The Auditors Approach to Fair Value

http://www.journalofaccountancy.com/Issues/2003/Jun/TheAuditorSApp...

AUDITING / BUSINESS & INDUSTRY

The Auditors Approach to Fair Value

SAS no. 101 expands auditors role in assessing fair value measurements.
BY SUSAN L. MENELAIDES, LYNFORD E. GRAHAM AND GRETCHEN FISCHBACH

EXECUTIVE SUMMARY
STATEMENT ON AUDITING STANDARDS (SAS) NO. 101, Auditing Fair Value Measurements and Disclosures, gives
auditors guidance on understanding how an entitys management calculates fair value and on determining whether that
measurement conforms with GAAP.
THE SASs 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 DONT 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.
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 lgraham@bdo.com .
GRETCHEN FISCHBACH is a technical manager on the AICPA audit and attest standards team. Her e-mail address is
gfischbach@aicpa.org .

he auditing standards board (ASB) issued Statement on Auditing Standards (SAS) no. 101, Auditing Fair Value
Measurements and Disclosures, in January. The standard, which is effective for audits of financial statements for periods
beginning on or after June 15, contains significantly expanded guidance for auditing fair value measurements and disclosures.
This article will help practitioners understand its more significant aspects.
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.

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Its 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
managements 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.

What Auditors
Must
Understand
About Fair Value
How the
reporting entity
estimates fair
value
How to
use a fair value
measurement
specialist
GAAPs
fair value
requirements

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 .)

The ABV
The AICPA awards the Accredited in Business Valuation (ABV) credential to candidates with the required
education and experience who have passed a full-day rigorous examination. An ABV candidate must hold a valid

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CPA license.

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 managements 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 companys 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).

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.

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 managements 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.

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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 managements
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 managements 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 specialists 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 entitys 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 statements requirements.
OTHER GUIDANCE: CURRENT AND TO COME
SAS no. 101 does not provide guidance on auditing specific assets, liabilities, components of equity, transactions or industryspecific 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 auditors 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.

Copyright 2013 American Institute of Certified Public Accountants. All rights reserved.

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