Management Engaged vs. Employed Valuation Specialist: The Effect on Evidential Planning Assessments for the Audit of Fair Value Measurements

We examine the differential effect of management engaged versus employed valuation specialists on auditor planned evidential procedures related to auditing fair value measurements (FVMs). Accounting estimates are inherently difficult to audit, and the complex finance-based modeling that underlies estimates of many financial instruments may be beyond auditor expertise. Thus, we also examine to what extent auditor fair value expertise mitigates overreliance on management’s process, rather than engaging in a critical analysis of the overall estimate. Inspection reports issued by the PCAOB consistently cite audit firms for deficiencies related to FVMs, raising concerns about auditors' application of professional skepticism and consideration of potential management bias. These deficiencies have led to the perception that auditors may not effectively evaluate FVMs or the inputs and assumptions made by management or specialists used in them. Using auditors with varying levels of fair value domain-specific expertise, we conduct a quasi-experiment to examine how management’s valuation specialists (engaged vs. employed) affects auditors’ evidential planning judgments for complex FVMs of financial instruments. We rely on psychological distance theory to predict how auditors process information and reach judgments for FVMs. We find that when the valuation specialist is management-engaged (outsourced FMV specialists), auditors with higher domain-specific expertise are more likely than auditors with lower domain-specific expertise to conduct a higher percentage of evaluative (i.e., judgment based) as compared to confirmatory audit procedures. Further, the judgment of auditors with less domain-specific expertise is influenced by the source of management provided evidence. Overall, these findings suggest that the source of FVMs impacts the perceived reliability of evidence gathered from management, resulting in differential perceptions of persuasiveness and nature of evidence gathered beyond assessments of the risk of material misstatement