how do look-back analyses and evidence specificity affect ......motivation • complex estimates...

How Do Look-Back Analyses and Evidence Specificity

Affect Auditors’ Planning Judgments?

Ann Backof University of Virginia

Roger MartinUniversity of Virginia

Jane ThayerUniversity of Virginia

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

Motivation• Complex estimates play an increasingly important role in

financial reporting (e.g., Bratten et al. 2013; Lev et al. 2010).

• Audit planning is a crucial step in the completion of an effective audit (Mock and Wright 1993).

• Relatively little is known about the factors that affect auditors’ planning for the audit of complex estimates.

ContributionsCharacteristics of

management-provided evidence

Contributions• Influence of auditors’ ex post review of evidence obtained

and evaluated as part of a prior period audit on the current period audit.

Evidence Specificity

Auditors’ Assessments of the Reliability of Management's

Estimation Process

Consistency of Estimation Inaccuracy with Mangement’s

Incentives

Auditor’s Planning Judgment’s

Contributions• Extend the research examining the auditing of complex

estimates (e.g., Cannon and Bedard 2014; Griffith et al. 2015a, 2015b) by identifying two factors that affect auditors’ planning for the current period audit of complex estimates.

• Complex estimates enhance the relevance of information provided to financial statement users (Lundholm 1999), but management has the ability to opportunistically manage those estimates (Hodder et al. 2006; Dechow et al. 2010).

• The reliability of the information reported in the financial statements hinges on the effectiveness of the audit of these estimates (Griffith et al. 2015a).

Theoretical Model

Specificity of Prior Period Evidence

Management Competence

Management Credibility

Reliability of Management's

Estimation Process

+

+

ManagementTrustworthiness

+

+

Tversky and Kahneman (1994) Sloman et al. (2004)Hamilton (1998)Slater and Rouner (1996)

Estimation Inaccuracy Direction

-

Hypothesis 1

MORE Specific Prior Period

Evidence



+

UNDERstatedPrior Period Assumption


+

+

+

H1:Auditors’ assessments of the reliability of management’s estimation process will be highest when prior period evidence is more specific and the direction of the prior period estimation inaccuracy is a potential understatement of firm book value.

+

Reliability of Management's

Estimation Process

Hypothesis 2

MORE Specific Prior Period

Evidence



Reliability of Management’s

Estimation Process

+

+

OVERstated Prior Period

Assumption


+

+

-

H2:Auditors’ assessments of the reliability of management’s estimation process will be lowest when prior period evidence is more specific and the direction of the prior period estimation inaccuracy is a potential overstatement of firm book value.

PCAOB (2010, 2012)AS No. 14 ¶ 27

Hypothesis 3

Reliability of Management’s

Estimation Process

Risk of Material Misstatement in Current Period

Estimate

Planned Audit Effort

-

+

H3: Lower (higher) reliability assessments of management’s estimation process will lead to higher (lower) risk assessments of material misstatement in the current period estimate and more (less) allocation of planned audit effort.

AS No. 13 ¶ 6

AS No. 13 ¶37

Research Method• 117 audit seniors* from 8 accounting firms

• Planning audit of impairment analysis of trademark• Look-back analysis• Actual year-to-date results for current year

• 2 x 2 between-subjects design• Specificity of prior period evidence• Estimation inaccuracy direction

• Dependent Variables• Reliability of management’s estimation process • ROMM in current period estimation• Likelihood of changing hours allocated for current prior audit

PRIOR YEAR WORKPAPER

KEY ASSUMPTION #2 Revenue Growth Rate Management’s Assumption: 8% annual growth in revenues by location through 2018, 3% thereafter. Management-provided justification for this assumption: When we acquired the Chatsworth Cheddar trademark in 2003, the average revenues (per store) from sales of Chatsworth Cheddar was $21,390. In 2013, the average revenues (per store) from sales of Chatsworth Cheddar was $42,074. We expect revenues (per store) from sales of Chatsworth Cheddar to grow annually at 8% through 2018 and 3% (average inflation rate) thereafter. The 8% growth rate is consistent with the projected average industry growth rate which the company has historically met. We plan to achieve our expected growth by:

• Increasing sales prices – We intend to increase prices in the 3% to 5% range each year, which is

consistent with historical pricing practices of the company and our competitors. Results of recent market research indicate that price increases can be maintained and marketing plans are in place to educate both our distributors and our consumers on the rationale for price increases.

• Increasing customer demand – Brand recognition of Chatsworth Cheddar as a consistent and high quality cheese has led to increased sales volume each year since 2003. Our new marketing campaigns, third party endorsements, and prime retail space are expected to increase awareness of the Chatsworth Cheddar brand in future periods.

CURRENT YEAR LOOK-BACK ANALYSIS

KEY ASSUMPTION #2

Revenue Growth Rate In planning for the audit of the year ending December 31, 2014, you are asked to perform a look-back analysis of the assumptions used to derive the valuation of the trademark as part of the impairment analysis for the year ending December 31, 2013. The estimated fair value as of December 31, 2013 was calculated using a discounted cash flow model based on three key assumptions, including management’s revenue growth rate assumption. Below is a chart showing management’s revenue growth rate assumption used in the 2013 estimate, as well as the actual revenue growth since the prior year estimate was made.

Management’s key

assumption (as of 12/31/2013):

8% annual growth rate through 2018; 3% annual growth rate thereafter

Update since prior year

estimate (as of 8/31/2014):

Revenues per store have grown 9% compared to the same time period in the prior year.

Sensitivity analysis: If a 9% (instead of 8%) growth rate had been used in the prior year estimate, the fair value estimate of the trademark increases to $3.343 million which is $278,000 above the book value. See the attached revised DCF calculation for this computation, as well as the results of the look-back analysis for the estimated fair value as of December 31, 2012 and December 31, 2011.

Additional information gathered as part of look-back analysis:

Conversations with management indicate that actual growth differed from predicted growth due to a few factors. In particular, the projected price increase and new branding of the cheese went into effect sooner than anticipated, positively impacting actual growth. However, management attributes the majority of the difference between expected and actual revenue growth in the current year to a new fermentation process that the company’s main competitor implemented this year on a trial basis…

Updated Original 12/31/2012 12/31/2011

Fair value estimate 3,343$ 3,205$ 3,284$ 3,265$

Book value 3,065 3,065 3,065 3,065

Fair value is in excess of book value 278$ 140$ 219$ 200$

Projected Net Cash Flow ($ in 000s)

2014 2015 2016 2017 2018 2019 20202021 into Pertuity

(1) No. of Stores Selling

Chatsworth Cheddar during the year 77 84 91 98 105 112 119 120(Assumption: 7 new stores each year up to cap of 120 stores)

(2) Projected Average Sales per store 45.86 49.99 54.49 59.39 64.74 66.68 68.68 70.74 (Assumption: Revenue growth of 9% per store through 2018, 3% thereafter)

(3) Projected Royalties 141.25 167.96 198.33 232.81 271.89 298.71 326.90 339.54 (Contractual: 4% of sales)

(4b) Projected Royalties 2021 into Perpetuity:

(4) Projected Net Cash Flow 141.25 167.96 198.33 232.81 271.89 298.71 326.90 4,850.59

(5) Present Value of Projected Net Cash Flows 128.41 138.81 149.01 159.01 168.82 168.62 167.75 2262.84(Assumption: 10% Discount Rate )

141.2488 167.957664 198.3300082 232.8089174 271.8875571 298.713796 326.9049105 4850.593871

Summed Present value of net cash flows 3,343$

(1) No. of Stores Selling Chatsworth Cheddar = No. of Stores in Prior Year + 7. Maximum number of stores = 120.

(2) Projected Average Sales per Store = Average Sales per Store in Prior Year * (1+.09) Years 2014-2018

= Average Sales per Store in Prior Year * (1+.03) Years after 2018

(3) Projected Royalties = [Projected Average Sales per Store for Current Year * 4%] * No. of Stores Selling Chatsworth Cheddar in Current Year Note: Royalties paid are based on a contractual rate of 4% of per store sales of Chatsworth Cheddar.

(4a) Projected Net Cash Flow = Projected Royalties

(4b) Projected Royalties 2021 into Perpetuity {Gordon-Growth Model} = Projected Net Cash Flow in 2021 / (.10 - .03) (5) PV of Projected Net Cash Flows = Projected Net Cash Flows / (1+.10)No. of years to discount

Assumptions:

9% revenue growth through 2018

3% steady growth rate after 2018

4% royalty rate

7 new stores opening each year up to a maximum of 120 stores

10.0% discount rate (WACC)

12/31/2013

Current Year Sensitivity AnalysisManagement-Prepared Impairment Analysis for Chatsworth Cheddar Trademark

(Amounts in 000s)

Understated Overstated

Less Specific

7.37(1.39)n=27

A

7.62(1.18)n=29

B

7.50(1.28)n=56

More specific

7.73(1.19)n=26

C

7.17(1.47)n=29

D

7.43(1.36)n=55

7.55(1.29)n=53

7.40(1.34)n=58

df MS FTwo-tailed

p-value

Big 4 1 12.35 7.61 0.007Specificity 1 0.01 0.01 0.956Direction of Inaccuracy 1 1.11 0.68 0.410Specificity * Direction 1 5.91 3.64 0.059

Auditors’ Assessments of the Reliability of Management’s Estimation Process

H1 supported (F1,106 = 2.28, one-tailed p = 0.067)

H2 supported (F1,106 = 2.68, one-tailed p = 0.052)

Auditors’ Planning Judgments• H3: Lower (higher) reliability assessments of management’s

estimation process will lead to higher (lower) risk assessments of material misstatement in the current period estimate and more (less) allocation of planned audit effort.

• H3: ROMM b = -0.26 one-tailed p = 0.036Effort b = -0.24 one-tailed p = 0.021

H3 supported

Additional AnalysesSpecificity of Prior Period Evidence





Reliability of Management's Estimation Process

ROMM


Interaction

Big 4

0.609(0.041)

0.725(<0.001)

-0.612(0.014)

0.709(<0.001)

0.640(<0.001)

-0.261(0.033)

0.903(0.027)

More Specific





ROMM


Big 4

0.700(<0.001)

-0.762(0.031)

0.629(<0.001)

0.792(0.002)

-0.212(0.096)

1.090(0.065)


Evidence Bias

-0.490(0.060) -0.675

(0.077)

0.104(0.172)

Less Specific





ROMM


Big 4

0.809(<0.001)

-0.587(0.058)

0.726(<0.001)

0.472(0.004)

-0.189(0.136)

0.803(<0.001)


Evidence Bias

0.204(0.252) 0.972

(0.019)

0.452(0.001)

Conclusions• Auditors reviewing more specific evidence when the prior

period estimation inaccuracy is inconsistent (consistent)with management’s incentives provide the highest (lowest) reliability assessments of management’s estimation process.

• These effects then flow through to auditors’ planning judgments, with higher (lower) reliability assessments leading to lower (higher) risk assessments and planned audit effort.

• The way in which the direction of the estimation inaccuracy impacts auditors’ planning judgments (i.e., perceptions of estimation process or evidence bias) depends on the specificity of prior period evidence.

Thank you!

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