1.

FEATURE
2. AUDITING /BUSINESS & INDUSTRY

The Auditor’s 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
June 1, 2003

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TOPICS

 Forensic and Valuation Services

o Valuation Methods, Approaches, and Analysis
 Auditing
o Performing an Audit
EXECUTIVE SUMMARY
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.
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.

What Auditors
Must
Understand
About Fair Value
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 How the
disclosure, it does not establish detailed guidance for auditing specific types reporting entity
of fair value estimates. Instead, the SAS provides guidance on understanding estimates fair
management’s process for developing fair value estimates and evaluating value
whether the measurement conforms to generally accepted accounting
principles (GAAP). Consequently, the auditor evaluates the significant How to use a
assumptions, considers the appropriateness of the valuation model and tests fair value
the underlying data. The auditor does this even when management uses a measurement
valuation specialist to prepare the estimate. specialist

GAAP’s 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 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 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
Working With IFAC
made using valuation techniques involve
uncertainty and subjectivity. For that reason
SAS no. 101 is the first auditing standard the ASB
auditors should assess the risk that the
developed in conjunction with the international
estimate could be misstated by considering
auditing and assurance standards board of the
factors such as
International Federation of Accountants. This
collaboration affected the style in which the
The length of the forecast period (for
standard setters wrote the SAS. This is because
estimates made using the discounted cash
U.S. auditing standards indicate required
flow method).
procedures by means of the word should , but
international auditing standards apply that term
The number of significant and complex
only to primary audit requirements. Yet, there are
assumptions.
instances when international standards require
certain procedures but do not indicate the
The degree of subjectivity of the
auditorshould perform them. SAS no. 101 contains
assumptions.
similar language. For example, certain of its
provisions might state “the auditor evaluates the
Whether and to what extent the
data” to mean “the auditor should evaluate the
assumptions are dependent on the occurrence
data.”
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.