Article: Auditing Fair Value Measurements

By Patrick Terry

The measurement of the fair values of assets, liabilities, and components of equity has become increasingly prevalent over the past decade as a result of many factors. These include, among others, the influences of the marketplace, regulators, and accounting standard setting bodies.  The requirement to make this measurement may arise from both the initial recording of transactions and later changes in values.  Changes in value measurements that occur over time may be treated in different ways under Generally Accepted Accounting Principles (GAAP), with some reflected in the determination of income and others reflected in other comprehensive income and equity.  GAAP varies in the level of guidance that it provides on measuring fair values and disclosures.  While this article provides some insight into how auditors evaluate fair value and disclosures for compliance with Financial Accounting Standard (FAS) 157 “Fair Value Measurements,” it does not address specific types of assets, liabilities, components of equity, transactions, or industry practices.

Fair value, as defined by the Financial Accounting Standards Board (FASB), is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  Although GAAP does not prescribe the methods for measuring the fair value of an item, it expresses a preference for the use of observable market prices to make that determination.  In the absence of observable market prices, GAAP requires fair value to be based on the best information available in the circumstances, which is inherently imprecise due to the underlying assumptions about future conditions, transactions, or events whose outcome is uncertain and will, therefore, be subject to change over time.

In planning an audit, auditors assess the risk of material misstatement in the entity’s financial statements. This assessment takes into consideration many aspects of the entity, and it ultimately results in the nature, timing, and extent of planned audit procedures for the entire engagement.  Because of the wide range of possible fair value measurements from relatively simple to complex and the varying levels of risk of material misstatement associated with the process for determining fair values, the planned audit procedures associated with the measurement of fair value can vary widely. For example, substantive testing of the fair value measurements may involve (a) testing management’s significant assumptions, the valuation model, and the underlying data; (b) developing independent fair value estimates for corroborative purposes; or (c) reviewing subsequent events and transactions.

Management, under the guidance of those charged with governance, is ultimately responsible for making fair value measurements and disclosure in financial statements.  As a result, in the normal course of an audit, the auditor will initially develop an understanding of the accounting and financial reporting processes used in determining fair value measurements and disclosures including the following: appropriate valuation methods; identification and support of any significant assumptions; preparation of the valuation; and compliance of the fair value presentation and disclosure with GAAP.  In some cases, the measurement of fair value and the resulting process set up by management to determine fair value may be simple and reliable, such as management referring to published price quotations in an active market to determine fair value for marketable securities held by the entity.  Some fair value measurements, however, are inherently more complex than others and involve uncertainty about the occurrence of future events or their outcome; consequently, assumptions are required in order to complete the measurement process.  In instances where the availability of observable market prices is limited and the complexity of the item to be measured is beyond management’s skill and knowledge, management may employ a specialist to determine the fair value measurement.  The use of a specialist does not reduce the responsibility of management.  In order to form opinions of fair value, specialists utilize their knowledge and specialized training to incorporate management’s assumptions into accepted valuation methodologies.

Subsequent to gaining an understanding of the processes management uses to develop these measurements and disclosures, the auditors begin testing management’s fair value measurements and disclosures by evaluating whether management’s assumptions are reasonable, an appropriate model was used, and information utilized was reasonably available and relevant.  

Assumptions are generally supported by differing types of objective evidence from internal and external sources, and some are more significant than others.  The auditor considers the reliability of both internal and external sources in light of both historical and market information.  Determining which assumptions are significant is the responsibility of management, and these are usually the focus for auditors.  Generally, significant assumptions relate to matters that materially affect the fair value measurement and are (a) sensitive to variation or uncertainty, and (b) susceptible to misapplication or bias.  During the course of procedures, the auditor may employ techniques and/or encourage management to use sensitivity analysis to help identify other significant assumptions.

Assumptions must be reasonable individually in relation to historical and market information, but they must also be reasonable in relation to other assumptions.  Assumptions are frequently interdependent and, accordingly, need to be considered consistently.  For assumptions to be reasonable individually and in the aggregate, they need to be realistic and consistent with (a) the general economic environment, (b) existing market information, (c) the plans of the entity or assumed plans of market participants, (d) assumptions made in the prior periods, (e) past experience, (f) other assumptions affecting the financial statements, and (g) the risk associated with cash flows.

The auditor will evaluate management’s intent and ability to carry out specific courses of action where intent is relevant to the use of fair value measurements, the related requirement involving presentation and disclosure, and how changes in fair values are reported in the financial statements.  The auditor’s procedures in obtaining evidence of management’s intent and ability may include inquiries with appropriate corroboration of responses, as in management’s past history of carrying out stated intentions, the level of detail in devising plans, stated reasons for pursuing specific plans, as well as the entity’s economic ability to follow through with intentions.

In the absence of observable market prices, management must estimate the fair value measurement using a valuation method.  The auditors will evaluate whether the valuation method is appropriate under the circumstances, which requires professional judgment; furthermore, they will also gain an understanding of management’s rationale for selecting a particular method.  These considerations typically include guidance from GAAP, appropriateness relative to the item being valued and for the business, industry and environment.  In selecting the appropriate valuation method, management should clearly document the reasoning for a particular method over others and the potential impact other methods not used may have on the measurements. If between periods management changes methodologies, the auditor will evaluate management’s justification to ensure the new method provides a more appropriate basis of measurement, as in the introduction of an active market for an equity security, which may indicate that the discounted cash flows method to estimate fair value of the security is no longer appropriate.  Other situations such as changes in accounting standards or regulations may also justify the use of another valuation method.

When management uses a valuation model to measure fair value, the auditors do not function as an appraiser and are not expected to substitute their judgment for that of management.  Rather, the auditors review the model and evaluate whether the assumptions used are reasonable and whether the model is appropriate considering the item being measured and the entity’s circumstances.

Information gathered by management for use in valuation models should be available without excessive cost to obtain.  Ordinarily, management would seek out similar transactions or situations where circumstances are common to the entity’s circumstances, as in prevailing discount rates.  However, such information is more accurate or precise if determined through specific studies.  Information obtained in this manner may also be more relevant, but the cost of obtaining these benefits may be prohibitive.  Accordingly, GAAP provides that costly exercises to obtain information utilized in valuations are not required.

The auditor will also test the process, the data and assumptions used to arrive at the fair value measurements and disclosures, including the information used by the specialist, to ensure it is accurate, complete, and relevant.  These tests can include verification of the source data, re-computation of calculations, and review of information for internal consistency as well as consistency with management’s intent and ability to carry out specific courses of action.

Another test the auditors may perform is to make an independent estimate of fair value to corroborate the entity’s fair value measurement.  In using an alternate model to measure fair value, the auditors may develop their own assumptions, instead of management’s, to make a comparison with management’s fair value measurements.  Using their understanding of management’s assumptions, the auditors ensure their independent estimate takes into consideration all significant variables, and evaluates any significant differences from management’s estimate.

Auditors are required to evaluate events and transactions subsequent to end of the audit fieldwork, but prior to issuance of the auditor’s report. This evaluation may provide evidence regarding management’s fair value measurements as of the balance sheet date.  Often times, these transactions provide a more direct and succinct method of substantiating the fair value measurements as opposed to the procedures noted above relating to management’s assumptions, valuation models, and the like.  However, some subsequent events or transactions may reflect changes in circumstances occurring after the balance sheet date and, thus, do not constitute appropriate audit evidence of the fair value measurement at the balance sheet date.

Due to the inherent opportunity for bias, error, and the ultimate outcome of management’s current judgments, estimates in measuring fair value of an item are normally highlighted in financial statements as well as communications with those in charge of governance.   Consequently, as the requirements for fair value measurement of assets, liabilities, and components of equity continue to grow, having a sense of the auditor’s perspective in evaluating these measurements can be beneficial and possibly ease the burden of the process.

With offices across the southeast and resources around the globe, Decosimo’s significant experience is an advantage in resolving your valuation issues.  If you have a valuation question, please feel free to call us in confidence at 800.782.8382.

The contents and opinions contained in this article are for informational purposes only. The information is not intended to be a substitute for professional accounting counsel. Always seek the advice of your accountant or other financial planner with any questions you may have regarding your financial goals.

By Patrick Terry