Audits of fair value measurements (FVM) are challenging because the valuations are typically developed by management (or third-party valuation professionals retained by management) using significant professional judgment and other qualitative inputs. This challenge is caused, in part, by a gap in understanding by each profession of what the other profession requires to successfully deliver its services. Thanks to a collaborative effort within the valuation profession, that gap may significantly narrow.
The use of FVM in financial reporting has been increasing in all industries. Because of the many types of valuations performed and the diverse background of people doing valuation work, the quality of this work may vary.
"Fair value measurements by their nature are more subjective," said Travis Harms, CPA/ABV/CEIV, senior vice president at Mercer Capital. "There are a number of variables and potential assumptions involved, each with a range of reasonableness, which increases the difficulty of auditing them as compared to other accounting estimates."
This variability has not gone unnoticed by the regulators—especially when the work does not meet the auditing and disclosure standards. In response to the regulatory concern regarding the inconsistency and deficiencies around FVM, the valuation profession and the valuation professional organizations (VPOs) set out to create a more uniform set of performance requirements designed to make the valuation profession more consistent and valuations more auditable. The AICPA, in partnership with the American Society of Appraisers (ASA), the Royal Institution of Chartered Surveyors (RICS), and others, developed the Certified in Entity and Intangible Valuations (CEIV) credential program. The CEIV program will help valuation professionals protect the public interest by better defining the scope and documentation of work, providing a system for quality monitoring, and establishing a code of ethics for credential holders.
The foundation of the CEIV credential is the Mandatory Performance Framework (MPF or framework) and the Application of the MPF (collectively the "MPF documents"). The MPF documents establish minimum requirements for scope of work and documentation when conducting a valuation that will be used by management to support its fair value disclosures for financial statement reporting purposes.
The framework and the Application of the MPF were designed to be used by all valuation professionals who provide valuation services for financial reporting purposes. Valuation professionals who have earned the CEIV credential are required to adhere to the framework and the application of the MPF when they perform relevant work. The leaders in the valuation profession who created the framework also believe that adhering to the MPF documents should be considered best practice for valuation professionals who do not have the CEIV credential.
The following tips can help auditors as they audit FVM:
Auditors should understand and document underlying assumptions and management's rationale in arriving at fair values. Auditors who work on public companies will need to understand the requirements in PCAOB Auditing Standard (AS) 1105, Audit Evidence; AS 1215, Audit Documentation; and AS 1210, Using the Work of a Specialist, among others. Auditors who also work on private companies will need to understand the requirements in the comparable auditing standards published by the AICPA (e.g., AU-C Section 230, Audit Documentation).
"For auditors, the challenge is to adequately document the work that was performed, including what was known or knowable at the valuation date," said Travis Chamberlain, CPA/ABV, a principal at CliftonLarsonAllen LLP.
Procedures that are commonly used and documented to assess the reasonableness of management's FVM include, but are not limited to, comparing management's assumptions for reasonableness to third-party reports, market research, third-party vendor databases, and financial statements of similar companies (see the sidebar "The MPF: Assisting With Documentation").
Understand the relationship between management assumptions and calibration
Management, or its third-party valuation professionals, will typically develop a model for valuing something like a business or intangible assets. Regardless of whether management or a retained third-party valuation professional prepares the model, management is responsible for providing the information that will be used as the model's inputs. Inputs may include "management assumptions" (e.g., revenue growth of 5% over the next eight years) that are classified as "unobservable," meaning that someone outside of the company would be unable to confirm this information with publicly available data.
Auditors need to be alert to the fact that when a model uses an unobservable input on the initial measurement date, FASB ASC Topic 820, Fair Value Measurement, requires that management calibrate those unobservable inputs on subsequent measurement dates.
"While private companies may not care so much about intangibles on their balance sheets, or how much of the purchase price is allocated to goodwill versus customers or trademarks, users of the financial statements do care," said Steve Siefert, financial and valuation senior manager at Baker Tilly Virchow Krause LLP. "The initial valuation can affect future accounting, including impairment. Getting it wrong can affect market valuation and future earnings, so if they get it wrong, market participants will care."
ASC Paragraph 820-10-35-24C requires that:
If the transaction price is fair value at initial recognition and a valuation technique that uses unobservable inputs will be used to measure fair value in subsequent periods, the valuation technique shall be calibrated so that at initial recognition the result of the valuation technique equals the transaction price. Calibration ensures that the valuation technique reflects current market conditions, and it helps a reporting entity to determine whether an adjustment to the valuation technique is necessary (for example, there might be a characteristic of the asset or liability that is not captured by the valuation technique). After initial recognition, when measuring fair value using a valuation technique or techniques that use unobservable inputs, a reporting entity shall ensure that those valuation techniques reflect observable market data (for example, the price for a similar asset or liability) at the measurement date.
The key is that the unobservable inputs used in the valuation are calibrated such that the model provides a value for the asset based on the observed transaction price on the date of the initial transaction. For example, management developed a discount rate for future cash flows of a recently acquired operating unit in order to estimate the operating unit's fair value on the date the operating unit was purchased (the transaction date). On subsequent measurement dates (e.g., when assessing company value to evaluate goodwill for impairment as required by Topic 350, Intangibles—Goodwill and Other), management must use the initial discount rate applied on the transaction date as a starting point and update the assumptions and inputs used to develop the discount rate on subsequent measurement dates based on all relevant market participant assumptions (e.g., changes in risk profile, firm-specific outlook, cost of capital, and market conditions).
Management may not simply default to using the same discount rate used on the transaction date for subsequent measurement dates, even if the subsequent measurement date is close to the initial measurement date (see the sidebar "The MPF: Helping Auditors Understand the Relationship Between Management Assumptions and Calibration").
Back-testing is the process of comparing an observed value of a security that resulted from a transaction in the marketplace or write-off with the FVM of that same security estimated on a prior measurement date(s). The purpose of back-testing is to improve management's ability to arrive at the best FVM with the benefit of using information from an actual transaction. The process improvement usually focuses on the qualitative factors affecting FVM (i.e., where professional judgment is required). Auditors should discuss with management if processes are in place that periodically retroactively evaluate FVM when a liquidation event or exit value has been observed. If a company does apply back-testing to improve its FVMs, auditors should note three important concepts:
- In the event back-testing identifies differences between the FVM on the measurement date and the observed transaction price, this does not indicate that the FVM on the measurement date was wrong or that management's process is insufficient. Instead, it could mean that there were significant events within the business or larger macroeconomic variables that impacted the value in the interval between the two dates. It could also indicate that this iterative process is at one point on the continuum of improvement and that, given the same facts and circumstances in the future, the gap between FVM on the measurement date and a subsequent observed value would be smaller.
- Topic 820 does not explicitly require back-testing. This process is consistent with the standard's requirements of evaluating and, if needed, modifying or supplementing valuation methodologies when certain events take place.
- Back-testing is fundamentally different, both in purpose and application, from the requirements established by Topic 855, Subsequent Events.
Management (including any retained third-party valuation professionals) must ensure that FVM includes requirements for robust analyses and documentation of both the quantitative and qualitative elements used when back-testing as well as the process of how the results of back-testing are used to improve management's ability to estimate FVM in the future. If these are in place, auditors will have a much easier job of assessing whether management's fair value estimates are reasonable.
Evaluate changes in fair value approaches and methods
Auditors should assess the consistency of fair value methods used by management. ASC Paragraph 820-10-35-25 requires consistent application of the valuation techniques unless the change is more representative of fair value. Auditors and management should note that under Topic 820, a change in valuation technique (or the weight applied to multiple techniques) when done to reflect a more representative fair value is considered a change in an accounting estimate. ASC Paragraph 820-10-50-7 notes, however, that the disclosures for a change in accounting estimate required by Topic 250, Accounting Changes and Error Corrections, are not required for a revision resulting from a change in a valuation technique or its application when a change in technique is made to achieve a more representative fair value estimate.
Part of the auditor's job is to educate clients on the work they do relating to auditing of management's FVM, including the necessity of understanding and evaluating appropriateness of the model, model inputs, and valuation approaches and methods. This education will provide the client with a clearer understanding of the support and documentation they need to provide auditors and may motivate management to better understand how fair value estimates were developed and supported. This may also include reminding management that it is responsible for the financial statements, including fair value estimates included in those financial statements, even if those fair value estimates were prepared by third-party valuation professionals.
Communicate with third-party valuation professionals
Management, the valuation professionals, and the auditors should be aligned on the scope of the valuation and how the work of the valuation professional will be used well before the valuation begins. Auditors should request that management require the valuation professional to communicate the preliminary valuation approach and methods that will be used in the valuation, including key inputs and expected outputs/values, who is responsible for information needed and deliverables, and the timing of the fieldwork. The discussion should include potential challenges with the valuation (e.g., limited client records or analyses) and any limitations the client may be imposing on the valuation professional's analysis (e.g., management is requesting a limited valuation analysis instead of a comprehensive valuation analysis). This communication can save significant time upfront and avoid possible delays to the audit instead of addressing misaligned expectations after the valuation report has been received.
Understand valuation professionals' qualifications
Depending on whether the client retains a third-party valuation professional or the auditor retains a valuation professional (to help evaluate management's fair value estimates), several auditing standards apply to the engagement. PCAOB AS 1210 applies to either situation (management hired or auditor hired). For auditors who audit private companies, the AICPA's AU-C Section 620, Using the Work of an Auditor's Specialist, describes auditors' duties when they are using the work of specialists, and AU-C Section 500, Audit Evidence, paragraph .08, addresses what auditors must consider when management retains the specialist.
These responsibilities include evaluating whether the valuation professional possesses the necessary competence, capabilities, and objectivity. This process should include inquiring into interests and relationships that may compromise the valuation professional's objectivity, and all considerations should be thoroughly documented within the auditor's engagement file.
Review valuation professionals' work
To improve communication and understanding between specialists and auditors, auditors should determine whether the specialists considered various valuation methods relevant to the type of valuation performed and understand why they used or did not use them. Auditors should understand that there is a range of reasonable assumptions, and specialists should listen to suggestions from the auditors.
Management's prospective financial information (PFI) is often one of the primary inputs into a fair value estimate. Management is responsible for any PFI it creates. Auditors should review and challenge any budgets and forecasts provided by management. Because valuation professionals are not required to "audit" the PFI, it is not an uncommon practice for valuation professionals to take management's PFI at face value and incorporate it into their models. Valuation professionals themselves have been critical of those who have adopted this approach, but without any requirements establishing a set of uniform expectations, there was often little recourse (see the sidebar "The MPF: Assisting With Reviewing Prospective Financial Information").
The MPF: Assisting with documentation
Mandatory Performance Framework (MPF) Section 1.4 requires valuation professionals to provide in the work file sufficient documentation to support a conclusion of value such that an "experienced professional" not involved in the valuation engagement could review and understand the significant inputs, analyses, and outputs and how they support the final conclusion of value. Auditors should note that this section of the MPF establishes a requirement for valuation professionals to prepare a sufficient level of documentation so that a professional who has experience in reviewing valuation engagements (this includes, but is not limited to, management, auditors, attorneys, and other valuation professionals) will be able to readily identify the significant components of the report and how they support the conclusion of value. The MPF strongly encourages that this information be included in the valuation report but does not require it. If, however, an auditor does not see this information in the report, it must be in the working papers, and the auditor will need to discuss with management and the valuation professional how best to review that information.
The MPF: Helping auditors understand the relationship between management assumptions and calibration
Some of the most important information management can provide to auditors to help them audit fair value measurements is the inputs and updated inputs developed and used when management is required to calibrate its valuation techniques.
The Application of the Mandatory Performance Framework (MPF) Section A1.2.5 requires that the valuation report or working papers contain the following information, as applicable:
- Assessment of fair value of the subject interest at the initial transaction (for example, consideration of unit of account, principal market, market participants, and methods and inputs used to determine fair value).
- The relevance of all calibrated inputs used to estimate fair value on subsequent measurement dates.
- The evaluation of all inputs used to estimate fair value on subsequent measurement dates.
- The evaluation of management's rationale and support for the inputs used to estimate initial fair value of the subject interest and its Topic 820 hierarchy classification (for example, level 1, level 2, or level 3).
- The rationale for any changes in valuation approaches or methods used for subsequent measurement dates as compared to the initial transaction.
When an auditor is auditing FVM disclosures prepared by a valuation professional following the MPF requirements, and the FVM requires calibration, an auditor can use MPF Section A1.2.5 as a complementary set of instructions to assess whether management has, in fact, sufficiently documented "how much" as it relates to FVM and calibration. This assessment may require conversations with management and, as needed, the third-party valuation professional. Everyone will come to the table with the same expectations, and while reasonable minds may differ, at least the discussions will take place, and conclusions reached will be sufficiently documented.
The MPF: Assisting with reviewing prospective financial information
With the publication of the Mandatory Performance Framework (MPF) documents, auditors should expect that when management provides them with prospective financial information (PFI) that has been prepared in accordance with the MPF requirements, the valuation professional who prepared it will have worked with management to ensure the PFI is representative of expected value and properly supported. The support for the PFI must contain documented analysis that includes, as applicable:
- The identification of the party or parties responsible for preparation of the PFI.
- The process used to develop the PFI from the perspective of market participants.
- The explanation of key underlying assumptions used in the PFI such as revenue forecasts, percentage of market share captured by the entity, or how the projected profit margins compare to those of other market participants.
- The steps used in, and results of, testing the PFI for reasonableness including, but not limited to:
- A comparison of the PFI to expected cash flows;
- A comparison of the PFI to actual performance;
- A comparison and evaluation of the prior year's PFI against actual historical results (when prior PFIs are available); and
- An analysis of the forecast relative to economic and industry expectations.
- An analysis of any evidence that contradicts management's assumptions or conclusions used in its PFI.
- The rationale for any adjustments made to management's PFI.
- Evidence that a mathematical and logic check was performed. For example, this may include, but is not limited to, checking for: use of inaccurate cell references in applying functions; simple summation errors; use of improper functions in the spreadsheet; and use of improperly specified "macros" in the context of the use of the spreadsheet analyses.
- The financial statement line items of the prospective balance sheet and cash flow statements, if available.
As noted earlier, auditors can take this list of documentation requirements and use it to supplement their audit procedures and help ensure that their audit procedures are addressing the right issues and risks, and that management can adequately support its PFI.
"The greatest challenge for auditors is not that they and the valuation specialist are coming up with different conclusions from the same data, but rather that the ideal data set does not exist."
—Travis Harms, CPA/ABV/CEIV, senior vice president at Mercer Capital
"One of the key challenges in goodwill impairment testing is considering whether future results are grounded in current realities."
—Steve Siefert, financial and valuation senior manager at Baker Tilly Virchow Krause LLP
"Valuation is naturally a forward-looking exercise that involves estimates subject to additional scrutiny and application of judgment, and not everyone will agree upon the estimates and judgment calls made in arriving at those estimates. Fair value estimates may be derived, in part, from budgeting and forecasting processes that vary from company to company and that may be integrated in varying degrees with accounting processes."
—Travis Chamberlain, CPA/ABV, a principal at CliftonLarsonAllen LLP
About the authors
Maria L. Murphy (email@example.com) is a freelance writer based in Wilmington, N.C. Mark O. Smith (Mark.Smith@aicpa-cima.com) is a lead technical manager for Forensic and Valuation Services at the AICPA.
To comment on this article or to suggest an idea for another article, contact Ken Tysiac, editorial director, at Kenneth.Tysiac@aicpa-cima.com or 919-402-2112.
- "How to Improve Audit Planning Effectiveness and Efficiency," JofA, June 12, 2017
- "Audit Documentation: Tips for Getting It Right," JofA, June 2017
- "Checklist: Coping With Audit Changes," JofA, March 2017
- "ASB Issues New Going Concern Auditing Standard," JofA, Feb. 22, 2017
- CEIV Education for CPAs (#158510, online access; #GT-CEIVLC, group pricing)
For more information or to make a purchase, go to aicpastore.com or call the Institute at 888-777-7077.