An Analysis of Auditors' Perceptions Related to Fair Value Estimates

Published date01 March 2017
Date01 March 2017
© 2017 Wiley Periodicals, Inc.
Published online in Wiley Online Library (
DOI 10.1002/jcaf.22263
An Analysis of Auditors’ Perceptions
Related to Fair Value Estimates
Susan D. Hermanson, William A. Kerler III, and Julian D. Rojas
In the early 2000s,
the collapse of Enron
cost investors bil-
lions of dollars and
crippled thousands
of individuals’ retire-
ment savings. Enron
is known as one of
the largest account-
ing and corporate
fraud scandals in his-
tory, and although
many factors con-
tributed to the fraud,
fair value accounting
played a signifi-
cant role (Bentson,
2006). Through their
manipulations of fair
value data, Enron’s
accountants were
able to use “account-
ing devices to report
cash flow from opera-
tions rather than
from financing and
to otherwise cover up
fair-value overstatements and
losses on projects undertaken
by managers whose compensa-
tion was based on fair values”
(Benston, 2006, p. 465). Enron’s
manipulation of fair value
accounting allowed its execu-
tives to conceal the fraud for
quite a long time and
to mislead and cheat
investors out of bil-
lions of dollars.
Following the
Enron and other
scandals (e.g., Adel-
phia, Tyco, World-
Com, Xerox), the
Sarbanes-Oxley Act
(SOX) was enacted
to make it more dif-
ficult for these types
of fraud to occur
again. Despite efforts
to improve account-
ing, fair value
accounting came
under scrutiny again
as a potential con-
tributing factor in
the 2007–2008 bank-
ing crisis that led to
the largest financial
recession since the
Great Depression
(Bowen& Khan,
2014; Laux & Leuz,
2009). Church and
Shefchik (2012) analyzed
Public Company Accounting
Oversight Board (PCAOB)
inspection reports of large
This study investigates auditors’ understanding
of Level 1, 2, and 3 fair value estimates (FVEs)
and their perceptions of the adequacy of the
associated auditing standards and internal firm
guidance. The results indicate that Level 1 and
Level 2 FVEs are encountered more frequently
than Level 3 FVEs, and that auditors perceive
themselves to have the greatest knowledge and
comfort related to Level 1 FVEs followed by Levels
2 and 3, respectively. Auditors believe Level 3 FVEs
are the most difficult to audit, while Level 1 FVEs
are the least difficult to audit. While still overall
confident, auditors are the least confident opining
on financial statements with significant Level 3
FVEs, followed by financial statements with Level
2 and Level 1 FVEs, respectively. Auditors believe
professional auditing standards, internal firm guid-
ance, and required disclosures related to FVEs are
all adequate. Finally, auditors believe determining
whether they have done “enough” is the greatest
challenge when auditing FVEs, while the cost–
benefit consideration is perceived as the greatest
cause of FVE testing failures. © 2017 Wiley Periodicals, Inc.
Editorial Review
The Journal of Corporate Accounting & Finance / March/April 2017 19
© 2017 Wiley Periodicals, Inc. DOI 10.1002/jcaf
public accounting firms for
the years 2004 through 2009
and found that fair value
measurement deficiencies as
a percentage of all audit defi-
ciencies increased from 35.3%
in 2004 to 60.3% in 2009. The
authors suggest the increase
in fair value accounting stan-
dards during this time period
and the resulting “movement
toward fair value accounting
has very likely introduced new
challenges for the auditor”
(Church & Shefchik, 2012,
p.54). Christensen, Glover, and
Wood (2012) investigated the
importance of management’s
fair value estimates and their
impact on companies’ finan-
cial statements and considered
whether auditing fair value
estimates has become unrealis-
tic. The authors “demonstrate
with publicly available data
that very small changes to fair
value inputs, in fact changes
that are within a reasonable
uncertainty range, can result in
significant changes to account
values, and in some instances to
net income—effects as large as
50times larger than the typical
materiality applied by the larg-
est accounting firms” (Chris-
tensen et al., 2012, p. 128).
Fair value estimates are
categorized into one of three
levels based on the availability
of inputs market participants
would use to price an asset
or liability. Level 1 inputs are
the most reliable, while Level
3 inputs are the least reliable.
The purpose of this study is to
examine auditors’ perceptions
related to each level of FVEs.
Specifically, we first investigate
auditors’ perceptions regarding
their understanding of each
level of fair value estimates,
including their knowledge of
FVEs, frequency of encoun-
tering FVEs, comfort with
auditing standards regarding
FVEs, difficulty auditing FVEs,
and their confidence opining
on financial statements with
significant FVEs. We next
investigate auditors’ percep-
tions of the adequacy of audit-
ing standards and internal firm
guidance regarding auditing
each level of FVEs.
The results of a survey
of37 practicing auditors
experienced in auditing fair
value estimates find that audi-
tors perceive themselves to be
knowledgeable about fair value
estimates, with the greatest
knowledge of Level 1 FVEs,
followed by Level 2 and Level
3, respectively. We also find that
auditors encounter fair value
estimates frequently, with Level
1 and Level 2 FVEs encoun-
tered more frequently than
Level 3 FVEs. Auditors also
indicate they are comfortable
with auditing standards regard-
ing FVEs with greater comfort
for standards related to Level 1
estimates compared to Levels2
and 3. Auditors believe Level3
fair value estimates are more
difficult to audit than Level2,
which are more difficult to
audit than Level 1 FVEs. Addi-
tionally, auditors are confident
opining on financial state-
ments with significant FVEs,
with the highest confidence
on financial statements with
significant Level 1 FVEs, fol-
lowed by financial statements
with Level2 and Level 3 FVEs,
We also find that auditors
believe both professional audit-
ing standards related to FVEs
and internal firm guidance are
adequate, with guidelines for
Level 1 FVEs most adequate,
followed by guidelines for Level
2 and Level 3 FVEs, respec-
tively. Auditors also indicate
the required financial statement
disclosures related to FVEs
are adequate. Finally, auditors
believe the greatest cause of
FVE testing failures is the cost–
benefit consideration, and they
believe the greatest challenge
when auditing FVEs is deter-
mining whether they have done
“enough.” We elaborate on these
findings and discuss implica-
tions in the concluding section.
The remainder of this
article is as follows: We next
discuss the relevant prior litera-
ture and develop our research
hypotheses and research ques-
tions. We then discuss the
research methodology and
results. We conclude with a
discussion of the findings and
Fair value accounting
is based on the concept of
utilizing market prices to cal-
culate the value of assets and
liabilities. “In recent years,
accounting and auditing
standard-setters in the U.S. and
abroad have issued a number
of authoritative pronounce-
ments that, collectively, indicate
institutional embracement of
FVA [fair value accounting]”
(Bell & Griffin, 2012, p. 148).
In fact, the Financial Account-
ing Standards Board (FASB)
has been switching the United
States from a purely historical
cost-based accounting system
to one partially grounded on
fair values since the 1970s
(Curtis, 2009). With a fair
value accounting approach, the
increases and decreases in the
value of an asset or liability are
updated on the financial state-
ments to reflect current market
conditions and values, and
therefore may be considered
more relevant information to
investors and creditors to use

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