Auditing Fair Values

Professor Jennifer Joe

Relevant Financial Accounting

Standards
ASC 820 (Accounting Standards Update (ASU)
No. 2011-04, Fair Value Measurement (Topic
820): Amendments to Achieve Common Fair
Value Measurement and Disclosure
Requirements in U.S. GAAP and IFRS
IFRS 13 (Fair Value Measurement)
These standards require that FV be measured
based on an exit price (not the transaction
price or entry price) determined using several
key concepts.

Items Which Permit/Require FV

Measurement
Derivatives and non-derivative financial assets and liabilities
Assets and liabilities in a business combination, goodwill, contingent
consideration, and intangible assets
Asset retirement obligations
Impairments of intangible or long-lived assets
Liabilities for exit and disposal activities
Assets of pension and other postretirement benefit plans
Guarantees
Consideration received that should be recognized as revenue
Real estate held for sale
Financial Instruments
Disclosures of long-term debt and other financial instruments not carried
at FV on the balance sheet

Key concepts
Definition: Fair value (FV) is defined as the
price that would be received to sell an asset or
paid to transfer a liability in an orderly
transaction between market participants at
the measurement date.
The FV of a liability is based on the amount that
would be paid to transfer that liability to
another entity with the same credit standing.
The valuation of a liability should incorporate
nonperformance risk, which represents the risk
that a liability will not be paid.

Key concepts
Determining the Market
Valuation is based on the principal market (the
market with the greatest volume and level of activity
for the asset or liability being measured at fair value.
IF no principal market, then use the most
advantageous market (the market in which the
entity would maximize the amount received to sell an
asset or minimize the amount that would be paid to
transfer a liability).
If no known potential or accessible markets, the
reporting entity will need to value the asset in a
hypothetical market based on assumptions of
potential market participants

Key concepts
The FV standards emphasize the unit of
account Thus, an asset or liability measured
at FV may be (1) a standalone asset or
liability (e.g., a financial instrument) or (2) a
group of assets, a group of liabilities, or a
group of assets and liabilities (e.g., a
reporting unit or a business).
FV is a market-based measurement, not an
entity-specific measurement. FV of an
asset/liability should be determined based on
a hypothetical transaction at the
measurement date, from the perspective of a
market participant.

Valuation
Determining FV often requires a variety of
assumptions as well as significant judgment.
A reporting entity shall use valuation techniques
that are appropriate in the circumstances and for
which sufficient data are available shall be used to
measure fair value, maximizing the use of relevant
observable inputs and minimizing the use of
unobservable inputs
The objective of using a valuation technique is to
estimate the price at which an orderly transaction
to sell the asset or to transfer the liability

Valuation Techniques
Three widely used valuation techniques are
market approach - based on mkt prices; mark-to-market
market transactions involving identical or comparable (that is,
similar) assets, liabilities, or a group of assets and liabilities,
such as a business.

cost approach replacement cost; mark-to-cost

the amount that would be required currently to replace the
service capacity of an asset

income approach CF on earnings discount flow approach;

Mark-to-model
The income approach converts future amounts (for example,
cash flows or income and expenses) to a single current (i.e.,
discounted) amount. e.g. Option-pricing models, such as the
Black-Scholes-Merton model

Valuation Techniques
The determination of what constitutes observable inputs requires significant
judgment. Observable inputs have the following hierarchical order:
Prices or quotes from exchanges or listed markets (e.g., NYMEX, CBOT, or New
York Stock Exchange (NYSE)) in which there is sufficient liquidity and activity;
Proxy observable market data that is proven to be highly correlated and has a
logical, economic relationship with the instrument that is being valued (e.g.,
electricity prices in two different locations, or zones that are highly
correlated); and
Other direct and indirect market inputs that are observable in the marketplace
Evidence that an input is market-based and observable:

Not proprietary: sources other than within the reporting entity

Readily available: Market participants should be able to obtain access to the data
Regularly distributed: timely
Transparent
Verifiable
Reliable
Supported by market transactions

Required Disclosures

The objective of the disclosures is to help

users of the financial statements assess
1) the valuation techniques and inputs used
in measuring assets and liabilities at fair
value on the balance sheet on a recurring
and nonrecurring basis
2) the effect of recurring fair value
measurements determined using significant
unobservable inputs (i.e., Level 3
measurements) on earnings or other
comprehensive income for the reporting

Fair Value Hierarchy

To increase consistency and comparability in fair value
measurements and related disclosures, the standards
establish a fair value hierarchy that categorizes the
inputs to valuation techniques used to measure fair
value into three levels.
The fair value hierarchy gives the highest priority to
quoted prices (unadjusted) in active markets for
identical assets or liabilities (Level 1 inputs); and the
lowest priority to unobservable inputs (Level 3 inputs).
By distinguishing between inputs that are observable in
the marketplace, and therefore more objective, and
those that are unobservable and therefore more
subjective, the hierarchy is designed to indicate the
relative reliability of the fair value measurements.

Fair Value Hierarchy

Level 1 inputs are quoted prices (unadjusted)
in active markets for identical assets or
liabilities that the reporting entity can access
at the measurement date.
A quoted price in an active market provides
the most reliable evidence of fair value and
shall be used without adjustment to measure
fair value whenever available

Fair Value Hierarchy

Level 2 inputs are inputs other than quoted prices included within Level 1 that
are observable for the asset or liability, either directly or indirectly.
If the asset or liability has a specified (contractual) term, a Level 2 input must
be observable for substantially the full term of the asset or liability. Level 2
inputs include the following:
Quoted prices for similar assets or liabilities in active markets
Quoted prices for identical or similar assets or liabilities in markets that are not
active
Inputs other than quoted prices that are observable for the asset or liability, for
example: Interest rates and yield curves observable at commonly quoted
intervals, Implied volatilities
Market-corroborated inputs.

Adjustments to Level 2 inputs will vary depending on factors specific to

the asset or liability. Those factors include the following:
The condition or location of the asset
The extent to which inputs relate to items that are comparable to the asset or
liability (including those factors described in paragraph 820-10- 35-16D)
The volume or level of activity in the markets within which the inputs are observed.

Fair Value Hierarchy

Level 3 inputs are unobservable inputs for the asset or
liability (e.g., a reporting entitys own data)
Unobservable inputs shall be used to measure fair
value to the extent that relevant observable inputs are
not available, thereby allowing for situations in which
there is little, if any, market activity for the asset or
liability at the measurement date.
Level 3 inputs may include information derived
through extrapolation or interpolation that cannot be
directly corroborated by observable market data.
In developing Level 3 inputs, a reporting entity need
not undertake exhaustive efforts to obtain information
about market participant assumptions

Audit Standards on FV
AU sec. 328 & AU sec. 342 provide the procedural
requirements related to auditing fair value measurements
(FVM).
AU sec. 328 requires auditors obtain an understanding of
the entitys process for FVM and disclosures, and of the
controls sufficient to develop an effective audit
approach (N,T,E)
controls over data
segregation of duties between those committing the entity to
the underlying transactions and those responsible for
undertaking the valuations
expertise and experience of those persons determining the FVMs
role that information technology has in the process
types of accounts or transactions (routine and recurring or not)

Understanding The Entitys

Process For FVM and Disclosure
Extent to which the entitys process relies on a service
organization to provide fair value measurements or the data that
supports the measurement.
Extent to which the entity engages or employs specialists in
determining fair value
The process used to develop and apply management
assumptions used in determining the FVM and the documentation
supporting the FVM
The process used to monitor changes in managements
assumptions
The integrity of change controls and security procedures for
valuation models
The controls over the consistency, timeliness, and reliability of the
data
the inherent limitations of internal control, including the risk of
management override

Substantive Procedures of
FVMs
When the client estimates FV using a valuation method, AU sec.
328.18 requires the auditor to evaluate whether the company's
method of measurement is appropriate in the circumstances.
Auditor should obtain written representations from management
regarding the reasonableness of significant assumptions, including
whether they appropriately reflect managements intent and ability to
carry out specific courses of action, where relevant, to the use of FVMs
The appropriateness of the measurement methods, including related
assumptions, used by management in determining fair value and the consistency
in application of the methods.
The completeness and adequacy of disclosures related to fair values.
Whether subsequent events require adjustment to the fair value measurements
and disclosures included in the financial statements.

The auditor should consider whether to engage a specialist and use the
work of that specialist as evidential matter in performing substantive
tests

Substantive Procedures of
FVMs
The standards require auditors to take one or a
combination of 3 approaches:
1. Test management's process
Evaluate significant assumptions used by management
for reasonableness (how consistent with market?)
Evaluate the appropriateness of managements model, if
applicable
Test the data used (Is it complete, accurate and relevant;
time sensitive?)
evaluate the consistency of managements assumptions

2. Developing an independent estimate

3. Reviewing subsequent events or transactions after
year end but before issuance of audit opinion.

Disclosures
Evaluates whether the entity has made adequate
disclosures about fair value information
If an item contains a high degree of measurement
uncertainty, the auditor assesses whether the
disclosures are sufficient to inform users of such
uncertainty.
If the entity has not appropriately disclosed fair
value information required by GAAP, the auditor
evaluates whether the financial statements are
materially misstated.

PCAOB Findings on FV
Auditing
Failure to perform sufficient subjective
audit procedures to test the
reasonableness of the fair value estimates
Failure to identify and test controls over
inputs to FVM
Failure to test FVM hierarchy
classifications and disclosures
Failure to evaluate the reasonableness of
assumptions
(source Acuitas Inc. Survey of FV Audit Deficiencies)