By Jacquelyn Lumb
While PCAOB standards technically apply only to audits of public companies, the American Bankers Association (ABA) believes the Board’s proposal on auditing estimates, including fair value measurements, will have a significant impact on the audits of banking institutions. In a comment letter to the PCAOB, the ABA noted that accounting estimates and fair value measurements are pervasive throughout bank financial statements, primarily through the allowance for loan and lease losses (ALLL) and the measurement of other financial assets and liabilities. The PCAOB’s proposal mirrors an IAASB proposal to a large degree, according to the ABA, and since the Auditing Standard Board of the AICPA is likely to adopt the IAASB proposal without significant modification, the proposal will affect non-public companies in the U.S.
High cost of compliance. The ABA wrote that the PCAOB’s proposal appears to codify the extensive documentation that auditors of large banks have demanded in response to PCAOB inspections in order to support the quantitative assumptions made by management in its accounting estimates. The language the proposal uses to encourage auditors to challenge any potential bias in management’s judgments will result in substantially higher audit costs, in the ABA’s view, and could endanger the ability of local auditing firms to audit community banks if they would have to hire valuation and credit risk specialists. The costs of the expanded documentation and responsibilities will exceed the benefits without any significant improvement to the auditing of the ALLL—the most import item on the balance sheet, the ABA warned.
Unlikely benefit. The ABA advised that any declines in investor confidence in bank financial statements have not been the result of insufficient auditor scrutiny, but because of highly judgmental estimates of the fair value of financial instruments and ALLL made during periods of illiquidity in the markets and economic uncertainty. No auditing standard will increase investor confidence in the assumptions during these times, according to the ABA. With the standard’s requirement to forecast the depth and timing of future economic uncertainty, the ABA said there is probably nothing an auditor can do to increase investors’ confidence in estimates at any point in the economic cycle, which renders the benefits of the proposal highly questionable.
Bias inherent in credit losses standard. The proposal’s focus on professional skepticism and the elimination of management bias in accounting estimates seem reasonable for fair value estimates since they should be determined by market-based assumptions, but the ABA said that subjectivity and bias are inherent features of the credit losses on financial instruments standard. By that standard’s design, there is no practical way to reduce management bias in a way that brings investor confidence in the financial statements, the ABA advised, and it recommended that any guidance related to reducing management bias should not apply to the standard.
The ABA also recommended that the PCAOB specifically address the work of regulatory examiners in assessing the reasonableness of management assumptions since their work and those of auditors are similar and many of the same substantive tests are conducted by both parties.
Method for determining accounting change. If a company changes its method for determining an accounting estimate, the proposal would require auditors to determine the reasons for the change and evaluate the appropriateness of the change. This would require onerous documentation by banks, according to the ABA. The PCAOB should clarify the difference between methods and analyses, the ABA advised, and it should provide guidance on how auditors and bankers can interpret when a change in method occurs in a fluid environment, such as credit risk analysis.
The ABA included a copy of its comment letter to the IAASB in which it addressed some of the same criticisms it has with the PCAOB’s proposal.