How Do Auditors Assess Key Inputs in a Discounted Cash Flow Model of Goodwill?

Abstract

Using verbal protocol analysis, this study examines how 21 experienced auditors from four different firms assess the seven key inputs in a discounted cash flow (DCF) model used by management to value goodwill. The analysis compares the auditors’ processes against a theoretical model derived from an analysis of accounting and auditing standards and authoritative sources of valuation methodology and identifies systematic omissions and inaccurate applications of key audit steps. It also relates those issues to audit outcomes at the individual input and the overall goodwill evaluation levels. The study’s findings can help regulators, practitioners and academics to better understand the limitations of auditors’ competencies so that they can design strategies for mitigating them.

Novice Auditors and Audits of Fair Values: Knowledge and Skill Requirements*

“…The verbal protocol analysis method requires participants to "think aloud" when performing the task that is the subject 6. The paper is a part of an ongoing research program that investigates various aspects of experienced auditors' processes (Boritz and Timoshenko 2022) and novice auditors' processes (this paper) when auditing complex FVs. In this research, the same quasi-experimental instrument is used, and similar research approaches are followed, as in Boritz and Timoshenko (2022); however, there is no overlap between the subjects or the data in these two papers.…”

“…This research falls under the heading of human factors research, which includes functional analysis and task analysis (Lees et al 1999; Boritz and Timoshenko 2022). It aims to design and implement better and more capable systems for achieving specified goals.…”

“…15 The case instructions were designed to encourage the participants to follow their normal auditing process. The materials were adapted from materials used in a previous study (Boritz and Timoshenko 2022). 16…”

How Does Management Voluntary Disclosure Behavior Influence Auditors’ Judgments?

“…In this study, we examine how the voluntary disclosure of forward‐looking information influences auditors’ skepticism toward such information. Auditors rely on forward‐looking information provided by management as evidence when they assess complex estimates and reach conclusions about going‐concern audit report modifications (Feng and Li [2014], Joe, Vandervelde, and Wu [2017], Griffith [2018], Boritz and Timoshenko [2022]). While prior research suggests that investors and analysts frequently view voluntarily disclosed forward‐looking information as credible and rely on such information for investing decisions (Healy and Palepu [2001], Hirst, Koonce, and Venkataraman [2008]), we provide theory and experimental evidence demonstrating that auditors, in contrast, view voluntarily disclosed forward‐looking information as less credible than either mandatorily disclosed or privately held information and require more testing of such information before relying on it for audit decisions.…”

“…Prior research has largely focused on investor or analyst judgments of voluntarily disclosed forward‐looking information (Hirst, Koonce, and Venkataraman [2008]), wherein the findings suggest that these users perceive information provided by managers to be credible because releasing biased information could be costly to managers. Yet auditors use the same forward‐looking information to form going‐concern audit report modifications (Feng and Li [2014]), to evaluate complex estimates (Griffith [2018], Boritz and Timoshenko [2022]), and to develop audit procedures (Ball, Jayaraman, and Shivakumar [2012], Krishnan, Pevzner, and Sengupta [2012]). Complementing this research, we show that auditors are more skeptical of voluntarily disclosed forward‐looking information even when the forecasts are consistent with prior years.…”