How Do Look-Back Analyses and Evidence Specificity Affect Auditors Planning Judgments?

Transcription

1 How Do Look-Back Analyses and Evidence Specificity Affect Auditors Planning Judgments? Ann Backof University of Virginia Roger Martin University of Virginia Jane Thayer University of Virginia

2 Research Question How does the direction of a prior period estimation inaccuracy in a forward-looking assumption underlying a complex estimate and the specificity of the evidence provided by management to support that prior period assumption affect auditors planning decisions regarding the current period audit of complex estimates?

3 Motivation Complex estimates play an increasingly important role in financial reporting (e.g., Bratten et al. 2013; Lev et al. 2010). Audit planning is a crucial step in the completion of an effective audit (Mock and Wright 1993). Relatively little is known about the factors that affect auditors planning for the audit of complex estimates.

4 Contributions Characteristics of management-provided evidence

5 Contributions Influence of auditors ex post review of evidence obtained and evaluated as part of a prior period audit on the current period audit. Consistency of Estimation Inaccuracy with Mangement s Incentives Evidence Specificity Auditors Assessments of the Reliability of 's Estimation Process Auditor s Planning Judgment s

6 Contributions Extend the research examining the auditing of complex estimates (e.g., Cannon and Bedard 2014; Griffith et al. 2015a, 2015b) by identifying two factors that affect auditors planning for the current period audit of complex estimates. Complex estimates enhance the relevance of information provided to financial statement users (Lundholm 1999), but management has the ability to opportunistically manage those estimates (Hodder et al. 2006; Dechow et al. 2010). The reliability of the information reported in the financial statements hinges on the effectiveness of the audit of these estimates (Griffith et al. 2015a).

7 Theoretical Model Specificity of Prior Period Evidence Tversky and Kahneman (1994) Sloman et al. (2004) Hamilton (1998) Slater and Rouner (1996) Estimation Inaccuracy Direction - Competence Trustworthiness Credibility Reliability of 's Estimation Process

8 Hypothesis 1 MORE Specific Prior Period Evidence Competence Trustworthiness UNDERstated Prior Period Assumption H1:Auditors assessments of the reliability of management s estimation process will be highest when prior period evidence is more specific and the direction of the prior period estimation inaccuracy is a potential understatement of firm book value. Credibility Reliability of 's Estimation Process

9 MORE Specific Prior Period Evidence Competence Hypothesis 2 PCAOB (2010, 2012) AS No Trustworthiness OVERstated Prior Period Assumption - H2:Auditors assessments of the reliability of management s estimation process will be lowest when prior period evidence is more specific and the direction of the prior period estimation inaccuracy is a potential overstatement of firm book value. Credibility Reliability of s Estimation Process

10 Hypothesis 3 H3: Lower (higher) reliability assessments of management s estimation process will lead to higher (lower) risk assessments of material misstatement in the current period estimate and more (less) allocation of planned audit effort. Reliability of s Estimation Process - Risk of Material Misstatement in Current Period Estimate AS No AS No Planned Audit Effort

11 Research Method 117 audit seniors* from 8 accounting firms Planning audit of impairment analysis of trademark Look-back analysis Actual year-to-date results for current year 2 x 2 between-subjects design Specificity of prior period evidence Estimation inaccuracy direction Dependent Variables Reliability of management s estimation process ROMM in current period estimation Likelihood of changing hours allocated for current prior audit

12 PRIOR YEAR WORKPAPER KEY ASSUMPTION #2 Revenue Growth Rate s Assumption: 8% annual growth in revenues by location through 2018, 3% thereafter. -provided justification for this assumption: When we acquired the Chatsworth Cheddar trademark in 2003, the average revenues (per store) from sales of Chatsworth Cheddar was $21,390. In 2013, the average revenues (per store) from sales of Chatsworth Cheddar was $42,074. We expect revenues (per store) from sales of Chatsworth Cheddar to grow annually at 8% through 2018 and 3% (average inflation rate) thereafter. The 8% growth rate is consistent with the projected average industry growth rate which the company has historically met. We plan to achieve our expected growth by: Increasing sales prices We intend to increase prices in the 3% to 5% range each year, which is consistent with historical pricing practices of the company and our competitors. Results of recent market research indicate that price increases can be maintained and marketing plans are in place to educate both our distributors and our consumers on the rationale for price increases. Increasing customer demand Brand recognition of Chatsworth Cheddar as a consistent and high quality cheese has led to increased sales volume each year since Our new marketing campaigns, third party endorsements, and prime retail space are expected to increase awareness of the Chatsworth Cheddar brand in future periods.

13 Revenue Growth Rate CURRENT YEAR LOOK-BACK ANALYSIS KEY ASSUMPTION #2 In planning for the audit of the year ending December 31, 2014, you are asked to perform a look-back analysis of the assumptions used to derive the valuation of the trademark as part of the impairment analysis for the year ending December 31, The estimated fair value as of December 31, 2013 was calculated using a discounted cash flow model based on three key assumptions, including management s revenue growth rate assumption. Below is a chart showing management s revenue growth rate assumption used in the 2013 estimate, as well as the actual revenue growth since the prior year estimate was made. s key assumption (as of 12/31/2013): Update since prior year estimate (as of 8/31/2014): Sensitivity analysis: Additional information gathered as part of look-back analysis: 8% annual growth rate through 2018; 3% annual growth rate thereafter Revenues per store have grown 9% compared to the same time period in the prior year. If a 9% (instead of 8%) growth rate had been used in the prior year estimate, the fair value estimate of the trademark increases to $3.343 million which is $278,000 above the book value. See the attached revised DCF calculation for this computation, as well as the results of the look-back analysis for the estimated fair value as of December 31, 2012 and December 31, Conversations with management indicate that actual growth differed from predicted growth due to a few factors. In particular, the projected price increase and new branding of the cheese went into effect sooner than anticipated, positively impacting actual growth. However, management attributes the majority of the difference between expected and actual revenue growth in the current year to a new fermentation process that the company s main competitor implemented this year on a trial basis

14 Current Year Sensitivity Analysis -Prepared Impairment Analysis for Chatsworth Cheddar Trademark (Amounts in 000s) 12/31/2013 Updated Original 12/31/ /31/2011 Fair value estimate $ 3,343 $ 3,205 $ 3,284 $ 3,265 Book value 3,065 3,065 3,065 3,065 Fair value is in excess of book value $ 278 $ 140 $ 219 $ 200 Projected Net Cash Flow ($ in 000s) (1) No. of Stores Selling into Pertuity Chatsworth Cheddar during the year (Assumption: 7 new stores each year up to cap of 120 stores) (2) Projected Average Sales per store (Assumption: Revenue growth of 9% per store through 2018, 3% thereafter) (3) Projected Royalties (Contractual: 4% of sales) (4b) Projected Royalties 2021 into Perpetuity: (4) Projected Net Cash Flow , (5) Present Value of Projected Net Cash Flows (Assumption: 10% Discount Rate ) Summed Present value of net cash flows $ 3, (1) No. of Stores Selling Chatsworth Cheddar = No. of Stores in Prior Year 7. Maximum number of stores = 120. (2) Projected Average Sales per Store = Average Sales per Store in Prior Year * (1.09) Years = Average Sales per Store in Prior Year * (1.03) Years after 2018 (3) Projected Royalties = [Projected Average Sales per Store for Current Year * 4%] * No. of Stores Selling Chatsworth Cheddar in Current Year Note: Royalties paid are based on a contractual rate of 4% of per store sales of Chatsworth Cheddar. (4a) Projected Net Cash Flow = Projected Royalties (4b) Projected Royalties 2021 into Perpetuity {Gordon-Growth Model} = Projected Net Cash Flow in 2021 / ( ) No. of years to discount (5) PV of Projected Net Cash Flows = Projected Net Cash Flows / (1.10) Assumptions: 9% revenue growth through % steady growth rate after % royalty rate 7 new stores opening each year up to a maximum of 120 stores 10.0% discount rate (WACC)

15 Auditors Assessments of the Reliability of s Estimation Process Understated Overstated H1 supported (F 1,106 = 2.28, one-tailed p = 0.067) Less Specific More specific 7.37 (1.39) n=27 A 7.73 (1.19) n=26 C 7.55 (1.29) n= (1.18) n=29 B 7.17 (1.47) n=29 D 7.40 (1.34) n=58 df MS F 7.50 (1.28) n= (1.36) n=55 H2 supported (F 1,106 = 2.68, one-tailed p = 0.052) Two-tailed p-value Big Specificity Direction of Inaccuracy Specificity * Direction

16 Auditors Planning Judgments H3: Lower (higher) reliability assessments of management s estimation process will lead to higher (lower) risk assessments of material misstatement in the current period estimate and more (less) allocation of planned audit effort. H3: ROMM b = one-tailed p = Effort b = one-tailed p = H3 supported

17 Specificity of Prior Period Evidence (0.041) Additional Analyses Competence Interaction Estimation Inaccuracy Direction Trustworthiness (<0.001) Credibility (<0.001) Big (0.014) Reliability of 's Estimation Process (0.027) ROMM (<0.001) (0.033) Planned Audit Effort

18 Competence More Specific Trustworthiness Estimation Inaccuracy Direction (<0.001) Credibility (0.002) (<0.001) (0.060) (0.077) Big (0.031) Reliability of 's Estimation Process (0.096) (0.172) Evidence Bias ROMM (0.065) Planned Audit Effort

19 Competence Less Specific Trustworthiness Estimation Inaccuracy Direction (<0.001) Credibility (0.004) (<0.001) (0.252) (0.019) Big (0.058) Reliability of 's Estimation Process (0.136) (0.001) Evidence Bias ROMM (<0.001) Planned Audit Effort

20 Conclusions Auditors reviewing more specific evidence when the prior period estimation inaccuracy is inconsistent (consistent) with management s incentives provide the highest (lowest) reliability assessments of management s estimation process. These effects then flow through to auditors planning judgments, with higher (lower) reliability assessments leading to lower (higher) risk assessments and planned audit effort. The way in which the direction of the estimation inaccuracy impacts auditors planning judgments (i.e., perceptions of estimation process or evidence bias) depends on the specificity of prior period evidence.

21 Thank you!