Will Recent Changes to Auditing Standards Have an Impact on your Private Fund Audit?
By Derek White, CPA, Partner, Assurance Services
The Public Company Accounting Oversight Board (PCAOB) has issued new standards and related amendments on auditing accounting estimates, including fair value measurements, as well as supervising or utilizing the work of specialists. These standards (adopted in 2018) are effective for fiscal years ending on or after December 15, 2020 (2020 calendar year-ends).
While the revised PCAOB auditing standards are only applicable for public company audits, the AICPA has also recognized that the financial reporting environment is growing increasingly complex and has issued a new auditing standard with many similarities to those issued by the PCAOB. Statement on Auditing Standards (SAS) No. 143, Auditing Accounting Estimates and Related Disclosures, was released in July 2020 to provide increased guidance for auditors. SAS No. 143 is effective for audits of financial statements with periods ending on or after December 15, 2023 (2023 calendar year-ends). The new standard is anticipated to result in changes to the private fund audit approach and could lead to additional scrutiny from financial statement users and regulatory bodies in respect to a fund’s significant estimates, mainly investment valuation.
Recent Changes to Accounting and Auditing Standards
The PCAOB replaced AS 2501, Auditing Accounting Estimates, and retitled the standard Auditing Accounting Estimates, Including Fair Value Measurement. This change rescinds AS 2502, Auditing Fair Value Measurements and Disclosures, as well as AS 2503, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities. A new standard, AS 1210, Using the Work of an Auditor-Engaged Specialist, was released in addition to amendments to AS 1105, Audit Evidence, and AS 1201, Supervision of the Audit Engagement. In connection with these changes, numerous other PCAOB auditing standards were also revised.
Key Aspects of the revised standards include:
- Increased focus by auditors on the estimates and disclosures with a greater risk of material misstatement [in an effort to integrate requirements with the risk assessment standards].
- Greater emphasis on the application of professional skepticism including the requirement to address potential management bias.
- Direction on auditing the fair value of financial instruments, in particular, when pricing information is obtained from third parties.
- Enhanced requirements for the assessment of company specialists, including professional qualifications, knowledge, skill and relationship to the company; these requirements include the entity that employs the specialist in instances where the specialist is not employed by the company.
- Enhanced and expanded requirements for the auditor to evaluate the methods, significant assumptions and data used by a company’s specialist.
- Guidance for determining the evidence required to support an auditor’s conclusion regarding a relevant assertion when using the work of a company specialist.
- Enhancements to the requirements for evaluating the work of a company’s specialist as well as the requirements for the auditor to evaluate the work of an auditor-engaged specialist.
SAS No. 143 also addresses the auditor’s responsibilities related to accounting estimates and disclosures in an audit and augments the standards for auditing accounting estimates (under AICPA standards), which are now more in line with PCAOB AS 2501. The SAS places a focus on factors driving the inherent uncertainty of the estimation process, including potential bias on behalf of management and the need for professional skepticism. The standard additionally includes requirements to devise audit procedures that are responsive to the assessed risks of material misstatement at the relevant assertion level. Under SAS No. 143, auditors will now perform an analysis of the means by which management made its accounting estimates. Procedures that will be implemented or modified by private fund auditors following the adoption of SAS No. 143 may include:
- Further inquiry and testing of internal controls surrounding the estimation process (including related information system controls).
- Evaluation of audit evidence from events occurring up to the date of the auditor’s report (post-balance sheet data).
- In-depth evaluation of modeling performed by management to ensure that both the methodology and mathematical calculations are appropriate, accurate and in accordance with the technique selected.
- Testing of the integrity of significant underlying assumptions and data selected and utilized by management in its modeling.
- Independent development of an auditor’s point estimate or range when evaluating management’s estimate.
- A general assessment as to whether judgments made in selecting methodologies and inputs have given rise to indicators of management bias.
Anticipated Impact on Private Fund Audits
The increased focus on, and updated standards for, auditing estimates will undoubtedly have an impact on an audit team’s approach, when auditing investment valuation as described above. While these standards may not be immediately applicable, management should anticipate and be prepared for potential changes in the near term; changes including, but not limited to, added inquiries and requests for information supporting management’s estimates and related internal controls.
An engagement team’s requests will vary depending on the determination of significant risks and the level of evidence required to respond to those risks; however, it is anticipated that additional inquiry, effort, and time will be necessary on behalf of management and the audit engagement team. The auditors will gain a stronger understanding of the nature and methods used in developing key estimates, in particular those surrounding investment valuation. A significant impact of the revised standards on private fund audits, as inferred from the PCAOB guidance, will be on the use of pricing services and/or broker quotes. Auditors will be required to evaluate and obtain a greater understanding of both the relevance and reliability of information provided by such services.
A key consideration for management is the reliability of pricing sources or services utilized. When possible, the utilization of multiple pricing services is recommended to corroborate the valuation on the measurement date. Further, the use of multiple services will lead to less information being requested by auditors, supporting an individual pricing service’s processes, methods and inputs, which is a new audit requirement included in the revised standards. Auditors will also make inquiries and potentially review or test internal controls surrounding the use of pricing services. Please see “Evaluating Pricing Information from a Third Party” for further discussion on this matter.
A second area of emphasis is a manager’s use of unobservable inputs in the valuation process. While it is often necessary to utilize unobservable inputs when valuing private and other Level 3 investments, the revised requirements necessitate that auditors gain a stronger understanding of how the inputs were determined and evaluate the reasonableness of the inputs. As part of the audit process, management can anticipate requests to facilitate this understanding as well as to provide documentation surrounding the information considered in making the valuation determination. Auditors will be required to understand the rationale for any changes made to management’s methods, assumptions, and data sources from prior periods. During the audit process, auditors will test management’s ability to provide accurate estimates by back-testing prior period valuations. The requirements further refine the retrospective review of the outcome of previous accounting estimates.
Use of Specialists
In connection with recent changes to guidance relative to the use of specialists, management can anticipate increased audit emphasis on both specialists engaged by management and those engaged by the audit firm. Engagement teams may request evidence supporting the ways in which management utilizes the work of its specialists, inclusive of internal controls in place surrounding the work performed. It is recommended that management maintain documentation on its assessment of the professional qualifications of its specialists, as well as the relationships the specialist has with management (when external specialists are utilized). This will assist in the auditor’s required consideration of potential management bias.
During the audit process, a record of all information provided by management to its specialists will be requested. Additionally, engagement teams will be looking for a record of the findings and conclusions of the specialists utilized in the reporting process. With requirements for this increased level of documentation and evidence, the importance of working with specialists (either internal or external) with the appropriate level of knowledge, skill, reputation and standing is paramount. As anticipated, the focus of the engagement team will be on areas that are determined to be significant drivers of audit risk as it relates to the work performed by specialists. Management can assume auditors will look for more persuasive audit evidence in situations where the company has the ability to significantly alter or override the specialist’s judgments.
Preparing for Your Audit
Ongoing communication between management and the audit engagement team will be critical as standards become effective and auditor expectations evolve. In preparing for these anticipated changes, management should critically review the valuation process and the related internal controls for operating effectiveness. Management should evaluate internal policies surrounding the use of specialists, perform the necessary due diligence and gain comfort with the specialists’ knowledge and expertise.
Should you have any questions or seek additional guidance regarding these new standards and how they will impact your organization, please reach out to your Marcum audit engagement team.