Auditing IFRS 13: How reasonable are "reasonably possible alternative assumptions"?

Abstract

BACKGROUND AND OBJECTIVE OF THE STUDY

The so called balance sheet view dominates the current landscape of financial accounting. Under this paradigm, the main goal of accounting should be the correct valuation of the balance sheet. In practice, this leads to situations where preparers of the financial statements have to make estimates about the correct values of the items in the balance sheet. Some of these estimates can be highly complex and they can contain significant degrees of estimation uncertainty. One subgroup of complex and uncertain accounting estimates are level 3 fair value measurements. The main objective of this study is to find out how much there is estimation uncertainty (i.e. inherent risk) related to these kinds of measurements. Another main objective of this study is to analyze how that uncertainty is related to the materiality thresholds used in auditing financial statements. This kind of analysis is possible because International Financial Reporting Standard (IFRS) 13 requires preparers of financial statements to disclose the effects of "reasonably possible alternative assumptions" on the value of their level 3 fair value instruments.

DATA AND METHODOLOGY

The sample of the study was 50 largest (by assets) listed bank holding companies in the European Union. The methodology used in this study follows largely Christensen et al. (2012). In addition, ad hoc analysis is used in situations where previous academic literature does not offer any guidance. In brief, the methodology consists of analyzing the valuation changes of level 3 fair value instruments under the reasonably possible alternative assumptions and comparing those changes to equity, assets, pretax income and conventional audit materiality thresholds.

RESULTS

The disclosure behavior of the sample banks implied that 56 % considered estimation uncertainty in level 3 fair value estimates to be significant. On average, there was approximately 19 % estimation uncertainty related to level 3 fair value instruments. Also, on average, the value changes under reasonably possible alternative assumptions exceeded the conventional audit materiality thresholds.