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
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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.
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 disclosure, it
does not establish detailed guidance for
auditing specific types of fair value
estimates. Instead, the SAS provides
guidance on understanding management’s
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
GAAP’s fair
value requirements
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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.
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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
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).
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
management’s fair value estimation
process and relevant GAAP requirements,
to design their audit procedures.
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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.”
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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.
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