The auditor's approach to fair value: SAS no. 101 expands auditors' role in assessing fair value measurements.
The requirement to measure some financial statement items at fair value has been in the accounting literature for many years, but until now, the source of general auditing guidance has been SAS no. 57, Auditing Accounting Estimates. Fair value estimates differ from other accounting estimates because when market prices are not available management must estimate fair value using an "appropriate" approach and assumptions that reflect those that individuals in the marketplace would make. This unique aspect, combined with an increase in the number of accounting standards that require fair value measurements and disclosures, the complexity of some of those measurements and their significance to the financial statements, requires auditing guidance that is specific to such measurements.
It's important to note that while SAS no. 101 (see Official Releases, page 103) provides a general framework for auditing fair value measurements and disclosure, it does not establish detailed guidance for auditing specific types of fair value estimates. Instead, the SAS provides guidance on understanding management's process for developing fair value estimates and evaluating whether the measurement conforms to generally accepted accounting principles (GAAP). Consequently, the auditor evaluates the significant assumptions, considers the appropriateness of the valuation model and tests the underlying data. The auditor does this even when management uses a valuation specialist to prepare the estimate.
KNOW THE BASICS
Understanding how management develops its FVM&D is a critical first step that gives the auditor a foundation for designing auditing procedures. The auditor bases this understanding on his or her knowledge of
* The experience and expertise of the personnel involved in the measurement.
* The significant assumptions and data management used to develop the estimate.
* How management identified and used relevant market information when developing assumptions.
* How management monitored changes in the assumptions.
* The extent to which management used a specialist to develop the fair value estimate.
The auditor also must understand GAAP requirements for the particular fair value estimate. This can be a challenge because GAAP does not specify methods or processes for measuring items at fair value. Rather, GAAP indicates that fair values must be based on observable (for example, quoted) market prices. If observable market prices are not available, the techniques management uses for estimating fair value measurements should incorporate assumptions that individuals in the marketplace would use. If that information is not available, then GAAP permits an entity to use its own assumptions as long as there is no indication marketplace participants would use different assumptions.
WHEN MANAGEMENT USES A VALUATION SPECIALIST
Many recent important accounting pronouncements, including FASB Statement no. 141, Business Combinations, and FASB Statement no. 142, Goodwill and Other Intangible Assets, require the use of fair value estimates. This trend likely will continue, encouraging more entities to consult with valuation professionals who specialize in fair value measurements. While GAAP does not require management to engage an outside specialist to perform fair value measurements, many entities do so either because they do not have employees who can perform high-quality fair value measurements or because they want the objectivity, professional experience and skills of an outside specialist.
The valuation profession has established certain certifications and standards to reflect the professionalism and training of its members. One prominent group, the American Society of Appraisers (www.appraisers.org), offers testing and accreditation in various disciplines including business valuation. Its members, some of whom receive the accredited senior appraiser designation, follow the uniform standards of professional appraisal practice, which are recognized in the United States as generally accepted standards of professional appraisal practice. They cover numerous topics, including objectivity and standards for valuation report preparation. The AICPA also has an accreditation program for CPAs who specialize in business valuations. (More information is available at www.aicpa.org/members/div/mcs/abv.htm.)
Yet, even when management uses a qualified and objective specialist, it cannot abdicate responsibility for the fair value measurement it uses for financial reporting purposes. Management is responsible for the data that form the basis for the measurement, as well as the approach, methods and assumptions the specialist used in arriving at the fair value of an item.
The auditor should determine whether management's specialist has experience in fair value measurements and has used a fair value concept consistent with GAAP. Some specialists may be more familiar with value concepts they use when preparing valuations for other than financial reporting purposes. Those concepts may or may not be consistent with GAAP. Two examples are investment value, which is the value to a particular investor based on individual requirements and expectations, and liquidation value, which is the net amount a business can realize when it terminates and sells its assets piecemeal. Investment value takes into account the benefits that a particular buyer of an asset expects; but a fair value estimate under GAAP must take into account only the benefits that overall market participants expect. Likewise, for fair value measurements under GAAP liquidation value is rarely appropriate because it presumes a forced sale. Thus, the "willing seller" concept, which is integral to fair value under GAAP, does not exist in this context.
While many CPA firms offer professional valuation services, management needs to be aware that the Sarbanes-Oxley Act of 2002 prohibits a public company's audit firm from providing valuation services to it.
AUDITING FAIR VALUE ESTIMATES
Often, when observable market prices are not available, management will use a valuation method, such as the discounted cash flow method, to make the fair value estimate. GAAP requires such a method to incorporate assumptions that marketplace participants would use in their estimates. Measurements made using valuation techniques involve uncertainty and subjectivity. For that reason auditors should assess the risk that the estimate could be misstated by considering factors such as
* The length of the forecast period (for estimates made using the discounted cash flow method).
* The number of significant and complex assumptions.
* The degree of subjectivity of the assumptions.
* Whether and to what extent the assumptions are dependent on the occurrence or outcome of a future event and the availability of objective data to support the significant assumptions. Auditors use this risk assessment, combined with their understanding of management's fair value estimation process and relevant GAAP requirements, to design their audit procedures.
When management uses a valuation model, auditing procedures typically focus on
Evaluating the significant assumptions. These assumptions could materially affect the fair value estimate, and the auditor must consider whether they are reasonable and consistent with existing market information, the economic environment and past experience. If market information was not available and management used its own assumptions to estimate fair value, the auditor determines whether there is information that indicates marketplace participants would have used more appropriate assumptions. For example, in determining the fair value of a rare asset for which market information is not available, the auditor determines whether management considered information about sales of similar assets, the general economic environment in which the asset is used and past experiences with similar assets.
Determining the "appropriateness" of the valuation model. If management or its specialist used a valuation model to make the fair value estimate, the auditor should review the model and consider whether it is appropriate in the circumstances. For example, it may not be appropriate to use a discounted cash flow model for valuing an investment in a start-up entity because there are no revenues on which to reliably base the cash flow forecast.
Testing the data behind the estimate. The auditor also should test the data that management or its specialist used to develop the fair value estimate. In testing those data, the auditor should consider whether they came from a reliable source, were complete, mathematically accurate, relevant and consistent with other information he or she has obtained during the audit.
Some auditors may use their own valuation models to test the fair value measurements and disclosure. In doing so, an auditor may be able to eliminate or reduce the above tests by using his or her own model and assumptions and management's data. The auditor should test any such data from management that he or she uses in arriving at the fair value estimate.
Also, instead of testing the fair value estimate by evaluating the assumptions, determining the appropriateness of the model and testing management's data, the auditor sometimes may be able to test it by examining subsequent events or transactions that would confirm or refute the estimate. Auditors using their own models to assess a fair value measurement should be particularly mindful that the Sarbanes-Oxley Act prohibits them from performing such services for their publicly held clients.
The auditor should carefully read the report of a specialist management has used; it may disclose additional relevant information that needs to be considered during the audit. Also, the timing of the specialist's engagement to measure fair value is important to management and the auditor. A timely report leads to timely financial reporting by management, which in turn gives the auditor time to plan and perform procedures he or she considers necessary to properly evaluate the measurement.
In some cases, an auditor may need to use a specialist to evaluate the entity's fair value measurement. If the specialist is an employee of the audit firm or an outside person and that individual functions as a member of the audit engagement team, SAS no. 22, Planning and Supervision, applies. In other cases, SAS no. 73, Using the Work of a Specialist, applies.
Because SAS no. 101 provides specific guidance for auditing fair value measurements and disclosure, we recommend that auditors review their approaches to make sure they incorporate the statement's requirements.
OTHER GUIDANCE: CURRENT AND TO COME
SAS no. 101 does not provide guidance on auditing specific assets, liabilities, components of equity, transactions or industry-specific practices. That guidance is currently available in
* Other standards, such as SAS no. 92, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities (AICPA, Professional Standards, vol. 1, AU sec. 332).
* Nonauthoritative publications such as the auditor's tool kit titled Auditing Fair Value Measurements and Disclosures: Allocations of the Purchase Price Under FASB Statement of Financial Accounting Standards no. 141, Business Combinations, and Tests of Impairment Under FASB Statements no. 142, Goodwill and Other Intangible Assets, and no. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Although developed before the issuance of SAS no. 101, the AICPA practice aid titled Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices, and Pharmaceutical Industries discusses fair value concepts in the context of in-process research and development costs.
In the future, the ASB plans to issue a guide on auditing fair value measurements and disclosure relating to other specific assets, liabilities, components of equity or transactions.
* STATEMENT ON AUDITING STANDARDS (SAS) NO. 101, Auditing Fair Value Measurements and Disclosures, gives auditors guidance on understanding how an entity's management calculates fair value and on determining whether that measurement conforms with GAAP.
* THE SAS's PROVISIONS ARE EFFECTIVE FOR AUDITS of financial statements for periods beginning on or after June 15, 2003.
* TO DESIGN EFFECTIVE PROCEDURES FOR A FAIR VALUE audit, an auditor must be familiar with the expertise of personnel who performed the measurement, the assumptions they used, how they monitored and revised the assumptions over time and the involvement, if any, of external fair value specialists management may have engaged.
* SOME COMPANIES DON'T HAVE STAFF WHO CAN accurately estimate the fair value of their assets. So, they engage valuation specialists. But even when management seeks such help, it still is responsible for the accuracy of each fair value estimate in its financial statements.
* AUDITORS SHOULD ASSESS THE RISK OF MATERIALLY misstated fair value estimates. In doing so, they should consider the number, significance and subjectivity of assumptions used to make the estimates.
* THE ASB DEVELOPED SAS NO. 101 WITH IFAC. This unprecedented collaboration influenced the style in which the standard was written. For example, when the SAS says an auditor performs an action, it means the auditor is required to do so.
What Auditors Must Understand About Fair Value
* How the reporting entity estimate fair value
* How to use a fair value measurement specialist
* GAAP's fair value requirements
Working With IFAC
SAS no. 101 is the first auditing standard the ASB developed in conjunction with the international auditing and assurance standards board of the International Federation of Accountants. This collaboration affected the style in which the standard setters wrote the SAS. This is because U.S. auditing standards indicate required procedures by means of the word should, but international auditing standards apply that term only to primary audit requirements. Yet, there are instances when international standards require certain procedures but do not indicate the auditor should perform them. SAS no. 101 contains similar language. For example, certain of its provisions might state "the auditor evaluates the data" to mean "the auditor should evaluate the data."
SUSAN L. MENELAIDES, CPA, is a partner with Altschuler, Melvoin, and Glasser LLP and a member of the auditing standards board. Her e-mail address is Susan. L.Menelaides@aexp.com. LYNFORD E. GRAHAM, CPA, is director of audit policy with BDO Seidman LLP and a member of the auditing standards board. His e-mail address is email@example.com. GRETCHEN FISCHBACH is a technical manager on the AICPA audit and attest standards team. Her e-mail address is firstname.lastname@example.org.
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|Publication:||Journal of Accountancy|
|Date:||Jun 1, 2003|
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