His speech was devoted mostly to the new Auditing Standard No. 5, which, at this point, has lost all novelty by this time (at least for me.) It’s being hailed as the Next Big Thing in improving efficiency of audits; it’ll palliate the pain of the process, while assuring financial reporting integrity, etc. It’s an epicene kind of standard; it’s supposedly got both bases covered.
No offense to the chairman or anyone else involved in the development of AS 5, but the proof is in the pudding. If audit fees don’t drop to the liking of business types after AS 5, there’ll be howls from the business community. And if there are reporting blowups, there should be howls from the investor community.
(Which reminds me: Refco never had a clean opinion on its internal controls before it self-immolated. Seems like a long time ago - but that was just in August ‘05. Not even two years yet.)
Anyway - the most interesting topic covered by the Chairman had to do with auditing fair values. An excerpt from his speech:
I will take a moment to mention a few of the challenges auditors are confronting as issuers transition to fair value. First, valuation requires training, and many auditors may not have extensive training in valuation techniques. Second, auditors should be mindful that financial statement preparers can be biased (even if unknowingly so) in their assessments of fair values. As a result of this potential bias, preparers may fail to consider alternative valuation scenarios. Third, auditors should keep in mind that internal controls surrounding fair value measurements may be different from those over typical business transactions.
• Level 1 is a cinch: fair values based on prices in an observable market.
• Level 2 fair values are prices for instruments that don’t trade in a market on their own, but can be extricated from other instruments that are traded.
• And Level 3 fair values are pretty much estimates based on mathematical modeling wizardry.
I know I’m oversimplifying. I believe that Chairman Olson is referring to the difficulties for auditors in Level 2 and 3 fair values. And he’s right - they’d better get ready to handle the judgments and assessments they’re going to have to make in auditing those kinds of figures. There’s bound to be resistance from the auditing community - there’s increased exposure for them in the kinds of judgments on estimates they’ll have to make. At the same time, they’ve been doing that kind of “reasonableness judging” for years in the accrual arena. It’s just that they now have to adapt to a new set of circumstances. And it sounds like the PCAOB will be riding hard on them to make sure they adapt.