PCAOB Chairman James Doty recently announced plans to convene a task force on audits of fair value measurements, as well as plans to change the auditor’s report to provide more useful, relevant, and timely information to users of public company financial statements. The authors hope their commentary is helpful to standard-setters’ deliberations, and the authors believe it should be useful to auditing scholars, both as a supplemental reading in auditing courses and a source of ideas to help guide future research designs on auditor and user judgment and decision making for high uncertainty FVA estimates.

Bell, T. B., and J. B. Griffin. 2012. Commentary on Auditing High-Uncertainty Fair Value Estimates. Auditing: A Journal of Practice & Theory 31 (1): 147-155.

Debate over the relevance and reliability of fair value accounting (FVA) dates back at least seven decades, as evidenced by excerpts presented above from MacNeal’s 1939 “accounting classic,” Truth in Accounting. In recent years, accounting and auditing standard-setters in the U.S. and abroad have issued a number of authoritative pronouncements that, collectively, indicate institutional embracement of FVA. However, today’s business transactions, terms of contractual arrangements, and structures of financial instruments and other assets and liabilities are more varied and complex. Against this backdrop, continuing controversy over the usefulness and verifiability of high-uncertainty fair value estimates centers primarily on estimates and associated disclosures pertaining to assets and liabilities that are not traded in active markets, i.e., estimates involving the use of Level 2 and Level 3 inputs in the FASB’s fair value hierarchy in Fair Value Measurement.

This commentary addresses challenges faced by standard-setters, preparers, users, and auditors pertaining to high-uncertainty fair value estimates. The authors briefly describe the financial reporting environment and the difficulty of obtaining reasonable assurance for fair value estimates with high levels of inherent measurement uncertainty. They then discuss some characteristics of an effective accountability framework for fair value accounting.

This article is a commentary.

The authors discuss interdependencies between FVA disclosures and auditing attributes, within the context of an accountability framework for FVA, and propose a combination of changes to these institutional features whose joint effects should (1) improve transparency to users of the inherent (i.e., irreducible) level of measurement uncertainty in high-uncertainty FVA estimates and disclosures, (2) enhance the value to users of the audit of such estimates and disclosures, and (3) help standard-setters improve the clarity of related auditing standards.

The authors propose additional disclosures on management’s estimation processes, assumptions, and historical estimation accuracy that they believe provide the best avenues for improving the verifiability of decision-useful information on inherent measurement uncertainty. Also, the authors suggest a modified audit report conveying that only negative assurance has been obtained for high-uncertainty FVA estimates, reasons why, and an overview of the procedures performed by the auditor, which should provide a more faithful representation of the true nature and extent of assurance provided to users.

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These findings provide important insight into investors’ current perceptions of auditor independence, particularly in the absence of relative or comparative information, and suggests that it might be useful for regulators, when contemplating additional disclosure requirements, to allocate some attention to disclosures that have the potential to enhance investor perceptions of auditor independence. The findings of this study contribute to the forum of debate concerning the current state of audit-related disclosures and their value for investors.

Beck, A. K., R. M. Fuller, L. Muriel, and C. D. Reid. 2013. Audit Fees and Investor Perceptions of Audit Characteristics. Behavioral Research in Accounting 25 (2): 71-95.

Very little information is provided to the investor about the audits performed or the nature of the relationship between the auditor and client. It is difficult for investors and other external constituents to observe important qualitative aspects of an audit engagement such as the experience level, technical competence, conscientiousness, or objectivity of audit personnel.

The objectives of this research are two-fold. First, the authors investigate whether the provision of additional referent information about audit fees (percentile rank data relative to other firms in the industry that establish a comparative benchmark) alters user perceptions of audit characteristics. This enables them to determine what investors perceive, based on audit fees, about the audit characteristics, and whether their perceptions coincide with the audit fee–audit characteristic relationships identified in previous archival research. Second, the authors contrast the perceptions of investors who are merely supplied with the total dollar amount of the audit fees with the perceptions of investors who are told that a company’s audit fee is approximately average in comparison to the audit fees of other companies within the same industry. Making this latter comparison offers insights as to how investors perceive audit and company characteristics when lacking additional information, consistent with the current state of audit fee disclosures.

One hundred and fourteen accounting students were recruited to participate in the experiment. These students were enrolled in an undergraduate auditing course. The instrument was administered in two different semesters, but in the same course. The participants were randomly assigned to groups, and an initial ANOVA verified that there were no differences between the four groups in terms of age, gender, or investing experience. Participants were incented to participate via bonus points in the course. The evidence was gathered prior to January 2013.

The results of the study suggest that investors do develop perceptions about a company and its audit based on audit fees, as the authors find that providing supplemental audit fee disclosures indicating the relative magnitude of a company’s audit fees significantly influences investor perceptions of auditor independence, auditor effort, and audit quality. Specifically, the authors present evidence that when fees are presented to investors as low, average, or high (as compared to industry averages), investors commensurately perceive audit quality and auditor effort as being low, average, or high, respectively. When not provided with any additional information concerning the audit fee (similar to the present state of disclosures), investors assess audit quality and auditor effort as being average. However, they find that while investors perceive auditor independence as low, average, and high when fees are presented as high, average, or low, respectively, investors not provided with any relative fee information assess auditor independence as low.

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The authors find that the informative disclosure of non-GAAP earnings information enables investors to better understand firms’ future operating performance relative to opaque disclosures. Further, the results suggest that the most pervasive motive behind the disclosure of non-GAAP earnings information is to inform, although an economically significant proportion of firms appear to be opportunistic in that they only disclose non-GAAP earnings information when it increases investors’ perceptions of core operating earnings. The study should be useful to investors, financial analysts, regulators, and researchers for assessing the non-GAAP disclosure motives of management and the effect of these motives on market participants.

Curtis, A. B., McVay, S. E., & Whipple, B. C. 2014. The Disclosure of Non-GAAP Earnings Information in the Presence of Transitory Gains. Accounting Review 89 (3): 933-958.

Managers regularly highlight the transitory components of GAAP earnings in their earnings announcements, and frequently disclose non-GAAP earnings excluding these transitory components. The motivation for managers to disclose non-GAAP earnings, however, is heavily debated. On one hand, managers claim that they disclose non-GAAP earnings to aid investors in assessing the firm’s core operating performance. On the other hand, regulators express concerns that some managers may be motivated to inflate perceptions of core operating performance, which could mislead investors. Essentially, this ongoing debate centers on whether managers disclose non-GAAP earnings to inform or mislead. Non-GAAP earnings are generally more predictive of future operating earnings, but they can also be overstated to meet strategic earnings benchmarks on a non-GAAP basis. Because most transitory items are income-decreasing, both motives predict the same disclosure choice. Because both motives impact managers’ non-GAAP disclosure, it is difficult to determine which motivation is more pervasive or to provide evidence that a particular disclosure is unambiguously informative or opportunistic.

The authors examine the disclosure of non-GAAP earnings information in quarters containing transitory gains to investigate whether the primary motivation for these managers to disclose non-GAAP earnings is to inform or mislead.

The authors examine a sample of 1,920 firm-quarters with transitory gains in the form of net income-increasing special items of at least one penny per share from 2004 to 2009. They require sample firms to have (1) CRSP coverage, (2) a non-missing earnings announcement date on Compustat, (3) a non-missing 10-Q/K filing date on EDGAR, (4) at least two days between the earnings announcement and filing dates, and (5) data available for each of the variables, including one-year-ahead earnings.

Managers motivated to inform stakeholders about sustainable earnings will disclose non-GAAP earnings information excluding the gain, whereas managers motivated to report higher earnings will obscure the transitory nature of the gain by focusing on GAAP earnings.

• The most pervasive motivation for non-GAAP reporting in the presence of transitory gains is to inform.
• Nearly half of the sample discloses non-GAAP earnings information that allows investors to quickly and easily assess operating performance excluding the gain. Investors of these firms appear to efficiently price the transitory nature of these gains.
• The remaining earnings announcements contain more opaque disclosures. Among these firms, investors price the gain positively at the time of the earnings announcement, but this partially reverses at the time of the subsequent 10-Q/K filing. The evidence is consistent with investors not fully incorporating the transitory nature of the gain at the time of the earnings announcement.
• Among opaque disclosers, the authors find that approximately half appear to follow a consistent policy of non-disclosure across both transitory gain and transitory loss quarters. The other half, however, appear opportunistic because they disclose non-GAAP earnings information in transitory loss quarters, but not transitory gain quarters.
• The authors also find some evidence of egregious opportunism. In 101 firm-quarters, which is 5.3 percent of the sample, managers explicitly disclose non-GAAP earnings, excluding expenses but including transitory gains; this is more prevalent when it allows them to meet earnings benchmarks.

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