Auditing Fair Value Measurements

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.

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.

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

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

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.

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

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

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.

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

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.

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

Level 1

Level 1 – (Preferred) – uses quoted exit prices for identical assets in an active market.

Examples: Marketable Investments Inventory Equipment

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

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

Auditor’s Objective

“Obtain sufficient appropriate audit evidence to provide reasonable assurance

that fair value measurements and disclosures are in conformity with GAAP.”

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.

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

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)”

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)

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

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

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?

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.

Sub Events

Events and transactions that occur after the balance sheet date but before issuance date

may provide audit evidence regarding fair value measurements.

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.

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.

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.

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.

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.

SPECIFIC EXAMPLES, QUESTIONS AND COMMENTS