auditing fair value measurements. 2 general challenges presented to auditors: obtain a sufficient...
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Auditing Fair Value Measurements
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Auditing Fair Value Measurements 2 General Challenges presented to auditors:
Obtain a sufficient understanding of the entity’s processes and relevant controls for determining fair value measurements to develop an effective audit approach.
Evaluate whether the entity’s methods of measurement and significant assumptions are appropriate and are likely to provide a reasonable basis for the fair value measurements and related disclosures in the entity’s financial statements.
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Auditing Fair Value Measurements AU Section 328 (SAS No. 101)
Mandates that auditors sufficiently understand the process and relevant controls for determining how fair value measurements are derived.
Evaluate conformity of fair value measurements and disclosures with GAAP. How a particular fair value measurement should be derived in order to determine whether the client’s approach is reasonable.
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Definition of Fair Value (ASC 820) “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.”
Must consider: Price Principal (or most advantageous market) Market participants The asset or liability
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Fair Value Measurement & Market Price Fair Value – based on hypothetical
transaction as of the date of measurement The objective is to determine the “Exit Price” Market price is generally equal to or close to
fair value – however, this could diverge in troubled markets
No adjustment for transaction costs
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Principal or Most Advantageous Market Fair value measurement assumes that the
transaction to sell an asset or transfer a liability either: Occurs in the principal market for that asset or
liability In the absence of a principal market, occurs in the
most advantageous market for that asset or liability.
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Market Participants
Fair Value should be based on assumptions used by market participants.
Should Consider factors relating to: The asset or liability The principal or most advantageous market Market participants
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Assets
Fair Value assumes the highest and best use of an asset Use of the asset must be:
Physically possible Legally permissible Financially feasible
Highest and Best Use – determination based on use by market participants
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Highest and Best Use
“In-Use” – asset would provide maximum value through its use in combination with other assets as a group.
“In-Exchange” – asset would provide maximum value on a standalone basis.
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Liabilities
Fair Value measurement assumes: Liability is transferred to a market participant at
the measurement date. The related nonperformance risk is the same
before and after the transfer.
Maximize use of observable inputs Minimize use of unobservable inputs
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Valuation Techniques Under ASC 820 Market Approach
Uses prices and other information generated by market transactions involving identical or comparable assets or liabilities
Income Approach Uses valuation techniques to convert future amounts (cash flows,
earnings) to a present value amount
Cost Approach Uses current replacement cost – amount currently required to
replace the service capacity of an asset.
Note: Multiple techniques may be used.
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Fair Value Hierarchy
Fair value of an asset or liability should be grouped by hierarchy level for disclosure.
The level within the hierarchy is based the type of input: Observable Unoberservable
The hierarchy refers to the reliability of the inputs relative to the a valuation technique
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Level 1
Level 1 – (Preferred) – uses quoted exit prices for identical assets in an active market.
Examples: Marketable Investments Inventory Equipment
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Level 2
Adjusted Market Value – uses market value (or possibly other inputs) for similar assets, which are then adjusted for asset-specific information.
Examples: Land Land Improvements Buildings
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Level 3
Income approach to valuation Most subjective and open to error in
estimation Examples:
Customer lists Various other intangible assets
Independent appraisals may be useful
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Auditor’s Objective
“Obtain sufficient appropriate audit evidence to provide reasonable assurance
that fair value measurements and disclosures are in conformity with GAAP.”
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Fair Value Measurement - Accounting Estimate Many fair value measurements result from
approximations, rather than exact measures, and involve numerous estimates, classifications, judgments, and allocations.
Objective of auditing fair value measurements – enhance their reliability through the elimination of bias.
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Fair Value Measurement – Accounting Estimate Observable market price not available Can be imprecise due because based on assumptions
about future conditions, transactions, or events. Use information available to auditor at time of audit Measurements rely on valuation techniques
Use inputs and outcomes which cannot be directly verified by the auditor
Auditor must: Exercise Due Care Use of Professional Skepticism
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Risk Assessment Procedures
“When performing risk assessment procedures and related activities to obtain an understanding of the entity and its environment, including the entity’s internal control,… the auditor should obtain an understanding of the following in order to provide a basis for the identification and assessment of the risks of material misstatement for accounting estimates (including fair value measurements)”
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The Fair Value 2 Step
Step 1 – Understand the process for determining fair value measurements and relevant controls (this prepares you to develop your audit approach)
Step 2 – Evaluate the conformity of the measurements and disclosures with GAAP (execution of your planned approach)
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Step 1 - Identifying & Assessing the Risks of Material Misstatement Evaluate degree of estimation
uncertainty/complexity Determine if estimates identified as having
high estimation uncertainty give rise to significant risks
Define and understand assumptions used Design your plan
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Step 2 - Responding to Assessed Risks of Material Misstatement (Evaluate) For fair value measurements with observable
inputs, this is a fairly straight forward process.
For measurements with unobservable inputs: Consider the appropriateness of the valuation method (including
management rationale for using method) Test the client’s valuation (including assumptions, the model, and
the underlying data) Review subsequent events and transactions to corroborate
valuation
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Appropriateness of the Method
Based on individual circumstances Requires professional judgment Must understand management’s reasons for selecting
method 3 questions:
Has management sufficiently evaluated and appropriately applied the criteria provided by GAAP?
Is the method appropriate given the nature of the item being valued?
Is the method appropriate in relation to the client and its business?
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Test the Valuation
Test procedures used by management to develop an fair value and the data on which it is based. In doing so, auditor should evaluate whether:i. Assumptions used by management are reasonable in
light of measurement objectives
ii. The model used is valid
iii. Data on which the estimate is based is sufficiently reliable for auditor’s purposes.
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Sub Events
Events and transactions that occur after the balance sheet date but before issuance date
may provide audit evidence regarding fair value measurements.
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Other Considerations in Testing Develop a point estimate to evaluate
management’s point estimate. Auditor should obtain an understanding of
management’s assumptions or methods If auditor concludes use of a range is appropriate, range
should be narrowed until all values within the range are considered reasonable.
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Other Considerations in Testing
Use of a Specialist: Follow AU section 336 – Using the Work of A
Specialist Consider whether the specialist’s understanding
of fair value and the method used to determine fair value are consistent with those of management and GAAP
Still must obtain an understanding of the assumptions and methods used.
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Valuation Techniques
Auditors are not expected to be valuation experts
However, a solid understanding of various valuation techniques will enhance your effectiveness as an auditor.
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The Market Approach
Uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.
Based on the economic principle of efficient markets.
Often use market multiples – judgment required.
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Income Approach
Based on the economic principle of “anticipation”
Investor “anticipates” the expected economic income to be earned from the investment.
The expectation of future income is converted to a present value.
Can involve use of subjective variables.
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SPECIFIC EXAMPLES, QUESTIONS AND COMMENTS