Fair value measurements (FVMs) and asset impairment testing were among the most prevalent deficiencies found in audits in the wake of the economic crisis of 2008. Consulting firm Acuitas Inc. gives tips on how to mitigate some of the more common trouble spots:
Examine projected financial information (PFI) assumptions. Assess the reasonableness of improved margins and the change in weights assigned to various indications of value. Do not use PFI from a period prior to a reorganization. Evaluate the reasonableness of assumptions relating to revenue growth rates; capital expenditures; terminal growth rates and discount rates; customer attrition rates; the risk premium in the issuer’s weighted average cost of capital; and any significant difference between value indications from market and income approaches. Regarding impairment, test the model, inputs, and assumptions used to value a loan portfolio in connection with goodwill impairment analysis.
Adequately comprehend FVM pricing methods. FVM deficiencies can result from the use of poor pricing methods. Examine models and assumptions used by pricing services or valuation specialists. Ensure that the correct yield or discount rate applicable to the securities is used; investigate major differences between prices from different sources and adjustments made to third-party prices by issuers.
Look for weaknesses in testing. Test the assertion that there was no material change in value during interim testing, data provided to outside valuation specialists, and all items in a selected sample. Perform substantive tests and do not place sole reliance on internal controls or internal audit findings.
Look for weaknesses in FVM hierarchy disclosure testing. Identify and test controls over FVM hierarchy disclosures and test Level 2 and Level 3 FVM hierarchy classifications. Ensure an assessment is completed of whether an input is observable or unobservable when testing the FVM hierarchy classification.
Investigate and test controls over inputs to FVMs. Examine resolutions of pricing differences, the budgetary process, and classification of securities available for sale. Do not set risk thresholds too high, so as to obscure material errors. Be sure to identify weaknesses due to lack of supervision by qualified personnel in testing of hard-to-value financial instruments.
Examine other-than-temporary impairments (OTTI). Test controls over classification of securities as OTTI and the issuer’s evaluation of securities as potentially OTTI. Evaluate assumptions, calculations, and completeness of an issuer’s OTTI test.
Identify weaknesses in risk assessment and controls. Examine whether there was a failure to test asset impairment. Assess and identify deficiencies in the issuer’s methodology for determining fair value of reporting units and whether the timing of the impairment charge was appropriate. Identify deficiencies in controls related to triggering events. Test the issuer’s assertion that assets weren’t impaired, ignoring evidence that triggering events had occurred.
Identify asset mismatches. Identify mismatches between the group of assets being tested for impairment and the group of assets included in the calculation of carrying value. Identify an issuer’s departure from GAAP by allocating goodwill to reporting units.
For more, see Acuitas Inc.’s Survey of Fair Value Audit Deficiencies, which is available at tinyurl.com/9w9gzs3.
—By Morris E. Harris, CPA, CGMA (email@example.com), an AICPA manager for member specialization and credentialing.