Accounting estimates continue to pose significant audit challenges, particularly in areas that require management judgment and complex modeling. These estimates are not only pervasive across financial statements but also subject to increasing regulatory scrutiny due to their inherent subjectivity and potential for bias.

In its May 2025 edition of Audit Focus, the US Public Company Accounting Oversight Board (PCAOB) highlighted common deficiencies in audits of accounting estimates and emphasized key requirements under AS 2501 – Auditing Accounting Estimates, Including Fair Value Measurements. This article summarizes the key takeaways from that publication and presents practical examples and observed good practices that can assist auditors, particularly those working with smaller companies, in strengthening their audit approach.

Why Estimates Are High-Risk

Nearly every set of financial statements contains estimates, whether in the valuation of financial instruments, impairment testing, warranty provisions, or revenue recognition under complex arrangements. These figures are rarely deterministic. Instead, they are constructed using models, assumptions, and inputs that can vary significantly based on management judgment.

For example:

• Estimating credit loss allowances under an expected credit loss model requires judgment on future macroeconomic conditions and borrower behavior.
• Determining the fair value of a privately held investment demands assumptions about growth rates, discount rates, and market multiples—often in the absence of observable inputs.

Such estimates are inherently susceptible to bias or error, making them areas of significant audit risk that demand greater scrutiny.

Key Principles under AS 2501

Under PCAOB auditing standard AS 2501 – Auditing Accounting Estimates, Including Fair Value Measurements, auditors may apply one or a combination of the following three approaches:

1. Testing the Company’s Process

This includes evaluating:

• • The methods used by management
  • The data and assumptions relied upon
  • The consistency of those assumptions with internal and external information

Example: When auditing a company’s inventory obsolescence reserve, an auditor might assess whether the company’s estimation model appropriately reflects historical turnover trends and current market conditions.

2. Developing an Independent Expectation

Auditors can construct their own estimate using independent data or methods for comparison with management’s figure.

Example: In evaluating a fair value measurement for a real estate asset, the auditor may use market data to build a valuation model and assess whether management’s conclusion falls within a reasonable range.

3. Evaluating Subsequent Events or Transactions

This involves reviewing transactions or developments that occur after the balance sheet date but provide evidence regarding the estimate.

Example: A post-year-end sale of an asset may validate or challenge the company’s year-end valuation.

Common Deficiencies Observed

Despite the guidance, PCAOB staff continue to identify recurring deficiencies in estimate auditing:

• Failure to identify significant assumptions: Auditors sometimes proceed with testing without a clear understanding of the assumptions that materially influence the estimate.
• Insufficient challenge of assumptions: Audit procedures often do not go beyond inquiry or recalculations and fail to substantiate the reasonableness of management’s inputs.
• Overreliance on internal data: Vouching assumptions solely to internally generated forecasts without assessing their validity against external information.
• Lack of sensitivity analysis review: Auditors neglect to evaluate how changes in key assumptions would impact the estimate, especially in critical accounting areas.
• Conformity with applicable frameworks: Auditors sometimes fail to assess whether the estimation method aligns with the relevant accounting framework.

These issues can lead to audit deficiencies, especially when estimates materially impact financial results.

Practical Enhancements Observed in Audit Practice

The PCAOB has noted several examples of enhanced audit practices that can mitigate the risk of deficiencies:

Scoping and Methodology Alignment

Some firms have updated internal policies to ensure that engagement teams perform appropriate scoping of all accounting estimates, not just those labeled as critical or associated with significant risks. This helps ensure the consistent application of AS 2501 across engagements.

Engagement Quality Review (EQR) Enhancements

Certain firms require EQR partners to review the audit procedures related to accounting estimates, regardless of whether the estimate was deemed high-risk. This additional layer of oversight has helped strengthen audit documentation and challenge.

Use of External Methodologies

Firms have started mandating the use of structured audit programs, such as those from external methodology providers, which include detailed procedures for:

• Evaluating the reasonableness of assumptions,
• Incorporating relevant industry benchmarks, and
• Requiring sign-offs from both engagement and review partners.

Enhanced Risk Assessment

Leading practices now include risk assessments that tie specific elements of estimates to likely misstatements—for instance, assigning elevated risk to revenue estimates tied to performance obligations that rely heavily on future customer behavior.

A Closer Look: Evaluating Management Intent

Where an estimate depends on the company’s intent and ability to execute a course of action, such as a restructuring plan that supports asset impairment recoverability, AS 2501.17 requires auditors to consider:

• Past behavior in similar circumstances,
• Documented strategic plans or board minutes,
• Available financial resources, and
• Any third-party involvement.

Evaluating these aspects helps assess the realism of the assumption, not just its theoretical logic.

KNAV Comments

The PCAOB’s May 2025 Audit Focus reaffirms the importance of deep, evidence-based audit procedures when evaluating accounting estimates. Auditors must move beyond procedural compliance and engage in structured, skeptical, and judgment-driven analysis.

By its very nature, an accounting estimate involves a degree of informed judgment, often grounded in facts, but still inherently uncertain. While this uncertainty cannot be eliminated, the PCAOB’s guidance equips auditors with structured approaches to assess and mitigate the associated risks.

Firms that embed clear methodologies, enhance assumption testing, and enforce cross-checks through robust review protocols will be better positioned to meet regulatory expectations and, more importantly, uphold audit quality in an area of increasing complexity.