or conditions and in determining the nature, timing and extent of further audit procedures. (AICPA AU-C 540.A40)
For fair value accounting estimates based on current conditions at the measurement date, more variation may exist between the fair value amount
recognized in the prior period financial statements and the outcome or the amount re-estimated for the purpose of the current period. This is
because the measurement objective for such accounting estimates deals with perceptions about value at a point in time, which may change
significantly and rapidly as the environment in which our client operates changes. We may therefore focus on obtaining information that would be
relevant to identifying and assessing risks of material misstatement. For example, in some cases, obtaining an understanding of changes in market
participant assumptions which affected the outcome of a prior period fair value accounting estimate may be unlikely to provide relevant information
for audit purposes. If so, then our consideration of the outcome of prior period fair value accounting estimates may be directed more towards
understanding the effectiveness of management's prior estimation process, that is, management's track record, from which we can judge the likely
effectiveness of management's current process. (AICPA AU-C 540.A43)
Evaluate Measurement or Estimation Uncertainty
In identifying and assessing the risks of material misstatement, we should evaluate the degree of estimation uncertainty associated with accounting
estimates and determine whether any of those accounting estimates that have been identified as having high estimation uncertainty give rise to
significant risks. (AICPA AU-C 540.10-.11) Estimation uncertainty is the susceptibility of an accounting estimate and related disclosures to an
inherent lack of precision in its measurement. The degree of estimation uncertainty associated with an accounting estimate may be influenced by
factors such as:
l The extent to which the accounting estimate depends on judgment
l The sensitivity of the accounting estimate to changes in assumptions
l The existence of recognized measurement techniques that may mitigate the estimation uncertainty
l The length of the forecast period and the relevance of data drawn from past events to forecast future events
l The availability of reliable data from external sources
l The extent to which the accounting estimate is based on observable or unobservable inputs (AICPA AU-C 540.A45)
Based on the assessed risks of material misstatement, we should determine
l Whether management has appropriately applied the requirements of GAAP relevant to the accounting estimates; and
l Whether the methods for making the accounting estimates are appropriate and have been applied consistently, and whether changes from
the prior period, if any, in accounting estimates or the method for making them are appropriate in the circumstances. (AICPA AU-C 540.12,
PCAOB AU 328.19)
For example, if management has changed the technique for determining fair value, we should consider whether management can adequately
demonstrate that the technique to which it has changed provides a more appropriate basis of measurement or whether the change is supported by
a change in the GAAP requirements or a change in circumstances. The introduction of an active market for an equity security may indicate that the
use of the discounted cash flows technique to estimate the fair value of the security is no longer appropriate. (PCAOB AU 328.19)
In responding to the assessed risks of material misstatement, we should use one or a combination of the following approaches in auditing an
accounting estimate (PCAOB AU 328.23, PCAOB AU 342.10-13, AICPA AU-C 540.13):
l Having obtained the understanding described above, test the process used by management to develop the estimate, including assessing
the underlying data used by management to develop the estimate, testing the operating effectiveness of the controls over how management
made the accounting estimate and substantive audit procedures as considered appropriate (PwC Audit 5161)
l Develop a point estimate or a range to evaluate management's point estimate (PwC Audit 5162) and/or
l Review subsequent events or transactions occurring prior to the date of our report which confirm the estimate made (PwC Audit 5163)

When performing an integrated audit of financial statements and internal control over financial reporting, we may use any
of the three above approaches. However, the work that we perform as part of the audit of internal control over financial
reporting should influence our decisions about the approach we take to auditing an estimate because, as part of the audit
of internal control over financial reporting, we would be required to obtain an understanding of the process management
used to develop the estimate and to test controls over all relevant assertions related to the estimate. (PCAOB AU 342.10)

Specific Fair Value Measurement Considerations

GAAP requires that certain items be measured at fair value. ASC 820, Fai r Value Measurementsand Di sclosures, defines the fair value of an
asset (liability) as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date." Accordingly, in accordance with ASC 820, fair value is based on the exit price (the price that would be
received to sell an asset or paid to transfer a liability) and not the transaction price or entry price (the price that was paid for the asset or that was
received to assume the liability).
Assumptions used in fair value measurements are similar in nature to those required when developing other accounting estimates. However, if
observable market prices are not available, GAAP requires that valuation methods incorporate assumptions that market participants would use in
their estimates when that information is available without undue cost and effort. If information about market assumptions is not available,
management may use its own assumptions as long as there are no contrary data indicating that market participants would use different
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assumptions. (PCAOB AU 328.06)

The measurement of fair value may be relatively simple for certain assets or liabilities, e.g., where there are quoted prices (unadjusted) for identical
assets or liabilities in active markets. The measurement of fair value for other assets or liabilities may be more complex. A specific asset may not
have an observable market price or may possess such characteristics that it becomes necessary for management to estimate its fair value based
on the best information available in the circumstances (e.g., a complex derivative financial instrument). The estimation of fair value may be
achieved through the use of a valuation method (e.g., a model premised on discounting of estimated future cash flows). (PCAOB AU 328.08)
Because of the wide range of possible fair value measurements, from relatively simple to complex, and the varying levels of risk of material
misstatement associated with the process for determining fair values, our planned audit procedures can vary significantly in nature, timing and
extent. (PCAOB AU 328.23)
Involving a Specialist
The determination of an accounting estimate may range from simple to complex depending upon the nature of the estimate. However, in complex
estimates, there may be a high degree of specialized knowledge and judgment necessary to meet the professional requirements. In such cases,
the involvement of specialists should be considered. Refer to PwC Audit 2080 for guidance on specialists. (AICPA AU-C 540.14, PCAOB AU
328.20)
Documentation - Auditing ComplexAccounting Estimates
Smart Documentation Aura EGAs are available in the 2014 Aura libraries that may be used to document audit procedures related to complex
accounting estimates. Use of the Documentation Template When Auditing Complex Management Estimates [clickhere]is required for financial
statement-only audit and integrated audit engagements of both public and non-public companies if the Smart Documentation Aura EGAs are not
used to document audit procedures performed related to:
l Estimates, including fair value measurements, that present significant risks,
l Estimates, including fair value measurements, identified as presenting high estimation uncertainty, and
l Other critical accounting estimates.
In addition, if the Smart Documentation Aura EGAs are not used, the Documentation Template When Auditing Complex Management Estimates is
required for all financial statement-only audit and integrated audit engagements of public companies for estimates that present elevated risks.
Engagement teams may also use the Practice Aid when Auditing Management's Complex Estimates [clickhere]as a reference tool.
Engagement teams should exercise judgment in determining whether to use the Practice Aid and Documentation Template When Auditing
Management's Complex Estimates in other than required situations.
Tools for Auditing Fair Value Measurements
The Portfolio Summary Report should be used by engagement teams to summarize, based substantially on the amounts and disclosures included
in the entity's financial statements, information related to the reported fair values of financial instruments, including derivatives and pension assets.
The Portfolio Summary Report is used to facilitate a discussion amongst the engagement team and Financial Instruments, Structured Products and
Real Estate (FSR) or other appropriate valuation specialists (for example, Transaction Services) to assist engagement teams in the scoping and
planning of their related audit procedures. In addition to details related to individual investment holdings, this report will summarize a client's
portfolio based on pre-defined, standardized asset class categories. The judgment of whether to ultimately utilize a specialist in the auditing of fair
value measurements remains that of the engagement leader. The discussion with a valuation specialist regarding the nature of the entity's financial
instruments will help the engagement leader reach that conclusion. If the engagement leader concludes that a valuation specialist will be involved
in the execution of audit procedures, refer to PwC Audit 2085.
Completion of the Portfolio Summary Report is not required for Level 2 or 3 fair value measurements related to goodwill, intangibles or other long-
lived assets. Completion of the Portfolio Summary Report and discussion of the Portfolio Summary Report with a valuation specialist is required for
audits where the company is expected to report material Level 2 or 3 financial instruments fair values, except as follows:
l Employee benefit plan audits;
l Situations where material Level 2 or 3 financial instruments fair values are limited to amounts determined based on the "practical expedient"
approach to valuing alternative investments pursuant to ASC 820-10-35-59 (however, engagement teams are reminded that we must obtain
sufficient appropriate audit evidence in support of a client's use of the practical expedient approach in determining relevant fair value
measurements);
l Audits with no material Level 3 financial instruments fair values and no material Level 2 financial instruments fair values that the audit team
has determined reflect Model-Based Valuations (as defined in PwC Audit 5165.I02)
l Audits of Asset Management entities without material Level 3 financial instruments where material Level 2 financial instruments fair values
are limited to Level 1 investments reported as Level 2 as a result of International Fair Value Triggers; and
l Audits of subsidiaries or other stand-alone components of a consolidated entity if the Portfolio Summary Report has been prepared for the
consolidated entity.
If an engagement team determines completion of the Portfolio Summary Report or discussion of the Portfolio Summary Report with a valuation
specialist is not required for their engagement, they should document the rationale for this conclusion in the FSR Coordination EGA in Aura.
Similarly, engagement teams that complete the Portfolio Summary Report are required to include the Portfolio Summary Report in the FSR
Coordination EGA in Aura.

Technical References

AICPA AU-C 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures

PCAOB AU 328 Auditing Fair Value Measurements and Disclosures

PCAOB AU 342 Auditing Accounting Estimates

Issue Date: September 2015