Examining auditors’ ability to evaluate the reasonableness of fair value estimates

• Published date: 01 January 2024
• Author: Sabrina Gong,Yamin Hao,Nam Ho
• Date: 01 January 2024
• DOI: http://doi.org/10.1002/jcaf.22654

Received:  May  Revised:  July  Accepted:  July 

DOI: ./jcaf.

RESEARCH ARTICLE

Examining auditors’ ability to evaluate the reasonableness

of fair value estimates

Sabrina Gong1Yam in H ao 2Nam Ho1

Goodman School of Business, Brock

University, St. Catharines, Ontario,

Canada

Department of Accounting, Western

Washington University, Bellingham,

Wash ingto n, USA

Correspondence

Nam Ho, Goodman School of Business,

Brock University, Sir Isaac Brock

Way,St. Catharines, Ontario LS A,

Canada.

Email: nho@brocku.ca

Funding information

CPAOntario Center for Public Policy and

Innovation in Accounting

Abstract

One of the most difficult challenges facing contemporary auditors is evaluating

the reasonableness of fair value estimates (FVEs) made by management. Both

practitioners and academic studies have shown auditors to be deficient when

tasked with assessing FVEs. However,it is not well understood whether the root

cause of this deficiency lies in auditors’ lack of knowledge to appropriately evalu-

ate estimates or auditors’ lack of willingness to challenge management. Using the

setting of common auditors in M&A transactions, this study empirically exam-

ines whether the audit deficiency can be resolved by providing auditors with

additional knowledge or willingness. Our results show that common auditors

significantly outperform their peers when tasked with assessing the reason-

ableness of FVEs in purchase price allocations and reducing overallocation to

goodwill when managers have incentives to do so.Further, the evidence is consis-

tent with common auditors demonstrating improvedperformance in challenging

information environments, but not in scenarios where risks to auditors may be

perceived to be higher. The results suggest that it is their greater asset-specific

knowledge that drives mitigation of the audit deficiency and that targeting

improvements to knowledge rather than willingness is likely to be moreeffective

in improving auditors’ ability to evaluate FVEs.

KEYWORDS

auditor judgment, common auditors, purchase price allocation

1 INTRODUCTION

Over the past two decades, financial innovation and

advances in accounting standards have transformed the

knowledge needed for auditors to properly analyze finan-

cial statements. One of the most impactful changes has

been the wider adoption of fair value accounting (Marra,

). Properly evaluating assets measured at fair value

requires auditors to possess an in-depth understanding of

the underlying assets, market prices, and any models used

in the estimation, as well as the professional judgment to

apply appropriate levels of skepticism. Given these high

requirements, practitioners and regulators have expressed

growing concerns over the accuracy and reasonableness of

the fair value estimates (FVEs) in audited financial reports.

For example, a survey of PCAOB inspection reports done

by Acuitas Inc. reported that as of , % of all audit defi-

ciencies were attributable to fair value measurement and

impairment engagements (Acuitas, ). Additionally, in

the comment letters issued by the SEC in , approx-

imately % of all reviews were related to fair value or

intangible assets, such as goodwill (Deloitte, ). This is

consistent with academic literature suggesting that assess-

ing fair value and other intangible asset estimates poses a

128 ©  Wiley Periodicals LLC. J Corp Account Finance. ;:–.wileyonlinelibrary.com/journal/jcaf

GONG  . 129

significant challenge for auditors (e.g., Bratten et al., ;

Cannon & Bedard, ;Griffithetal.,).

Regulators have issued variouspieces of guidance aimed

toward the audit of FVEs, with the focus mainly on

addressing auditors’ possible lack of willingness to chal-

lenge management and be skeptical on matters involving

judgment. For instance, guidance released by the PCAOB

in  for the auditing standard, Auditing Account-

ing Estimates, Including Fair Value Measurements, effec-

tive December , , centered around enhancing and

emphasizing the importance of professional skepticism

(PCAOB, , a,b). However, a lack of will-

ingness to challenge managers could be due to auditors

lacking clients’ asset-specific knowledge rather than solely

due to an unwillingness to be in conflict with management.

While existing research has examined these two factors

separately (e.g., Ahn et al., ; Carcello et al., ), we

identify a setting where we are able to study both auditors’

knowledge of client asset-specific information and their

hesitance to challenge managers. This provides a unique

settingtoexaminewhichfactorplaysamoredominantrole

in determining FVE assessment quality.Such evidence can

provide useful information to regulators and audit firms

on what suitable remedies they should focus on in order to

overcome the challenges faced in auditing FVEs.

In order to assess whether auditors’ lack of asset-specific

knowledge or auditors’ lack of willingness to challenge

management plays a dominant role in the challenges in

auditing fair value and intangible assets estimates, we

study the setting of mergers and acquisitions (M&A) trans-

actions with a common auditor for the acquirer and the

target firm. This is a setting in which managers have incen-

tives to manipulate the fair value of assets, but auditors

have better knowledge about the underlying assets while

also being subject to other factors that may affect their

willingness to challenge management. Following SFAS

(effective July ), acquirers in M&A transactions are

required to disclose how they allocate the purchase price

paid between tangible assets, intangible assets with defi-

nite or indefinite lives, and goodwill. This is to be done

based on their estimation of fair values for the target firm’s

assets. We choose this setting because purchase price allo-

cation after M&A transactions includes multiple FVEs

that are subject to both management manipulation and

auditors’ assessment/approval. Prior studies have docu-

mented that management has incentives to manipulate

the price allocation in the M&A transactions, especially if

earnings-based bonuses are employed (Shalev et al., ).

For auditors, both their asset-specific knowledge and

their reluctance to challenge managers are likely to be

affected in situations where common auditors are present.

First, prior studies suggest that common auditors in the

M&A transactions are more willing to share information

with each other between offices, which helps reduce infor-

mation asymmetry during the M&A process (Dhaliwal

et al., ). In addition, due to the comparability of finan-

cial statements, common auditors should have a better

understanding of the assumptions and choices under-

lying accounting numbers in the target firms’ financial

statements (Cai et al., ). Therefore, common auditors

should be better informed about the target firm’s assets

than uncommon auditors. Simultaneously, M&As with

common auditors may generate greater risks to the auditor

in the form of high litigation risk or more attention drawn

to their performance in auditing M&A activities. This may

inspire auditors to increase their willingness to challenge

management in order to reduce the risks they face and

potential criticisms from stakeholders. If this is the case,

we should expect firms with common auditors to have

lower overallocation to goodwill when they are exposed to

additional risk or other factors that would enhance their

willingness.

On the other hand, common auditors may be less will-

ing to challenge management’s purchase price allocation

in the M&A transactions for fear of damaging their work-

ing relationships with valuable clients. Completed M&A

transactions result in a newly unified larger client that has

the potential for greater audit and non-audit fees. Com-

mon auditors may be more hesitant to risk upsetting these

clients. As discussed previously, managers haveincentives

to manipulate the price allocation in the M&A transactions

(Shalev et al., ). If FVE audit deficiencies are mainly

driven by auditors’ unwillingness to challenge managers

for fear of upsetting their clients, we should expect com-

mon auditors not to be effective in reducing overallocation

to goodwill.

To compile our data set, we source M&A transaction

data for the period of July  to December  from

the SDC database and merge it with purchase price allo-

cation data from DealStat and -K filings, auditor-client

engagement data from Audit Analytics, and firm data

from Compustat, CRSP, and Execucomp. Our final sam-

ple contains  transactions, % of which havecommon

auditors. Our results show that having a common auditor

significantly reduces the effect of earnings-based bonuses

on overallocation to goodwill.

To determine if our findings are driven by changes

in auditor knowledge or willingness, we conduct sev-

eral cross-sectional analyses based around the information

complexity of target firms (knowledge) and the risk posed

to auditors from high risk/attention M&As (willingness).

We uncover that the improvements are felt in challeng-

ing information environments (complex clients and clients

with opaque disclosures) but not in scenarios where

there were increased risks to auditors (high litigation

risk, increased oversight from institutional ownership, and