Audit of Complex Estimates As Verification of Management Number, How Institutional Pressures Shape Practice

Audits of Complex Estimates as Verification of Management
Numbers: How Institutional Pressures Shape Practice*
EMILY E. GRIFFITH, University of Wisconsin – Madison
JACQUELINE S. HAMMERSLEY, University of Georgia
KATHRYN KADOUS, Emory University
1. Introduction
Accounting estimates are items included in financial statements for which “the measure-
ment of some amounts or the valuation of some accounts is uncertain” (Public Com-
pany Accounting Oversight Board [PCAOB] 2003a, ¶1).1 Complex estimates—those
involving multiple assumptions and/or computationally difficult models—are increasingly
important to the financial statements. For example, U.S. and international standards
require estimation of postretirement benefits and annual computations of goodwill
impairments, and they allow use of model-based fair values. Meanwhile, economic pres-
sures have further increased the importance of valuation allowances and impairments
while simultaneously increasing the difficulty of assessing fair values. The uncertainty
inherent in estimates allows room for management bias (Lundholm 1999), and as esti-
mates become less reliable they become less useful to capital market participants (e.g.,
Richardson, Sloan, Soliman, and Tuna 2005; Lev, Li, and Sougiannis 2010). Collec-
tively these factors create an “urgent need to enhance the reliability of accounting esti-
mates” (Lev et al. 2010, 805).
Auditors are the arbiters of the reliability of financial reports. The increasing impor-
tance of complex estimates and the opportunity for management bias that estimates pro-
vide jointly imply that audit quality in this area is critical to the reliability of financial
reports. However, accounting estimates are, by their nature, difficult to audit, requiring
subjective forecasts of future events rather than a tally of past events. The auditor’s task is
to accumulate sufficient appropriate evidence regarding management’s assertions (PCAOB
* Accepted by Yves Gendron. Prior versions of this paper were titled “Auditing complex estimates: Under-
standing the process used and problems encountered.” We are grateful to John Fogarty for helpful discus-
sions about this project. We also thank Yves Gendron, two anonymous reviewers, Wendy Bailey, Michael
Bamber, Jean Bedard, Andy Call, Jeff Cohen, Jon Grenier, Stacie Laplante, Roger Martin, Dan Stone, Ar-
nie Wright, Hal Zeidman, and workshop and conference participants at Notre Dame, Kentucky, Arizona
State, South Florida, Florida State, Georgia, the Northeast Behavioral Accounting Research Seminar, the
2011 International Symposium on Audit Research, the 2011 ABO Section Research Conference, and the
2012 Auditing Section Mid-Year Meeting for comments on prior drafts of this paper. Additionally, we
thank the auditors who have given their time assisting with the interviews, their firms, and Sydney Traub
for her able research assistance. Jackie Hammersley is grateful for the support provided by a Terry Sanford
Research Award.
1. See PCAOB Interim Standards AU 342, entitled “Auditing accounting estimates,” which incorporates State-
ment on Auditing Standards (SAS) No. 57 (American Institute of Certified Public Accountants [AICPA]
1988). The PCAOB adopted the existing standard on auditing estimates (i.e., AICPA 1988) as part of its
Interim Standards in 2003 and made minor modifications in 2007 and 2010 to properly reference PCAOB
Auditing Standards adopted subsequent to 2003. However, PCAOB Interim Standards AU 342 on auditing
estimates remains in effect substantively as it was originally written in 1988.
Contemporary Accounting Research Vol. XX No. XX (XX XX) pp. 1–31 © CAAA
doi:10.1111/1911-3846.12104
2 Contemporary Accounting Research
2010d, ¶3; International Federation of Accountants [IFAC] 2008a, ¶6).2 For accounts
based on historical cost this means auditors verify the accuracy of those historical num-
bers; however, for estimates, the auditor’s task is to evaluate the reasonableness of the esti-
mate (see PCAOB 2003a, ¶7.b; PCAOB 2010d, ¶13; IFAC 2008b, ¶6.a).
Auditors have well-established procedures for verifying the accuracy of transactions
and balances valued at historical cost, but these procedures are of little use in evaluating
estimates, which include “subjective as well as objective factors” (PCAOB 2003a, ¶4; see
also IFAC 2008b, ¶18). For example, assumptions used to develop estimates (such as man-
agement’s future plans for a division, sales forecasts, etc.) cannot be verified in the same
manner as objective factors. In addition, the complex finance-based modeling underlying
some estimates may be beyond an auditor’s expertise (Power 2010). Thus, the complexity
of many estimates and their judgment-based nature creates difficulties for auditors who
attest to their reasonableness (Copeland 2005), and these difficulties cause problems for
auditor judgment that have captured regulators’ attention (e.g., PCAOB 2010e).
This paper has three goals that together will contribute to a better understanding of
key decisions auditors make and the persistent problems that auditors have with respect
to estimates. The first goal is to understand the process of auditing complex estimates and
the problems that auditors encounter along the way. The differences identified above in
task goals and structure between auditing estimates and auditing other accounts presum-
ably influence how the task is performed, yet the literature has not examined how esti-
mates are audited in a systematic way. In addition, standards allow a variety of
approaches. We contribute to the literature by providing an understanding of how audi-
tors make key judgments and decisions in this area. Our second goal is to interpret the
process used to audit estimates using institutional theory. Further, given that there are
problems with these processes and that auditors are aware of the problems, we examine
whether theory suggests impediments to change in this process. The third goal is to iden-
tify root causes of the decision problems that auditors face in auditing estimates. Our
description and theory-based analysis provide insight into how current practices in audit-
ing estimates arose and inform researchers’ efforts to improve audit quality in this impor-
tant task.
Considerable research investigates auditor judgments about estimates, including fair
values (see Bratten, Gaynor, McDaniel, Montague, and Sierra 2013 for a recent review).
Much of that research focuses on judgment outcomes. While prior studies are informative
about conditions under which auditors allow management bias to survive the audit (Hack-
enbrack and Nelson 1996; Johnstone, Sutton, and Warfield 2001; Kadous, Kennedy, and
Peecher 2003), they do not provide a cohesive framework for understanding the process of
auditing estimates or which steps in the process are most vulnerable to the effects of man-
agement incentives.3 Our look into the backstage of the audit process will allow research-
ers to better understand this process and to move beyond merely acknowledging that
auditors are susceptible to management influence (Power 2003). The insights from our
analysis allow readers to understand how and where in the process the influence is applied,
why that influence is likely to be successful, what institutional features allow the influence
to thrive, and how it might be mitigated. These insights can inform future research aimed
2. The financial statement assertions include existence or occurrence, completeness, valuation or allocation,
rights and obligations, and presentation and disclosure (PCAOB 2007, ¶28).
3. For example, Hackenbrack and Nelson (1996) show that auditors permit more aggressive reporting when
engagement risk is lower. Johnstone et al. (2001) hypothesize that direct incentives (i.e., financial, employ-
ment, contingent fees) and indirect incentives (i.e., interpersonal relationships, auditing the firms’ work) can
impair auditor independence, especially in tasks requiring significant auditor judgment. Kadous et al. (2003)
show that auditors who are more committed to a goal of supporting the client evaluate the client’s aggres-
sive accounting method as more appropriate.
CAR Vol. XX No. XX (XX XX)

Auditing Complex Estimates 3
at improving audit quality in this critical area. This paper answers Martin, Rich, and
Wilks’s (2006) call for more research on the audit steps and procedures used to audit fair
values and other estimates, as well as Nelson and Tan’s (2005, 47) call for researchers “to
shed insights on the tasks that auditors perform and on emerging audit practices” to bet-
ter address problems in specific areas such as auditing estimates.
We interviewed 24 very experienced U.S. auditors who regularly deal with complex
estimates. The interviews allow us to understand how the task is actually performed in
practice (Hirst and Koonce 1996). Interviews also provide us with auditors’ unique
insights into the problems that they experience and the underlying causes of these prob-
lems. We use auditing standards as a framework for our description of the process fol-
lowed by our interviewees when auditing complex estimates, and we analyze the content
of the interviews and recent PCAOB inspection reports to understand the most critical dif-
ficulties in auditing estimates. We then apply institutional theory to provide insight into
the underlying causes of these difficulties and impediments to changes that could resolve
the difficulties.
Auditing standards allow a variety of approaches to evaluating the reasonableness of
an estimate. Our main finding with respect to the process is that auditors overwhelmingly
reported testing management’s process for generating complex estimates rather than using
an approach that relies less on management’s assertions (i.e., developing independent
expectations or reviewing subsequent events data). Additionally, auditors reported per-
forming few of the recommended steps to audit management’s process, and, in particular,
none described considering whether additional factors beyond the assumptions made by
management should be included in the management’s model. Auditors’ language in
describing these steps focused on confirmation or verification of elements of the manage-
ment’s model. These issues raise concerns that management may be able to lead auditors
“down the garden path” because auditors do not tend to generate independent estimates
or consider what management has neglected to include in its estimation model. Instead
they appear to accept management’s model as a starting point and verify aspects of that
model. That is, auditors appear to be trying to fit the task of auditing estimates into the
verification model that applies to accounts that are based on historical cost.
Consistent with this observation, the problems that our auditor interviewees identify
indicate an overreliance on management assertions, and such overreliance is corroborated
by our analysis of PCAOB inspection reports. That is, auditors sometimes fail to ade-
quately test assumptions and data underlying the estimation model, fail to consider con-
trols over management’s process and the data, and fail to fully understand the model.
Auditors and the PCAOB both also indicated a failure to notice and reconcile conflicting
evidence (e.g., external evidence about default rates that contradicts management’s
assumptions). Finally, auditors noted significant problems in coordination with and over-
reliance on the work of audit-firm specialists.
We view these problems as arising from two root causes, both of which are consistent
with the legitimation propositions of institutional theory. First, audit firm policies and
professional standards emphasize verifying aspects of management’s model rather than
critically evaluating the reasonableness of the estimate. Second, audit firms’ chosen divi-
sion of knowledge among auditors and valuation specialists results in auditors having
insufficient knowledge of valuation to engage in the necessary critical analysis of manage-
ment or specialist models. We conclude that auditors, informed by the findings in the
PCAOB inspection reports, are aware of these problems, suggesting that this area is ripe
for change; however, the area lacks direction for how to change. Because the root causes
of the problems are inherent in the method auditors use, it is likely that the institutional
change necessary to improve the audit of complex estimates will not occur unless compel-
ling evidence supports a new method and that method is supported by standard setters.

Institutional theory further suggests that firms apply the verification frame to audits
of estimates, even though it is not optimal for this task, because it has been legitimated in
other audit tasks. Framing the task of auditing estimates as one of verification rather than
evaluation results in auditors overlooking evidence that conflicts with management’s model
or is outside of that model. Insufficient valuation knowledge is problematic in that rela-
tively inexperienced auditors, who also likely lack knowledge of how their work fits into
the bigger picture, perform many audit steps, even difficult ones such as preparation of
independent estimates. Moreover, auditors typically enlist audit-firm specialists in auditing
estimates because they do not have valuation expertise, but they may overrely on special-
ists because of coordination issues and lack of a common vocabulary. Overall, these insti-
tutionalized conventions suggest that the problems we identified with audits of estimates
will persist until a superior approach is identified and supported by firms and regulators.
In the next section of the paper, we describe institutional theory, which we use to
interpret our interview and PCAOB inspection report data. Section 3 describes our inter-
view methodology. Sections 4 and 5 describe how estimates are audited and the problems
that occur during the audit of estimates, respectively. Section 6 analyzes the evidence from
the interviews and PCAOB inspection reports through the lens of institutional theory. Sec-
tion 7 provides conclusions and their implications for research.
2. Institutional theory and audit practice

Institutional theory examines how authoritative guidelines for social behavior within orga-
nizations are created, adopted, disseminated, and changed over time (Scott 2005).
Accounting researchers have employed institutional theory to understand practices related
to audit committee oversight (Beasley, Carcello, Hermanson, and Neal 2009), corporate
governance actors’ influence on the audit and the effectiveness of the corporate governance
process (Cohen, Krishnamoorthy, and Wright 2010), the role of professional associations
in prompting change in public accounting (Greenwood, Suddaby, and Hinings 2002), the
development of consulting units within public accounting firms (Greenwood and Suddaby
2006), and the expansion into consulting by public accounting firms (Malsch and Gendron
2013). We apply institutional theory to our interview and PCAOB inspection report data
to understand practices and problems surrounding audits of estimates, to identify root
causes of these problems, and to examine whether the PCAOB provides pressure for conti-
nuity or change in auditing practices related to estimates.
Institutional theory posits that organizations respond to the pressures and constraints
of their environments by developing and changing existing practices that establish or
enhance the organizations’ legitimacy within the environment (Meyer and Rowan 1977;
DiMaggio and Powell 1983; Zucker 1987; Greenwood et al. 2002). Organizations achieve
legitimacy by conforming to accepted ways of doing business, either by copying the prac-
tices of other, successful organizations or by adapting widespread practices that have
otherwise been “legitimated” within the environment (Pfeffer 1981). Further, it is difficult
for members of organizations who are embedded in their fields and face these legitimating
pressures to identify new practices, while people on the margins of organizations typically
lack the power to change legitimated practices (Garud, Hardy, and Maguire 2007). Thus,
previously legitimated practices tend to persist.
Two important consequences arise from organizations’ legitimacy-oriented develop-
ment of practices. First, the practices developed to support organizations’ legitimacy goals
do not always help organizations meet their other goals efficiently or effectively because
the legitimated practices may not be appropriate for the specific organization or the given
task (DiMaggio and Powell 1983). That is, they are adopted because they reflect norms,
not because they are the best approach to an organization’s operational goals. Moreover,
institutional practices used for one purpose within an organization can affect the practices

the organization adopts elsewhere. This occurs because novel practices are at risk of being
viewed less favorably because they diverge from already institutionalized (and thus,
accepted) practices (Zucker 1987).
Second, the practices developed by different organizations within an environment tend
to converge to the extent that the organizations adopt increasingly similar practices in
their pursuit of legitimacy through processes known as mimetic, coercive, and normative
isomorphism (DiMaggio and Powell 1983). Mimetic isomorphism occurs in response to
uncertainty about the right course of action and results in organizations modeling their
actions or processes on those of other similar organizations (Mizruchi and Fein 1999).
Coercive isomorphism occurs because of formal and informal pressure from another orga-
nization, such as a government agency or regulator, to act in a certain manner. Normative
isomorphism occurs when the training and interaction that is common across members of
an industry or profession result in commonly used practices (DiMaggio and Powell 1983).
However, as both DiMaggio and Powell (1983) and Mizruchi and Fein (1999) note, it is
often impossible to distinguish among the three types of isomorphism. As convergence
within and across organizations continues, the legitimated practices become more
entrenched in organizational and societal perceptions of appropriate or best practices.
While much of the institutional theory literature focuses on how organizations converge
on common institutionalized practices, this theory also describes how and why organizations
change (or do not change) established practices (Greenwood et al. 2002). Practices change
when their legitimacy is seriously called into question as a result of functional, political or
social pressures (Oliver 1992). That is, change occurs in response to events or “jolts” that
destabilize the acceptability of current practices (Greenwood et al. 2002). Jolts prompt the
introduction of new ideas and the consideration of the need to change, which leads organiza-
tions to innovate, seeking solutions to identified problems (Greenwood and Suddaby 2006).
The process of moving from idea generation to acceptance of new practices is not well under-
stood; however, researchers believe that the new practices must be “theorized” (Strang and
Meyer 1993). Theorization requires specification of a problem that can be fixed with a
change in procedure and justification of the change (Tolbert and Zucker 1999). The change
becomes accepted as social consensus about its value develops (Suchman 1995) and it
becomes fully institutionalized when widespread adoption of the method occurs.
Greenwood and Suddaby (2006) note that a difficulty with institutional theory lies in
explaining how and why people within institutions become motivated to change. They
examine the conditions that affect this change process for consulting units of public
accounting firms. They conclude that since these units bridge organizational fields, they
are more open to change than other units because they come into contact with alternative
examples on a regular basis. We examine auditing practices that are central to the function
of the firm and are subject to regulatory oversight (increasing the need for perceived legiti-
macy) and that do not bridge other fields. Consequently, it is an open question how moti-
vation for change develops within the auditing practices of these firms.
In this paper, we examine two questions that flow from institutional theory. Our primary
concern is whether auditors have adapted the legitimated procedures used to verify historical
account balances to the audit of complex estimates. We also examine whether the PCAOB,
through the use of mimetic and coercive isomorphism, creates pressure for continuity or
change in the procedures used to audit estimates. Addressing these questions will help us to
understand the causes of the persistent problems with audit quality around estimates.
3. Interview method
We use interviews to collect data relevant to the propositions of institutional theory in the
context of auditing estimates. We interviewed 24 partners and senior managers from six
large audit firms during October and November 2010. We chose the interview method

because we are interested in how auditors actually perform audits of estimates, rather than
how standards describe that process. In addition, auditing standards in this area are vague
and allow substantial flexibility in approach. Auditors are in the best position to tell us
what they do to audit estimates and how they apply the vague standards. In addition,
interviews can provide insight into the problems that auditors experience during the pro-
cess of auditing estimates. Understanding this process and the associated problems is a
precondition to identifying underlying causes of the problems and improving auditor per-
formance in this area (Gibbins and Qu 2005). Thus, we asked interviewees to describe the
major steps in the process of auditing complex estimates and the difficulties they com-
monly encounter throughout this process.
We developed a semi-structured interview script with open-ended, neutral questions
because this format is designed for “complete and consistent coverage in each interview of
themes under study [while] minimizing researcher intrusion” (Lillis 1999, 84). We developed
the interview script in consultation with the national director of assurance policies of a Big 4
auditing firm. We initially drafted the script after discussions with this partner, the partner
provided feedback on the content and terminology of the questions, and then we revised the
script considering those suggestions. After completing three interviews, we revised the script
again to ensure that we could capture the data of interest in a straightforward way.
We sought very experienced auditors as interviewees because they are likely to provide
the most useful insights into the process of auditing estimates and the associated problems.
Very experienced auditors have access to the entire process of auditing estimates in their
roles as reviewers and past preparers, while staff members and seniors know the details of
only a few steps in the process. They also have experience with a greater number and vari-
ety of clients, which increases the generalizability of their interview responses (Cohen,
Krishnamoorthy, and Wright 2002). Because of their enhanced perspective and higher lev-
els of experience, we also expect these auditors best understand the problems that arise in
auditing estimates and their underlying causes.
We identified interviewees by asking contacts at each of the large firms that operates
in our region to provide us with contact information for one or two senior managers,
partners, and technical consultation directors for the office or region who would be willing
to talk to us about auditing complex estimates. The firms we contacted are BDO Seidman,
Deloitte, Ernst & Young, Grant Thornton, KPMG, and PricewaterhouseCoopers. Partici-
pating auditors were from offices in five cities, and their audit experience ranged from 8 to
41 years, with an average of 19 years. To provide context about the backgrounds of the
auditors describing the audit process, Table 1 reports demographic information for each
auditor interviewed, including rank, years of experience, responsibility for technical con-
sultation, and any estimate accounts mentioned during the interviews.
All of our interviewees indicated that they regularly dealt with audits of complex esti-
mates and 11 had current national, regional or office level responsibility for consultation
on technical accounting and auditing issues. Thus, our interviewees have significant experi-
ence with diverse accounts containing estimates and with their firms’ methodology for
auditing these accounts. They are therefore able to provide us with meaningful insights
into their processes. Regarding sample size, we followed recommendations for qualitative
research to continue interviewing until redundancy in responses is achieved such that no
new information is collected with additional interviews (Morse 1995, 2000; Lincoln and
Guba 1985).4
4. Our sample size of 24 interviewees from six firms is within the range of sample sizes in other qualitative
interview studies in auditing. These studies used 22–36 interviewees from one to six firms (Cohen et al.
2010; Trompeter and Wright 2010; Gendron and Bedard 2006; Gendron, Bedard, and Gosselin 2004; Cohen
et al. 2002; Hirst and Koonce 1996).

TABLE 1
Interview participant demographics
Years of Technical consultation

Identifier Rank experience responsibility? Estimate accounts mentioned
P1 Partner 24 Yes
P2 Partner 16 No
P3 Partner 13 No
P4 Partner 41 Yes Impairments, revenue
P5 Partner 19 Yes Impairments
P6 Partner 25 Yes Fair value
P7 Partner 21 Yes Impairments, fair value
P8 Partner 19 Yes Impairments
P9 Partner 20 Yes
P10 Partner 35 No Fair value
P11 Partner 34 Yes
P12 Partner 35 Yes
P13 Partner 23 No
Mean: 25.5 Total: 9
M1 Senior Manager 13 No
M3 Manager 8 Yes Other unspecified complex estimate
M4 Senior Manager 9 Yes Fair value, derivatives, pensions,
self-insurance
M5 Senior Manager 8 No Impairments
M6 Senior Manager 10 No Fair value, revenue
M7 Manager 14 No Impairments
M8 Senior Manager 10 No Impairments, revenue
M9 Senior Manager 10 No Other unspecified complex estimate
M11 Senior Manager 20 No Impairments, fair value
Mean: 11.3 Total: 2
Two authors conducted phone interviews.5 We asked questions in the order they
appear in the script, but we allowed interviewees to elaborate as they wished. We docu-
mented the interviews by taking notes on a copy of the script during the interview, and we
completed our documentation of all responses before concluding each interview.6 In order
to avoid introducing our own structure on responses, during the interviews we asked for
clarification of responses when questions arose. For example, when an interviewee was
providing steps involved in auditing estimates, if it was not perfectly clear whether the
interviewee considered an item to be a new (separate) step or part of the prior step, we
asked the interviewee to clarify. Interviewees were free to refer to any materials they
wished, but we did not ask them to do so. Interviews ranged from 50 to 120 minutes in
length, with an average time of 69 minutes.
5. Given our desire to attain the views of very experienced auditors from several firms and locations, it was
not feasible to conduct face-to-face interviews. To compensate for the lack of face-to-face interaction, the
interviewers opened each call with introductions and a brief conversation about the purpose of the study to
build rapport. We promised the interviewees anonymity to encourage them to be candid.
6. In order to obtain frank responses from interviewees, we opted not to record the interviews. We believed
this was critical, given our focus on problems encountered and U.S. audit firms’ wariness of litigation. We
took various measures (described above) to minimize the risk of losing crucial details.

We began our interviews by asking auditors to think about the process of auditing a
complex estimate such as a fair value or impairment analysis. We asked them to walk us
through the key steps in the process and to describe what level auditor typically performs
the steps and the order in which they usually take place.7 We prompted auditors by asking
whether identifying accounts with significant estimates or impairments was the first step in
the process, and all 21 agreed that it was. For the remaining steps in the process, we asked
interviewees to identify the steps they believe are important when auditing estimates, but
we did not prompt them with any additional steps. We did not prompt them further
because we were interested in learning which steps very experienced auditors believe are
most important and are commonly performed when auditing complex estimates, and in
what order they are performed. Additional prompts could interfere with the auditors’
thought processes or could have communicated to the auditors that we considered certain
steps to be important. We did not ask auditors to focus on a particular audit as we sought
information about how auditors generally audit estimates and the problems they generally
encounter, as opposed to how they perform on cases that are particularly salient (e.g.,
because they are particularly risky or occurred very recently).
An author who did not participate in the interviews and a research assistant indepen-
dently coded the process steps the interviewees described. Following Miles and Huberman’s
(1994) recommended method, the noninterviewing author developed the coding scheme by
creating a “start list” based on the conceptual framework underlying the study prior to delv-
ing into the data and refining the coding scheme. Specifically, the author used the steps in the
process mandated by PCAOB Interim Auditing Standards AU 342 and 328 as a starting
point and added categories as needed based on the content of the interviews. The final coding
scheme includes categories for the 10 steps identified in the auditing standards plus five addi-
tional steps not identified in the standards. Initial interrater agreement on the coding of inter-
view responses about the process was 85.8 percent; the coders met to resolve differences and
the reconciled data are reported here. Cohen’s j, a measure of interrater agreement beyond
that predicted by random chance, was 0.84 (p < 0.01). Our discussion of auditors’ process in
the following section is based on these results.
Next, we asked auditors to think about the steps in which problems frequently arise
when auditing complex estimates.8 The noninterviewing author and research assistant fol-
lowed the same procedures described above to develop the coding scheme, code the inter-
view responses, and resolve differences in coding responses about problems with auditing
estimates. Initial interrater agreement on problems data was 79.7 percent (Cohen’s
j = 0.78, p < 0.01). Our discussion of auditors’ problems in Section 5 is based on the
reconciled data.
4. How are estimates currently audited?
Standards about auditing estimates
We use PCAOB Interim Standards AU 342 and 328 as a framework for describing the
process used to audit accounting estimates (PCAOB 2003a, b).9,10 We rely primarily on
7. We added this topic to the script after conducting three interviews; therefore, only 21 auditors answered
this item.
8. All 24 auditors answered this item.
9. In addition to adopting AU 342 (see footnote 1), the PCAOB also adopted the preexisting standard on
auditing fair values, AU 328 (which incorporates SAS No. 101 [AICPA 2003]), “Auditing fair value mea-
surements and disclosures” as part of its Interim Standards in 2003. Like AU 342, AU 328 remains in
effect substantively as it was originally written in 2003.
10. International Standards on Auditing No. 540, “Auditing accounting estimates, including fair value
accounting estimates and related disclosures,” essentially combines the guidance provided by AU 342 and
AU 328 into one standard, without substantively different requirements (IFAC 2008b).

AU 342, as this standard encompasses all complex estimates, including but not limited to
fair values. Although general standards provide guidance relevant to auditing all accounts
including estimates, we focus on standards specific to estimates because these standards set
forth the procedures that auditors are required to follow when auditing estimates (e.g.,
Goelzer 2010).
When evaluating estimates, AU 342 first requires auditors to identify all material
accounting estimates made by management (PCAOB 2003a, ¶8). Next, auditors must
obtain an understanding of how management developed the estimates (PCAOB 2003a,
¶10). While AU 342 does not elaborate on how to obtain this understanding, AU 328 indi-
cates that for fair value measurements, auditors must understand the method or model as
well as management’s reasons for using it (PCAOB 2003b, ¶18). Based on their understand-
ing of management’s process, auditors then use one or more of three possible approaches
to evaluate the reasonableness of management’s estimates. Auditors may: (i) review and test
management’s process for generating estimates, (ii) develop an independent expectation for
the estimate, and/or (iii) review subsequent events or transactions that are related to the
estimates (PCAOB 2003a, ¶10; PCAOB 2003b, ¶23). While neither standard advocates one
method over any other, we note that AU 328 provides 14 paragraphs of detailed guidance
on reviewing and testing management’s process, one paragraph on developing an indepen-
dent expectation, and two paragraphs on reviewing subsequent events.
If auditors decide to review and test management’s process, AU 342 allows them to
select any combination of the following steps to provide sufficient evidence about the esti-
mate: test controls over preparation of the estimates; test the relevance, reliability and suf-
ficiency of the data used in the model; test the accuracy of the computations made in
using the model; evaluate the appropriateness of the assumptions used; and, finally, con-
sider whether any relevant factors are missing from the model (PCAOB 2003a, ¶11).
Alternatively, AU 342 and 328 both allow auditors to develop an independent expec-
tation for the estimate using their own model and assumptions (PCAOB 2003a, ¶12). For
fair values, AU 328 explicitly requires that the auditor “takes into consideration all signifi-
cant variables” (PCAOB 2003b, ¶40), while AU 342 provides minimal direction about
how to develop an independent expectation (PCAOB 2003a, ¶12). Finally, in addition to
or instead of the other two approaches, auditors may consider whether there are any sub-
sequent events that provide evidence about the reasonableness of estimates (PCAOB
2003a, ¶13; PCAOB 2003b, ¶41). The final step in auditing estimates requires auditors to
consider whether there is a misstatement of the estimate that requires adjustment, given its
materiality relative to the financial statements taken as a whole (PCAOB 2003a, ¶14;
PCAOB 2003b, ¶47).
Auditors’ process of auditing estimates

Table 2 reports the key steps that auditors identified in the process of auditing estimates and
summarizes how they described performing those steps. We provide our interpretation of the
interview data about the process in this section. Detail supporting this interpretation, includ-
ing counts of auditors giving particular responses and quotations, can be found in Appendix
S1.11 Figure 1 depicts the consensus from the interviews about the auditors’ process, includ-
ing the order of step performance, frequency with which auditors described step perfor-
mance, and whether the steps are required by the estimates standards. While it is possible
that auditors did not give a complete accounting of the steps they perform when auditing
estimates or the troubles they encounter (due to time or other constraints imposed by the
interview method), we expect that steps are mentioned roughly in proportion to their impor-
11. Please see supporting information, “Appendix S1: Details of Auditors’ Process and Problems when Audit-
ing Complex Estimates” as an addition to the online article.

tance to the auditor. Thus, it seems fair to assume that steps that are omitted by most audi-
tors receive less attention during audits of estimates than do other steps.
We find that auditors described a process for auditing estimates that is broadly consis-
tent with auditing standards; however, the specific steps identified and the order of perfor-
mance of steps varies across auditors. All auditors began as prompted by identifying
accounts with significant estimates, which they identify by considering “the client’s busi-
ness and what types of accounts they have” (P3) and by using materiality as a frame for
understanding which accounts are important and determining which of these contain esti-
mates.12
This is generally followed by understanding management’s process or model used to
develop the estimate. The goal of this step is to understand enough about how manage-
ment generated its estimate to determine the audit approach to use. This includes under-
standing what judgments go into the estimate and where the higher risk areas are in the
process. The language auditors used to describe this step (e.g., “figure out,” “dig deep,”
“really understand”) emphasizes both the importance of thoroughly understanding man-
agement’s method and the absence of a standardized approach to obtaining this under-
standing. The latter implies auditors must use their judgment to decide how to approach
this step and whether their understanding is adequate after executing that approach.
Nonetheless, we note that the analytical judgment auditors describe applying in this
step uses management’s model as a starting point. They are working to understand what
management did to generate an estimate, rather than what an ideal approach would be.
This is generally followed by deciding which method to use to audit management’s
estimate. We find that auditors most commonly audit management’s process for generat-
ing the estimate, and they only rarely prepare an independent expectation or use subse-
quent events data to validate an estimate.
Next, auditors perform the various procedures to actually audit the estimate. The
order and inclusion of these steps varies by auditor; however, auditors collectively describe
the process of auditing management’s estimate as involving five major steps: testing con-
trols, testing data, testing management’s calculations, evaluating the assumptions used,
and evaluating the reasonableness of management’s model. Auditors described testing con-
trols and testing data using concrete and straightforward language. This is likely because
auditors commonly perform these steps when auditing accounts other than estimates and
they do not view these steps as having the more abstract goals of other steps unique to
estimates (e.g., understanding the model, evaluating assumptions). Similarly, auditors gave
relatively cursory descriptions of testing management’s calculations that convey a lower
level of judgment necessary to complete this step.
Interviewees each described using multiple methods to evaluate assumptions. The lan-
guage used (i.e., “validate,” “verify,” “look back”) suggests that, while they attempt to
exercise skepticism, they tend to focus on corroborating management’s assumptions rather
than determining an appropriate assumption independently for comparison to manage-
ment’s assumptions. Moreover, their descriptions convey that this process is heavily
dependent on auditors’ judgment to determine not only how much evidence is necessary
but also what type of evidence is appropriate to use in evaluating assumptions. Auditors
also explained that a key consideration when evaluating the reasonableness of manage-
ment’s method or model is whether the model makes sense, given the type of account
being estimated and the client’s industry (i.e., is the model typically used for an account
or industry). Auditors did not report considering whether there are relevant factors or
assumptions missing from the model.
12. We attribute quotes to auditors using the identifiers assigned in Table 1 (e.g., M1 indicates a manager
made the comment, P1 indicates a partner).

TABLE 2
Process performed when auditing estimates as described by interviewees
Panel A: Steps included in standards-based model
Number of
interviewees
describing
Steps and substeps described by interviewees (n = 21) Percentage
Identify accounts/areas with significant estimates 21 100.0

(a) Develop an understanding of management’s business
and industry to identify existing estimates 16 76.2
(b) Perform risk assessment and brainstorming during planning
phase to identify risky or subjective areas 7 33.3
(c) Establish materiality to guide identification of significant
accounts that may contain estimates 6 28.6
(d) Use experience with management and prior year’s workpapers
to identify existing estimates 5 23.8
(e) Ask management which accounts contain estimates 2 9.5
(f) Involve valuation specialist to identify estimates 1 4.8
Understand management’s method/model 19 90.5
(a) Understand management’s process for generating estimate
and consider underlying rationale for that process 15 71.4
(b) Understand who prepares estimate and their qualifications 6 28.6
(c) Understand assumptions underlying method/model 5 23.8
(d) Identify and understand controls around the process of
generating estimate 5 23.8
(e) Determine which elements of estimate are key drivers to
identify primary risks associated with estimate 4 19.0
(f) Understand inputs and data in the method/model 4 19.0
(g) Walk through the transaction flow related to estimate 3 14.3
(h) Use valuation specialist to obtain understanding of
method/model 1 4.8
Test controls over management’s method and data used 2 9.5
(a) Test controls around process used to generate estimate 2 9.5
Test relevance, reliability, and sufficiency of underlying data
used in model 13 61.9
(a) Verify inputs and data used in model agree to source data 9 42.9
(b) Gather substantive evidence about assumptions and data
used in model 6 28.6
(c) Verify mathematical accuracy of inputs used in model 3 14.3
Evaluate appropriateness of model assumptions 18 85.7
(a) Consider consistency of assumptions with each other and
sensitivity of estimate to changes in assumptions 12 57.1
(b) Assess historical accuracy of management projections 10 47.6
(c) Check for consistency with other forecasts and over time 7 33.3
(d) Verify growth rates, discount rates, etc. used in model 5 23.8
(e) Use specialist to evaluate and document appropriateness
of assumptions 5 23.8
(The table is continued on the next page.)

TABLE 2 (continued)
Panel A: Steps included in standards-based model
Number of
interviewees
describing
Consider whether relevant factors or assumptions are missing

from the model 0 0.0
Test management’s calculations 4 19.0
(a) Test calculations used to translate assumptions and key
factors into estimate 4 19.0
Formulate independent expectation 8 38.1
(a) Develop and compare independent expectation of estimate
to management estimate 6 28.6
(b) Use specialist to develop independent expectation 2 9.5
Review subsequent events 2 9.5
(a) Use transactions posted after year-end to support assumptions 2 9.5
Conclude whether estimate is materially misstated 13 61.9
(a) Analyze evidence and conclude, considering materiality 8 38.1
(b) Compare independent expectation to management estimate 3 14.3
(c) Reconcile differences between management estimate and
auditor’s expectation if possible 3 14.3
Panel B: Steps not included in standards-based model
Number of
interviewees
describing
Evaluate reasonableness of management model used 4 19.0

(a) Determine whether model is reasonable, given company
condition and whether it is used in a reasonable way to
generate estimate 4 19.0
Select audit approach 9 42.9
(a) Choose to audit management’s process or to formulate an
independent expectation 7 33.3
(b) Determine whether a valuation specialist is needed 6 28.6
(c) Consider whether subsequent events data will be useful 1 4.8
Evaluate reasonableness of estimate, considering audit evidence
and financial statements taken as a whole 6 28.6
(a) Consider whether the estimate makes sense, given other
evidence obtained during the audit 4 19.0
(b) Consider whether the estimate makes sense in terms of
the rest of the financial statements 1 4.8
(c) Assess what could go wrong in management’s process
and calculation 1 4.8
Document work 5 23.8
Review workpapers 1 4.8

Figure 1 Model of the process of auditing estimates as described by auditing standards and
interviewees
Test management’s process:

(90.5%)
Identify
accounts/ Evaluate reasonableness of management model used
areas with (19.0%)
significant
estimates
Test controls over management method and data used
(100.0%)
(9.5%) Evaluate
reasonableness of Conclude whether
Test underlying data used in model estimate, estimate is
Understand considering audit materially
management (61.9%) If yes
evidence and misstated
method/ financial (61.9%)
model Evaluate appropriateness of model assumptions statements taken
(90.5%) (85.7%) as a whole
(28.6%)
Consider whether relevant factors or assumptions are
Select audit missing from model
approach (0.0%)
(42.9%)
Test management’s calculations If no
(19.0%)
Formulate independent expectation

(38.1%)
Review subsequent events

(9.5%)
Description:
Percentage of 21 interviewees who discussed each step is shown in parentheses. Dotted lines indicate
steps described by interviewees that are not included in auditing standards about estimates (i.e.,
AU 342 and AU 328). Note that some interviewees also discussed two steps that are not
depicted above because they are not unique to the process of auditing estimates: documenting
work (23.8 percent) and reviewing workpapers (4.8 percent).
Four of the steps collectively identified by auditors—testing controls, testing data, test-
ing management’s calculations, and evaluating the assumptions used—coincide with those
in standards. The remaining step identified by auditors—evaluating the reasonableness of
management’s model—is not explicitly contemplated by the standards. In addition, none
of the auditors mentioned the fifth step identified in standards—considering whether there
were additional factors or assumptions beyond those already incorporated in the model
that should be taken into account. Finally, on average, auditors reported performing only
1.8 of the 5 steps outlined by the standards in auditing management’s process.13 While
these steps are not all strictly required by standards, our view is that it would be difficult
to collect sufficient evidence about the reasonableness of the estimate without performing
all steps in most cases.
Next, auditors complete the process by determining whether the estimate is reason-
able. If the estimate does not appear reasonable considering the rest of the audit evidence
and the financial statements taken as a whole, they iterate back through the original pro-
cess to collect additional evidence, or, in some cases, they decide that their initial approach
was inappropriate or inefficient and choose a new approach (e.g., preparing an indepen-
dent expectation of the estimate instead of testing management’s estimation process). Once
13. The 21 auditors that were asked to describe the process made 37 mentions of testing controls, testing data,
evaluating assumptions, considering external evidence, and testing calculations. The number of steps
reported by each interviewee (out of these five steps) ranged from 0 to 4, with a mean of 1.8 and a median
of 2.

the evidence is sufficient, auditors conclude whether the estimate contains a material mis-
statement. Auditors’ descriptions of this step reveal that deciding whether an estimate is
materially misstated is not a black and white decision; it involves significant judgment and
iteration with management. This creates an opportunity for management to influence
auditors’ judgments (intentionally or not) at a crucial point in the process of auditing
estimates.
Auditor rank and the process of auditing estimates

We asked interviewees to identify the rank of the auditor typically preparing each step in
the audit of complex estimates. Table 3 reports the results. We find that seniors or manag-
ers are the most common primary preparers of every major step in the process of auditing
estimates, while staff members and seniors combined are the primary preparers the major-
ity of the time for every step required to audit management’s process, prepare an indepen-
dent estimate, or evaluate subsequent events. Seniors were more likely than managers to
be named as the primary preparer for every step except identifying accounts with estimates
(seniors 28.1 percent versus managers 31.6 percent), evaluating the reasonableness of the
estimate considering other evidence obtained during the audit (27.3 percent versus 36.4
percent), and concluding about the account (22.2 percent versus 44.4 percent). These are
the steps likely requiring the most judgment, but it is notable that while managers are
more likely to be identified as the primary preparer for these tasks, seniors also commonly
prepare this work. Additionally, it is notable that staff auditors were listed as primary pre-
parers for nearly every step in the process. One implication of the heavy involvement of
senior and staff auditors throughout the process of auditing estimates is that many steps
are prepared by auditors who may lack the expertise acquired through experience and
training to adequately perform the work.
Partners are most likely to be involved as preparers in the early stages of auditing esti-
mates (i.e., identifying accounts with estimates, understanding management’s method,
selecting the audit approach, and evaluating the reasonableness of management’s method)
and the final stages (i.e., evaluating the sufficiency of evidence and concluding about the
account). Specialists are most involved in the early stages of the audit of estimates (i.e.,
understanding management method, selecting the audit approach, and formulating an
independent expectation).
5. What problems do auditors encounter in auditing estimates?
Problems identified by auditors
We sought evidence from our 24 interview participants about which steps in auditing esti-
mates, if any, they see as causing difficulties for their audit teams. Because interviewees
were selected by our firm contacts for their knowledge about and interest in improving the
process of auditing estimates, their perspective when describing problems was one of can-
dor and introspection. Thus, we expected auditors would provide their views of causes of
the problems they identified and insight into the ways in which these problems affect the
audit. This allows us to go beyond merely documenting types of problems auditors experi-
ence to providing evidence that many of these problems are related to a few underlying
causes. In Table 4, we summarize the types and frequencies with which the auditors
reported problems in the steps used to audit estimates. Below, we discuss the problems in
the order in which they occur throughout the process of auditing estimates to illustrate
how problems compound throughout the process. As we did for process, we provide addi-
tional details from the interviews in Appendix S1.14
14. Please see supporting information, “Appendix S1: Details of Auditors’ Process and Problems when Audit-
ing Complex Estimates” as an addition to the online article.

TABLE 3
Primary preparers of steps in the process of auditing estimates
Primary preparers identified by interviewees*,†
Step Staff Senior Manager Partner Specialist Team
Identify accounts/areas
with significant estimates 1.8% 28.1% 31.6% 17.5% 1.8% 19.3%
Understand management’s
method/model 4.2 35.2 31.0 11.3 14.1 4.2
Select audit approach 18.5 25.9 25.9 18.5 11.1 –
Evaluate reasonableness
of management model used – 40.0 40.0 20.0 – –
Test controls over
management’s method and
data used – 50.0 50.0 – – –
Test underlying data used –
in model 37.5 41.7 12.5 4.2 4.2
Test management’s
calculations 25.0 50.0 25.0 – – –
Evaluate appropriateness
of model assumptions 13.6 57.6 20.3 5.1 3.4 –
Formulate independent
expectation 23.1 38.5 7.7 7.7 23.1 –
Review subsequent events 25.0 50.0 25.0 – – –
Evaluate reasonableness
of estimate, considering
audit evidence and financial
statements taken as a whole 9.1 27.3 36.4 27.3 – –
Conclude whether estimate –
is materially misstated 5.6 22.2 44.4 22.2 5.6
Document work 16.7 16.7 33.3 16.7 16.7 –
Review workpapers – – – 100.0 – –
Notes:
* The table reports the primary preparers identified by the 21 interviewees who described the
process of auditing estimates reported in Table 2.
†
The table shows the percentage of total responses indicating each position as primary preparer
because some interviewees indicated more than one primary preparer.
Auditors first encounter problems when identifying accounts containing significant esti-
mates. One manager (M10) described the problem as starting the audit work before “getting
a very good understanding of the whole area in which there is significant risk.” This makes it
difficult to see where the risk resides, resulting in a misallocation of effort or in framing the
problem incorrectly so that the analysis that follows is inappropriate. For example, an audi-
tor could misidentify the reporting level (i.e., unit of analysis) for a goodwill impairment test,
causing him or her to include the wrong accounts in the analysis. These descriptions suggest
that identifying which accounts contain significant estimates is difficult because there is no
standard approach to completing this step and it requires substantial judgment.
Auditors next experience problems understanding management’s method or model.
Specifically, auditors sometimes fail to understand what the model’s key risk drivers are
due to a lack of knowledge about the methods or models used and therefore they misinter-
pret which assumptions are critical.

TABLE 4
Comparison of auditor- and PCAOB-identified problems
Panel A: Problems with steps in the process of auditing estimates*
Problems Estimates-related
mentioned deficiencies identified
Problem area by auditors Rank by PCAOB Rank
Problems in steps identified in estimates standard:

Evaluate appropriateness of model assumptions 13 1 73 1
Test underlying data used in the model 8 3 51 2
Understand the client method/model 6 4 19 5
Test controls over client method and data used 3 6 35 3
Consider whether relevant factors or assumptions
are missing from model 3 6 26 4
Identify accounts/areas with significant estimates 3 6 17 6
Formulate independent expectation 1 10
Review subsequent events 1 10
Problems in steps not identified in estimates standard:
Evaluate reasonableness of estimate, considering
audit evidence and financial statements
taken as a whole 9 2
Evaluate reasonableness of client model 5 5 6 7
Select audit approach 2 9
Total 54 227
Panel B: Problems with the general process of auditing estimates†
Problem area Problems mentioned by auditors Rank
Document work 7 1
Auditor inexperience 6 2
Coordination with specialists 5 3
Client issues 3 4
Total 21
Notes:
* These are problems identified by 24 auditors in the interviews that are comparable to deficiencies
identified in PCAOB inspection reports.
†
These are problems identified by auditors in the interviews that are not comparable to deficiencies
identified in PCAOB inspection reports. PCAOB inspections identify specific failures (see
“Appendix S2: Categories Used to Code Inspection Report Deficiencies” as an addition to the
online article for examples), rather than general problems related to issues such as
documentation (e.g., PCAOB 2012b), auditor inexperience, etc.
In choosing the audit approach, auditors report failing to involve a specialist to pro-
vide input on the method or assumptions contained in the estimate. One manager (M8)
explained that auditors “follow the planned approach even though there is a better
approach out there,” indicating an inflexibility or lack of responsiveness to changing con-
ditions that may impair audit quality.
Auditors also have problems evaluating the reasonableness of management’s model
because they often “audit to the client’s numbers rather than framing the problem inde-

pendently” (M2). Auditors focused solely on “the client’s numbers” may not notice
whether management’s method is inappropriate or has changed from the prior year with-
out reason. This issue is exacerbated by auditors’ lack of knowledge about valuation,
which causes them to rely on specialists without gaining their own understanding of the
model being used. Thus, auditors’ lack of knowledge about valuation and understanding
of valuation models continues to cause problems as auditors move past the preliminary
steps in auditing estimates (e.g., identifying significant estimates and understanding man-
agement’s method) into testing management’s process, likely increasing management’s abil-
ity to influence audit judgments.
Problems related to testing the underlying data used to prepare the estimate include
auditors overlooking the possibility that the data underlying the estimate is incomplete or
inaccurate. A partner (P7) characterized this problem as “taking management’s word with-
out validating sources,” and he attributed this problem to a failure to execute tests of con-
trols rather than a failure to realize testing was necessary, as well as to overreliance on
management.
Auditors described several problems evaluating the assumptions that underlie estimates.
Auditors often lack knowledge or experience with the finance methodology that forms the
basis for discount rates and other elements of models, and this makes it difficult to ask
appropriate follow-up questions to challenge assumptions and causes auditors to rely on
surface level analysis that may not make sense when considered more carefully. A partner
(P4) noted that auditing assumptions requires “directly challenging management’s assump-
tions,” and a manager (M4) observed a reluctance to do so because of the perception that
the “client knows their situation best and therefore has [the] best information about
assumptions.” Collectively, auditors’ descriptions of problems with evaluating assumptions
suggest that auditors’ lack of knowledge or experience with valuation models contributes to
these problems and makes it easy for management to influence their judgments.
Problems with considering whether relevant factors or assumptions are missing from
the estimate include failing to make use of relevant external benchmarks and failing to
evaluate inconsistencies between the estimate or underlying assumptions and implications
of the current economic environment. These failures occur because auditors do not always
understand how industry or economic information affects the company.
Finally, auditors have problems with evaluating whether the estimate is reasonable,
given the evidence collected and the pattern of information in the rest of the financial
statements. Auditors reported having trouble seeing the big picture that surrounds the esti-
mate, which can cause them to fail to realize how negative evidence collected during the
audit impacts the estimate. They indicated that taking a step back to see the big picture at
this stage helps them to avoid these problems, and a partner (P11) pointed out that
because “connecting the dots is difficult” auditors “need smarts” to be able to do this.
Auditors’ descriptions focus mainly on detecting bias in management’s estimates, high-
lighting the importance of auditors having the “smarts” to succeed in this step and avoid
undue management influence.
Our interviewees also reported some general problems with documentation that likely
affect multiple steps in the process of auditing estimates. In addition to concerns about the
sufficiency of audit documentation, auditors also expressed concerns about achieving
proper allocation of time between documenting audit work and other tasks. Their descrip-
tions suggest that auditors perceive a conflict between completing a good audit and com-
pleting good audit documentation.
Interviewees also reported some general problems related to auditor and client exper-
tise. Some problems stem from client issues such as lack of management expertise in gen-
erating estimates, and others relate to auditor inexperience with complex accounts or lack
of knowledge of relevant accounting rules related to auditing estimates. This suggests that

auditor knowledge and expertise are critical for proper performance of many steps of the
process of auditing estimates, from understanding management’s model to understanding
the evidence collected when testing management’s process to ultimately concluding
whether the estimate is materially misstated.
Finally, auditors noted that either relying too heavily on a specialist’s analysis or fail-
ing to involve a specialist can result in auditors failing to obtain an understanding of man-
agement’s method or model. Third-party specialists are sometimes reluctant to disclose
their proprietary models, and this can prevent the auditor from getting an understanding
of models. In general, when specialists are required, coordination issues that limit access
to specialists and dependence on specialists to understand the models prevent auditors
from gaining a sufficient understanding of the models to effectively evaluate the audit
work around estimates.
The problems auditors identified were largely focused on auditing management’s pro-
cess for preparing the estimate. Twenty-one (87.5 percent) of our interviewees (not tabu-
lated) described one or more problems with this approach, while only one auditor (4.2
percent) described a problem with each of the other two approaches (preparing indepen-
dent estimates and using subsequent events data to evaluate estimates). The relative infre-
quency of problems cited with independent estimates and use of subsequent events data
likely reflects the fact that these audit approaches are not used much.
In sum, the interviews indicate that auditors experience problems throughout the pro-
cess of auditing estimates. In addition to problems with auditing management’s process,
auditors noted problems with identifying significant estimates and choosing which audit
approach to take in the early stages of the audit and with evaluating the reasonableness of
the estimate at the end of the process. It is clear that auditors believe that the problems
primarily occur in the steps that require the most judgment to complete: understanding
management’s method or model; evaluating the reasonableness of the model used; evaluat-
ing the appropriateness of the assumptions used in the model; and evaluating the reason-
ableness of the estimate. Auditors seem to struggle in the final stages of auditing estimates
because they must consider two types of information not contained within the estimate or
model itself—external information about economic and industry conditions and informa-
tion about other aspects of the audit that may be inconsistent with the estimate or may
otherwise indicate potential problems with the estimate. It is also notable that auditors
attribute problems in several steps (understanding the model, evaluating whether the
model is reasonable, evaluating assumptions, considering whether relevant factors are
missing, evaluating the reasonableness of the estimate in light of other audit evidence, and
generating independent expectations), either directly or indirectly, to auditors’ lack of rele-
vant knowledge or expertise.
A key insight from the interviews is that the steps in auditing estimates are interre-
lated such that problems at one stage often cascade to affect other steps. As a manager
(M1) explained, “missing the dependencies at the beginning will make everything they do
wrong.” That is, a failure to understand management’s model often implies the auditor
doesn’t understand the significance of a particular assumption or the sensitivity of the esti-
mate to changes in that assumption. This makes evaluating the appropriateness of the
assumption and evaluating the reasonableness of the estimate difficult.
Problems identified by the PCAOB

In the previous section, we report the problems auditors identify as commonly occurring
on audits of complex estimates. In this section, we report the problems the PCAOB identi-
fies as commonly occurring on audits of complex estimates and examine whether and how
the PCAOB affects the audit of estimates. The PCAOB, as both standard setter and enfor-
cer of standards (through inspections), has two means of exerting coercive pressure for

change and/or continuity in audit practice. This coercive pressure has the potential to dis-
rupt the methods used to audit estimates, which could improve practices surrounding these
accounts and reduce the persistence of the identified problems. However, the PCAOB has
yet to issue any standards changing how complex estimates should be audited, so they
have not provided a regulatory jolt that would apply pressure to change institutionalized
practices through standard setting to date.15 Consequently, any pressure from the PCAOB
for changes to audit practice related to estimates currently must come from the inspection
process. Inspections have the potential to provide pressure to change audit practice if the
inspections reveal problems with the audits and the PCAOB identifies remedies to those
problems that are presented as more appropriate than existing practice.
We examine PCAOB inspection reports to evaluate whether they exert pressure for
change or continuity in the audit of complex estimates. The public portion of inspection
reports provides information to firms about how and how well other firms audit esti-
mates. We analyze the public portion of PCAOB inspection reports along three dimen-
sions: the extent to which accounts containing estimates are identified as problematic,
what accounting and auditing issues are associated with these accounts, and in which
steps in the process of auditing estimates deficiencies occur.16 We also analyze the private
portions of the three inspection reports that were released when firms failed to satisfacto-
rily address quality control criticisms within one year of the initial release of the inspec-
tion reports in our sample.17 We examine these reports for additional evidence about
whether the PCAOB exerts pressure for continuity or change in practice through the pri-
vate portions of the inspection reports. It may be that the PCAOB uses the private com-
ments to suggest remedies to problems identified in the public comments. This analysis
provides insight for our theoretical analysis of current audit practices for auditing esti-
mates (Section 6). It also allows us to corroborate interviewees’ descriptions of problems
encountered when auditing estimates and to provide additional insight into those
problems.
The PCAOB takes a risk-based approach when selecting the audits to be inspected
by choosing audits that they believe have higher risk of material misstatement (PCAOB
2008). They further choose the areas of these audits they view as likely to pose the
biggest accounting, auditing, or compliance challenges (Olson 2008). Thus, while inspec-
tion reports are not representative of all deficiencies that might exist on audit engage-
15. In 2012, the PCAOB added “Accounting estimates including fair value measurements and related disclo-
sures” to its list of other active standard-setting topics. On September 30, 2013 the PCAOB announced
that it is drafting a proposed standard, however, no timeline has been announced for its release (PCAOB
2013c).
16. We analyzed the 2008 and 2009 inspection reports of the annually inspected audit firms. In 2008, there
were ten annually inspected firms: BDO Seidman, Crowe Horwath, Deloitte, Ernst & Young, Grant
Thornton, KPMG, KPMG Canada, Malone and Bailey, McGladrey and Pullen, and PricewaterhouseCo-
opers. In 2009, there were only eight annually inspected firms, as KPMG Canada and Malone and Bailey
did not require annual inspection. Church and Shefchik (2012) examine the content of inspection reports
for annually inspected firms for an overlapping period (2004–2009); however, their analysis does not focus
on audits of estimates. They report more generally on the severity of deficiencies identified, whether the
deficiencies resulted in misstatement, the frequency of deficiencies, accounts affected over time, and audit
firm responses to inspection reports.
17. PCAOB inspection reports contain public (Part I) and private (Part II) portions. Part I contains a listing
of audit deficiencies discovered during inspection and is the source of our analysis reported in Tables 4, 5,
and 6. Part II typically relates to issues with the firms’ quality control systems. The PCAOB initially
releases this portion of the report only to the inspected firm and these comments remain private if the firm
addresses them to the PCAOB’s satisfaction within one year. If a firm fails to satisfactorily address any of
these comments within one year, the PCAOB publicly releases the portions of the report discussing the un-
remediated criticisms; any criticisms that have been satisfactorily addressed are redacted before release.
The PCAOB released three Part II reports for the annually inspected firms in our sample time period
(PCAOB 2012a; PCAOB 2013a, b).

ments, they do provide evidence about the types of problems auditors have when
auditing material, higher risk areas (which the following analysis shows frequently
include estimates). This directed search for problems related to material and higher-risk
areas is indicative of one way in which the PCAOB could exert pressure on audit
firms, although it is unclear ex ante whether this pressure is for change or continuity
in the audit process.
Two authors independently coded the content of the public portion of the inspection
reports. For each issuer listed in each audit firm’s report, we identified the financial state-
ment account group(s) with auditing deficiencies. When disclosed, we also collected the
general accounting or auditing issue for the account. Finally, we coded the auditing defi-
ciency(ies) based on the inspection report descriptions.18 This coding was necessary
because the PCAOB did not identify the auditing standards to which the deficiencies
related at the time these inspections were performed. We developed a coding scheme
describing 15 unique auditing deficiencies.19 The first seven deficiency types in the coding
scheme identify problems with how auditors use valuation or other models that underlie
estimates (i.e., problems within the process of auditing estimates outlined in Figure 1).
The remaining eight categories are not specifically related to use of models. The coders’
initial agreement was 71.9 percent; Cohen’s j was 0.68 (p < 0.01). Coders mutually agreed
on the final category codes, which are used in the analysis.
Table 4, panel A summarizes the types of auditing deficiencies the inspectors identified
related to the audit of estimates and their frequencies. Inspectors identified a total of 331
deficiencies of which at least 227 (68.6 percent) are related to the audit of estimates.20
The PCAOB noted problems with nearly every step that standards describe in the process
of auditing estimates, including considering whether relevant factors are excluded from the
model, the step that our interviewees did not indicate they performed. The exception is
that the PCAOB made no mention of problems specifically related to preparation of inde-
pendent estimates or review of subsequent events, which we expect occurred because firms
do not use these approaches very frequently.21
Table 5 summarizes the accounts with PCAOB-identified auditing deficiencies. The
PCAOB identified 168 accounts with deficiencies, with 99 (58.9 percent) of these related
to four particularly judgment-laden accounts: revenue, investments and securities, good-
will, and allowance for loan losses. Several other accounts with deficiencies similarly
require significant judgment to audit, and many contain estimates (e.g., intangibles,
income taxes, accounts receivable, derivatives, and long-lived assets). The high fre-
quency of deficiencies related to complex accounts requiring significant judgment or
estimation makes this analysis useful for our purpose, and the types of accounts with
18. Each account group could have multiple deficiencies. For example, in BDO Seidman’s 2009 inspection
report, the PCAOB identified eight issuers with auditing deficiencies. For Issuer A, the PCAOB identified
four account groups with deficiencies (i.e., fixed-maturity securities, available-for-sale investments, claims
losses, and revenue). The accounting and auditing issues for this issuer included fair value, impairment,
estimation, and meeting audit objectives, respectively, for the above-identified accounts. Finally, the
PCAOB identified two auditing deficiencies for the fixed-maturity securities: relying on controls without
testing their effectiveness and failure to test data used in valuation models (PCAOB 2010a).
19. Please see supporting information, “Appendix S2: Categories Used to Code Inspection Report Deficien-
cies” as an addition to the online article.
20. The inspectors also noted 104 other deficiencies, some of which are clearly not related to audits of esti-
mates (e.g., problems with analytical procedures and confirmations), and others may or may not relate to
estimates (e.g., failure to collect sufficient evidence).
21. The PCAOB is charged with inspecting whether auditors comply with auditing standards. Since the stan-
dards allow auditors to choose one or more of three approaches and make no mention of when one is
preferable, the PCAOB would be unlikely to cite deficiencies about approaches not used if an approved
approach is used. Instead, PCAOB deficiencies focus on how the audit work performed falls short of stan-
dards for the approach the auditors chose.

TABLE 5
Accounts with PCAOB-identified deficiencies
Account Number Percentage
Revenue 32 19.0
Investments and securities 31 18.5
Goodwill 19 11.3
Allowance for loan losses 17 10.1
Pension plan assets 12 7.1
Inventory 7 4.2
Intangibles 7 4.2
Income tax accounting 6 3.6
Accounts receivable 4 2.4
Contingent liability 4 2.4
Derivatives 3 1.8
Long-lived assets 3 1.8
Assets 2 1.2
Controls 2 1.2
Going concern 2 1.2
Other 17 10.1
Total 168 100.0
TABLE 6
Accounting issues for accounts with PCAOB-identified deficiencies
Accounting issue Number Percentage
Fair value 41 31.5

Impairment 30 23.1
Estimation 17 13.1
Revenue recognition and measurement 9 6.9
Existence 6 4.6
Valuation 5 3.8
Completeness, existence, and accuracy 4 3.1
Existence and valuation 4 3.1
Classification 3 2.3
Existence and accuracy 3 2.3
Other issues 8 6.2
Total 130 100.0
Note:
The PCAOB did not identify the accounting or auditing issue for the remaining 38 accounts with
deficiencies.
deficiencies overlap considerably with the types of estimates interviewees discussed (as
shown in Table 1).
Table 6 summarizes the accounting and auditing issues that the PCAOB identified as
related to the deficiencies. The table reveals that fair value, impairments, and estimation
accounted for 88 of 130 (67.7 percent) issues identified. This indicates that the deficiencies
identified by the PCAOB related to more subjective accounting.

Comparison of auditor-identified and PCAOB-identified problems

In panel A of Table 4, we also analyze the extent to which the estimates-related defi-
ciencies corroborate our understanding of the problems the auditors noted by ranking
the respective frequencies of problems cited by each source. We note that the PCAOB
identified auditing deficiencies, but stopped short of suggesting how auditors could have
prevented the deficiency from occurring or recurring in the future. We did not identify
any suggestions from the PCAOB for different audit methods that would have been
more appropriate in the circumstances. Thus, we conclude that the only pressure the
PCAOB applies in the public portion of the inspection reports is to properly execute
the chosen course of audit action; that is, the PCAOB’s pressure is for continuity of
practice rather than for a change in approach. The PCAOB reported deficiencies
related to six steps identified in the estimates standards and one step not identified in
these standards. In contrast, the auditors reported problems in each of these seven
steps plus problems in four other steps related to engagement management. The latter
are not comparable with PCAOB-identified deficiencies because PCAOB inspections
identify specific failures rather than general problems related to engagement manage-
ment. The general problems identified by auditors are reported in panel B of Table 4.
When we compare the problems noted by the inspectors and the auditors we see that
both groups cited problems with evaluating the appropriateness of assumptions most fre-
quently. Additionally, the seven steps with PCAOB-identified deficiencies also are rated in
the auditors’ top six problem categories (accounting for ties). These include problems with
evaluating assumptions, understanding the client method/model, testing the data used in
the model, testing controls over the estimation process, considering external evidence,
identifying accounts containing estimates, and evaluating the client method/model. Thus,
we conclude that the auditors have accurate views of the problems they experience when
auditing complex estimates.
Next, we examine the quality control issues identified when the PCAOB released Part
II of the inspection reports for firms that did not make sufficient progress remediating these
issues. The three reports each identified categories of deficiencies that were reiterated from
Part I of the initial inspection report. Interestingly, of the three deficiency categories identi-
fied, most were related to the audit of complex estimates: auditing estimates (three reports),
auditing fair value measurements (two reports), and performing the integrated audit (one
report). In all three reports, these discussions reiterated deficiencies from Part I and also ref-
erenced deficiencies on issuers that had not been publicly released in Part I of the report.22
These deficiencies were summarized by topic, rather than by issuer, so it appears the
PCAOB uses this portion of the Part II report to summarize themes underlying the deficien-
cies identified. We note that none of these discussions contained any suggestions for use of
alternative methods. Rather, the implication, often unstated, was that the audit firms
should increase the quality of execution of the tests that were planned. As such, this section
of the Part II report also does not pressure the firms to change their method for conducting
audits; instead, any pressure is for continuity of practice with better execution. This is likely
because the PCAOB is charged with inspecting firms to determine the degree of compliance
with PCAOB auditing standards and rules (i.e., Rule 4000 [PCAOB 2003c]). Consequently,
the PCAOB has limited options for suggesting alternative methods in the inspection process
if the work performed follows a PCAOB-approved process.
Two of the reports also contained sections on additional quality control concerns in
which the PCAOB listed concerns with audit supervision and review (two firms), profes-
sional skepticism (two firms), and risk of material misstatement as a result of fraud (one
22. The PCAOB describes in Part I only deficiencies that it believes show evidence that the inspected audit
firm had not obtained sufficient competent evidence to support its audit opinion(s) (PCAOB 2013b).

firm). Notably, the first two concerns were each related to auditing fair values and esti-
mates.23 The comments related the previously identified deficiencies to a lack of supervi-
sion and review. One report stated:
The reported deficiencies raise questions regarding the sufficiency, rigor, and efficacy of
the supervision and review activities of the Firm’s engagement managers, engagement
partners, and SEC concurring review partners, including their exercise of due care and
the thoroughness with which they review work papers. The inspection observations sug-
gest the possibility that more attention needs to be devoted to supervision and review
activities in connection with audit of areas involving a high degree of judgment, manage-
ment estimation ****. (PCAOB 2013a, 13).24
Another report focused on a lack of skepticism related to fair values:
In other instances, engagement teams failed to evaluate certain management assump-

tions or assertions that were used in the fair value estimates but were contrary to histori-
cal results or other evidence contained in the work papers. The deficiencies identified by
the inspection team suggest that engagement teams may be placing too much reliance on
management’s responses to the teams’ inquiries and not sufficiently challenging or evalu-
ating management’s assumptions, and that they may not be applying an appropriate
level of professional skepticism in subjective areas susceptible to management bias.
(PCAOB 2013b, 13)
In our view, these comments do not apply pressure for audit firms to change the
methods used to evaluate fair values and other complex estimates. Rather, these comments
encourage the firms to improve the efficacy of their existing procedures.25 To the extent
that root causes of the problems reside in the method, and a change in method is needed
to resolve problems, this approach will be unsuccessful. In that case, the PCAOB’s inspec-
tions focusing on estimates provide an illustration of how standard setters’ attempts to
influence audit practice can be ineffective (Malsch and Gendron 2011).
Overall, this evidence suggests that the PCAOB inspection process does not yield pres-
sure for change in approach or choice of procedures used on audits. While the PCAOB
appears to specify the problems it finds with the audits of complex estimates, it falls short
of theorizing the problems, in that it does not identify a change that would clearly be
more appropriate than current practices. Rather, its focus seems to be on identifying
weaknesses in the execution of chosen methods. Thus, the implication of the inspection
comments is that the problems are with the execution rather than the choice of methods.
This sort of feedback is unlikely to prompt the audit firms to conclude that a change in
method is required or to deduce what type of change would be effective. Given the
23. Of course, we cannot determine from the released portions of Part II of the inspection reports if the
redacted issues were satisfactorily addressed because the PCAOB made specific suggestions for change that
the firms were able to implement within one year. It could be that for less complex issues, the PCAOB
makes specific suggestions for improvement that are a source of pressure for change in practices. We can-
not know the content of the redacted portions of the Part II reports as the PCAOB is prohibited by law
from discussing their contents. However, our examination of these reports indicates that for complex
issues, such as auditing complex estimates, the PCAOB does not pressure the firms to change the nature
of their planned procedures. Instead, it appears they pressure the firms to increase the sufficiency and
extent of their planned procedures, effectively creating pressure for continuity in current practices.
24. **** indicates material that was redacted from the release of Part II of the report.
25. There was one comment in the three reports that we viewed as suggesting a specific change, however, it
was not clearly related to the audit of estimates. Rather, it concerned three partners’ workloads, and the
consequences for their effectiveness (PCAOB 2013b).

PCAOB’s mandate to inspect firms to determine whether they have complied with auditing
standards, it seems that the primary way that the PCAOB could pressure firms for
changes in practice is through changes in auditing standards.
6. Root causes of problems in audits of estimates and institutional reinforcement

Accounting estimates are difficult to audit because auditors must assess the reasonableness
of estimates, rather than merely verify their accuracy. The auditors we interviewed identi-
fied a number of problems their teams experience when auditing estimates, and these are
corroborated by our analysis of PCAOB inspection reports. We view these problems as
arising from two root causes, both of which can be viewed as institutionalized conventions
in the audit industry: (i) audit firms and standards overemphasize verifying aspects of
management’s model rather than critically evaluating the reasonableness of the estimate,
and (ii) audit firms divide audit and valuation knowledge such that auditors tend to lack
the knowledge they need to be effective at auditing estimates. In this section we first briefly
summarize our evidence for these root causes and tie them into Bratten et al.’s (2013)
framework of factors affecting the audits of fair values and other estimates. We then
employ institutional theory to explain why these conventions arose and persist, despite
being problematic for audit quality.
Regarding the first convention, our interviews reveal that auditors tend to use a verifi-
cation framework to audit management’s process for creating estimates, despite known
problems with this approach. While auditing standards allow a variety of approaches,
auditors overwhelmingly focus on testing management’s process rather than developing
independent estimates or relying on subsequent events. Moreover, while there is some
diversity in the reported types of work performed in testing management’s process, and
while we cannot be sure that auditors reported everything they would do on an engage-
ment, auditors report performing, on average, only 1.8 of the 5 steps recommended for
this audit approach. The steps they tend to focus on include evaluating the appropriate-
ness of management’s assumptions and testing the data used in the model rather than
evaluating whether factors and assumptions not considered by the model should be incor-
porated, and the language they use to describe their approach confirms this view.
This task framing causes auditors to accept management’s premise (or model) and
proceed to testing the individual pieces of the model, making it more difficult to notice
and process inconsistencies and to identify useful external evidence not incorporated by
management. Testing management’s model may be necessary when external data does not
exist that can be used to prepare an independent expectation, as when assets have not
traded. However, using a verification task framing as the default approach thwarts audi-
tors’ good-faith attempts to exercise skepticism. For example, several auditors note that
they use external benchmarks to evaluate management’s assumptions, but say they have
difficulty identifying when a difference signals a misstatement or that they overestimate the
level of support for management’s assumptions. The verification approach makes auditors
more likely to overlook or justify conflicting evidence and more likely to be led “down the
garden path” to management’s number.
The second problematic convention that we identified is that audit firms have created
a division of knowledge such that auditors are responsible for knowing how to audit com-
plex estimates, yet they have delegated the knowledge of how to value complex estimates
to valuation specialists. Further, fairly inexperienced auditors do the bulk of the work in
auditing estimates. This implies that auditors often lack the knowledge of accounting,
auditing, and especially valuation that is necessary to audit estimates (see also Martin
et al. 2006 and Smith-Lacroix, Durocher, and Gendron 2012).
Lack of knowledge likely underlies auditors’ difficulties with understanding manage-
ment’s and specialists’ models and coordinating work with specialists. As we previously

noted, knowledge problems cascade because a lack of understanding of a model implies a

lack of knowledge about which assumptions are critical (i.e., where the risks are), how to
validate those assumptions, and so forth, with the ultimate result of overreliance on man-
agement’s assertions. Moreover, auditors’ lack of knowledge and the attendant lack of
confidence in their own ability to generate reasonable estimates or even assumptions
makes auditors unsure of what questions to ask and reluctant to challenge management’s
estimates. This professional insecurity (e.g., Gendron and Suddaby 2004) likely makes
them more vulnerable to overreliance on management.
Our analysis supports the inclusion of professional skepticism and valuation knowl-
edge as key auditor-specific factors that can influence audits of estimates in Bratten et al.’s
(2013) framework. It also highlights the importance of considering how those factors
interact with task and environmental factors to influence audit quality. In particular, we
view inadequate valuation knowledge as having direct and indirect effects on audit quality
in audits of estimates. As we noted, it would be difficult to perform a high-quality audit
of an estimate without an understanding of how the estimate is developed, which assump-
tions are critical, and how changes in assumptions influence the estimate, even with the
help of a valuation specialist. As Bratten et al. (2013) note, valuation knowledge becomes
even more critical as task difficulty and estimation uncertainty increase.
On the other hand, the evidence we have collected about professional skepticism lar-
gely supports indirect effects. While individual auditors’ professional skepticism is clearly
needed for high audit quality around audits of estimates, we find that, given how audit
firms and standards frame the task of auditing estimates, it would be difficult for auditors
to engage in skeptical behaviors. That is, auditing standards, the inspection process, and
firms’ policies encourage auditors to frame the task of auditing estimates as one of finding
evidence in support of various aspects of management’s model (i.e., verification). Framing
the task as verification likely limits auditors’ ability to notice and incorporate conflicting
evidence, implying that even otherwise skeptical auditors may not be able to behave skep-
tically in this context. Thus, while we view professional skepticism as an important factor
in this context, we also view its failure as arising largely from task factors, which are dri-
ven by institutional pressures, as described below.
Institutional theory suggests several reasons that auditors tend to verify manage-
ment’s process for creating complex estimates rather than using one of the other allow-
able methods. First, while accounts containing complex estimates have grown in relation
to companies’ total assets over the last two decades (Barth 2006), auditing standards
regarding these accounts have not changed substantively since they were written in
1988. This lack of guidance about how auditors should address the changing circum-
stances left a vacuum to be filled. In such cases, institutional theory proposes that firms
will be guided by legitimated practices, even if these practices are not optimal for the
given task (Zucker 1987). Testing management’s process for developing complex esti-
mates likely is considered legitimate because the guidance that is available to auditors
in AU 328 and AU 342 largely focuses on this method. Recall that while auditing stan-
dards allow the use of three approaches, AU 342, for example, contains 14 paragraphs
of guidance on how to test management’s process and only three paragraphs combined
for the other two methods. Thus, testing management’s process is likely to be viewed as
the most “legitimated” method in part because it is clearer from the auditing standards
what must be done. That is, there are specific steps or procedures suggested for testing
management’s process but not for generating an independent expectation. Further, as
noted in the previous section, the PCAOB provides no feedback in inspection reports
that suggests alternative, superior methods for auditing estimates. Thus, the pressure
applied by the PCAOB appears to be for better execution while continuing current
audit approaches.

Second, institutional theory proposes that one way that organizations legitimize the
procedures for a new situation is by adapting the procedures they already use in other
situations, even if these procedures are not the best fit for the new situation (Zucker
1987). We find that auditors have adapted both the method and the structural approach
used to audit accounts without uncertainty to the audit of complex estimates. Nonesti-
mated accounts generally follow historical cost accounting and are audited by verifying
original costs. We find that firms adopted this verification approach when auditing com-
plex estimates even though verification is less appropriate for accounts whose valuation
involves uncertainty. Additionally, audit firms adapted the highly structured and rou-
tinely used method of breaking the audit into a series of compartmentalized steps to
the audit of complex estimates. This checklist-like approach easily accommodates verify-
ing discrete components of management’s estimates, but does not accommodate the
complexity of a more integrated process. By using this approach, firms create the illu-
sion that the audit program steps are unrelated; thus, interdependencies among the steps
are overlooked, preventing a more holistic, critical evaluation of the estimate. The per-
ceived legitimacy of existing verification methods for auditing nonestimated accounts
leads to framing audits of complex estimates as piecemeal verification tasks rather than
as critical evaluation tasks.
Finally, institutional theory proposes that procedures propagate across organizations
via mimetic isomorphism, a process of copying the policies and procedures of other orga-
nizations in an environment. This process makes the organizations more similar without
necessarily improving their efficiency or effectiveness (DiMaggio and Powell 1983). As we
demonstrate in our analysis of PCAOB inspection reports, audits of accounts containing
complex estimates are especially likely to be inspected. Further, inspection reports reveal
that inspection deficiencies are largely focused on problems with auditing management’s
process for creating estimates. Thus, the PCAOB’s inspection reports facilitate mimetic
isomorphism by signaling that this method is commonly used. Additionally, since the
PCAOB’s inspection reports identify problems with auditing management’s process but do
not suggest solutions to these problems, change that might result from coercive isomor-
phism is impeded. In fact, the lack of suggestion to use alternative methods implies tacit
agreement with, and increases the legitimacy of, the choice to audit management’s process.
Thus, despite a goal of improving audit quality, the inspection process may facilitate the
spread of suboptimal methods for auditing complex estimates, consistent with the proposi-
tions of institutional theory.
Institutional theory also explains the convention that has arisen surrounding the divi-
sion of knowledge between auditors and valuation specialists. Power (1996) argues that
auditors have long promoted the value of auditing knowledge over other types of knowl-
edge as a way of advancing the field. Power (2003) explains that the knowledge base of
auditing must be legitimated in the same way that procedures become accepted, so the cri-
teria to be considered a qualified auditing expert are a function of this legitimating pro-
cess. This suggests that auditors will model knowledge acquisition on practices followed in
other processes within their organizations and on those followed by other organizations
within their environment. Thus, auditors created a division of knowledge such that they
take responsibility for understanding how to obtain evidence about the accounting-related
elements of estimates and they delegate knowledge of and evidence gathering about valua-
tion-related elements of estimates to valuation specialists.
That said, it is clear that expert knowledge of valuation is required in order for com-
plex estimates to be auditable. If the measurement of complex estimates were viewed as
beyond the limits of expertise, complex estimates, and, by extension, financial statements
incorporating large estimated amounts, would not be auditable (e.g., Power 1996). Rather
than have auditors build valuation expertise themselves, audit firms choose to endorse and

rely upon the expertise of valuation specialists. That is, our interviewees describe the audit
team as being composed largely of auditors without deep or well-developed knowledge
about the models used to develop complex estimates, with expertise coming from special-
ists. This division of knowledge makes it difficult for auditors to understand the signifi-
cance of assumptions and the sensitivity of estimate values to changes in assumptions.
However, each of the firms interviewed follows this institutionalized convention, evidence
of mimetic isomorphism. Thus, audit firms have made complex estimates auditable by
relying on others (valuation specialists) who have the knowledge needed to evaluate these
accounts and by adapting their judgment frameworks and checklist-like audit programs to
this environment, consistent with institutional theory.
7. Conclusions and implications for research

Our findings indicate that the problems auditors experience with auditing estimates arise
from two root causes: (i) audit firms and standards tacitly approve a verification process
for auditing estimates, and (ii) audit firms divide knowledge between auditors and special-
ists such that auditors tend to lack the knowledge they need to be effective at auditing esti-
mates. These ideas advance the literature by providing insight into how and where, in the
process of auditing estimates, management’s influence might occur and why management’s
influence may be successful. That is, auditors’ framing of the task as verification, especially
when combined with an incomplete knowledge of valuation methods and procedures, nat-
urally results in auditors overrelying on management’s assertions, collecting too little evi-
dence overall and too much of it from management. In auditors’ own words, it could also
result in them overinterpreting the consistency of evidence with management’s assertions.
Our analysis has important implications for future research aimed at improving auditor
decision making. First, because these root causes are conventions that arise at the institu-
tional level, they suggest that an individual auditor will find it difficult to overcome this over-
reliance on management in the current environment. That is, an individual auditor who has
limited knowledge of valuation and who is tasked with following a set of verification steps is
unlikely to be able to perform a high-quality audit of a complex estimate. Thus, an impor-
tant insight from our analysis is that structural changes (i.e., changes in the process or
approach) are likely the most effective means of improving audit quality for estimates.
Related to this, we note that Bratten et al. (2013), in their analysis of prior research
on audits of estimates, indicate that regulators and others may place too much weight on
auditor-specific characteristics, including professional skepticism, in explaining low-quality
audits of estimates. We agree. However, while Bratten et al. (2013) implicate increasing
volatility in the environment and increasing task complexity, our broader analysis identi-
fies institutions’ responses to these increasing task and environmental demands as a key
causal agent of low audit quality. Both Bratten et al.’s (2013) and our work indicate that
research that examines how to identify more or less skeptical auditors and how to change
individual auditors’ level of skepticism may have limited success in improving audits of
estimates unless environmental and task conditions allow skepticism to operate.
Second, our analysis indicates that audit firms will be reluctant to change their
approach to this task. While we show that auditors are aware of the problems surround-
ing the audits of estimates, auditors and their firms are accountable to the PCAOB for
complying with auditing standards. Thus, it is likely that in the absence of a regulatory
jolt in the form of new standards or effective coercive pressure from the inspection process
that identifies a superior approach to auditing estimates, auditors will continue to strive to
improve performance on this task using current methods rather than adopting new meth-
ods to audit estimates.
Future research might generate positive change by more fully theorizing the prob-
lem and new practices, thus providing a viable alternative to current practice. That is,

research might focus on developing new audit methodologies that (i) rely less on man-
agement representations and/or (ii) employ integrated audit processes rather than com-
partmentalized verification steps, thereby addressing the root causes of current
problems. Current standards allow auditors to generate independent estimates, and this
would seem to meet both criteria. However, the International Auditing and Assurance
Standards Board (IAASB) appears to endorse an approach focused on testing manage-
ment’s process and data in its recently issued practice note on auditing financial instru-
ments (IFAC 2011, ¶114). Apparently because of cost (efficiency) concerns, they
characterize developing an independent estimate as a last resort. Because auditors cur-
rently do not tend to generate independent estimates very frequently, it is an open
question as to whether doing so would increase the reliability of estimates. We encour-
age future researchers to examine more fully the costs and benefits of developing inde-
pendent estimates, including whether there are predictable conditions under which the
benefits exceed the costs and whether and how technology can reduce the costs and
simplify the task of generating independent estimates.
Research could examine the effectiveness of alternative means by which firms could re-
frame the auditor’s task as critically evaluating the reasonableness of the overall estimate
rather than verifying the individual elements of management’s model or process. For
example, when modeling an estimate is overly complex and subsequent data are not infor-
mative, auditors may be able to take additional steps, such as explicitly considering what
features the model should have and what parameter values are reasonable before viewing
management’s model to avoid anchoring on management’s model and estimate.
Future research could also examine how auditors resolve problems that arise during
audits of estimates, especially contradictions among assumptions used to generate esti-
mates. A detailed examination of this resolution process, relying on in-depth interviews of
auditors, could enhance our understanding of how and under what conditions bias
remains in audited complex estimates. Finally, research using the theoretical insights of
institutional theory (e.g., the notion of institutional work [Lawrence, Suddaby, and Leca
2009]) could enhance our understanding of how other important auditing practices are cre-
ated, maintained, and modified.
In conclusion, we note that the auditors we spoke with were very forthcoming about
problems they experience in auditing estimates. It appears that auditors (and audit firms)
are well aware that they experience serious problems auditing estimates. This leads to
some interesting questions about the institution of auditing: Why do these problems per-
sist, given they are so well known? How do auditors gain sufficient comfort to sign off on
financial statements containing complex estimates, given their awareness of the shortcom-
ings in their own process? To what extent does problem persistence influence auditor per-
formance in other types of tasks? Our analysis provides some initial answers to these
questions, but they warrant future research, as does the question of whether complex esti-
mates are truly auditable, and, if not, whether audit technology to make them so can be
developed in the near term.
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SUPPORTING INFORMATION
Additional Supporting Information may be found in the online version of this article:
Appendix S1. Details of Auditors’ Process and Problems when Auditing Complex Esti-
mates
Appendix S2. Categories Used to Code Inspection Report Deficiencies

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Audits of Complex Estimates as Veriﬁcation of Management

Numbers: How Institutional Pressures Shape Practice*

EMILY E. GRIFFITH, University of Wisconsin – Madison

JACQUELINE S. HAMMERSLEY, University of Georgia

KATHRYN KADOUS, Emory University

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2. Institutional theory and audit practice

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Years of Technical consultation

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Auditors’ process of auditing estimates

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Panel A: Steps included in standards-based model

Identify accounts/areas with signiﬁcant estimates 21 100.0

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Panel A: Steps included in standards-based model

Consider whether relevant factors or assumptions are missing

Panel B: Steps not included in standards-based model

Evaluate reasonableness of management model used 4 19.0

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Test management’s process:

Formulate independent expectation

Review subsequent events

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Auditor rank and the process of auditing estimates

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Primary preparers identiﬁed by interviewees*,†

Step Staﬀ Senior Manager Partner Specialist Team

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Panel A: Problems with steps in the process of auditing estimates*

Problems in steps identiﬁed in estimates standard:

Panel B: Problems with the general process of auditing estimates†

Problem area Problems mentioned by auditors Rank

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Problems identified by the PCAOB

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Account Number Percentage

Total 168 100.0

Accounting issue Number Percentage

Fair value 41 31.5

Total 130 100.0

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Comparison of auditor-identified and PCAOB-identified problems

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Another report focused on a lack of skepticism related to fair values:

In other instances, engagement teams failed to evaluate certain management assump-

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6. Root causes of problems in audits of estimates and institutional reinforcement

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noted, knowledge problems cascade because a lack of understanding of a model implies a

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7. Conclusions and implications for research

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