The increase in the amount of fair value measurements, in financial reporting, creates a challenge for auditor. Auditing the fair value measurements is complex since fair value measurements often include assumptions that are based on judgment or other non-market-based information. An independent auditor, in conducting a fair value audit however, should test management’s fair value measurements and disclosures by performing substantive test on its evidences—just as with any financial statement assertion.
By doing so, auditor can see if the evidence supports management’s assertion and is able to ensure that the assertion is free from material misstatement.
Those substantive tests of the fair value measurements may include testing management’s significant assumptions, valuation model and the data that are used to backup the assertion. So, how does an auditor carry on the management’s fair value measurement test? Some fair value measurements are much more complicated than others. The level of complexity is due to the nature of the item being measured at fair value and the degree of sophistication of the valuation method itself. For example, if the equity of a reporting unit under SFAS 142 is not publicly traded, the fair value of the equity may be estimated by using valuation methods such as the discounted cash flow method or the guideline public company method. Before going to the main topic, let’s have a look at management’s vs. auditor’s responsibility in this particular subject. Read on..
Management’s Vs Auditor’s Responsibilities on Fair Value
Management is responsible for the valuation and the information disclosed in the valuation report; in connection with that obligation, it needs to:
- Establish organizational procedures to assure complete and adequate documentation of all the valuation activities.
- Select appropriate valuation methods and models.
- Arrange the collection of all necessary and desired data (benchmarks).
- Define and adequately support all significant assumptions.
- Prepare the valuation report.
- Ensure that the presentation and disclosure of the valuation conclusions for financial statement purposes are in accordance with IFRS.
Even when using an expert to determine certain required values, the overall responsibility still remains with management. Management has to ensure that the expert possesses special skills, knowledge, and experience in the field of valuation applicable to the particular subject. The professional qualification of the valuator should be documented in the report.
In contrast, the auditor’s responsibility is limited to assessing whether the significant assumptions used by management (and any experts) in the valuation process provide a reasonable basis for measuring the particular value in the context of an audit of the financial statements taken as a whole. The objective of the audit procedures is, therefore, to obtain sufficient and appropriate audit evidence to provide an opinion on the assumptions themselves.
The auditor may not shift responsibilities to the valuator; therefore, the auditor has to perform substantive procedures to test the entity’s valuation conclusions, including those prepared by the valuator.
As part of the auditor’s working papers, the valuation report must in general enable any knowledgeable reader to understand the results of the valuation processes and estimate the effects of the assumptions made on the conclusions (the so-called inter-subjective audit trail). The valuator’s report could be the basis for the auditor assessing the risks, whether from error or fraud, of material misstatement of the value conclusions, which depend on other factors, including the reliability of management’s processes.
Testing Reliability of Process Used By the Management
Complex fair value measurements normally are characterized by greater uncertainty regarding the reliability of the measurement process. The greater uncertainty may be a result of: (a) the length of the forecast period; (b) the number of significant and complex assumptions associated with the process; (c) a higher degree of subjectivity associated with the assumptions and factors used in the process; (d) a higher degree of uncertainty associated with the future occurrence or outcome of events underlying the assumptions used; or (e) lack of objective data when highly subjective factors are used.
Proper audit procedures for fair value measurement, therefore, require the auditor to understand management’s process for determining fair value measurements and to assess the risk of material misstatement of the fair value measurement. Audit procedures are designed based on the assessment of management’s process for determining fair value measures and on the risk of material misstatement.
Typical situations an auditor might encounter and procedures that an auditor might consider when auditing fair value measurements, are well presented on the SAS 101, AU 328:
- When the fair value measurement is made at a date other than the financial statement reporting date, the auditor should obtain evidence that management has taken into consideration any differences that may impact the fair value measurement between the date of the fair value measurement and the reporting date. This may occur when an outside valuation specialist—employed by the management—conducts the analysis as of a different date due to information constraints or timing constraints for the engagement.
- When collateral is an important aspect in the fair value measurement of an investment (FYI: certain types of investments in debt instruments measured at fair value have collateral assigned to them) the auditor should obtain sufficient appropriate audit evidence that the features of the collateral have been considered by management in estimating its fair value.
- When testing for impairment, possible impairment of the collateral must also be considered. In certain circumstances, the auditor should perform additional procedures, such as a visual inspection of an asset. A detailed inspection of the asset may reveal information about the current physical condition of the asset, which may impact its fair value. An inspection of a security or other asset may reveal a limitation as to its marketability, which may affect its value.
A critical step in determining appropriate audit procedures is gaining an understanding of the process used by management to determine fair value measurement. When the auditor tests managements’ fair value measurements, the evaluation process should consider the basis that management used in the fair value measurement.
Management’s assumptions in the fair value measurement should be reasonable and consistent with information available from the market. If market information is not available, the fair value measurement should be estimated using an appropriate valuation model for that particular asset or liability. Management should use all of the relevant information available on the date of measurement when determining an asset or liability’s fair value.
Testing Management’s Significant Assumptions, Valuation Model, and Data
Once the auditor gains confidence as to the reliability of the process used by management to determine fair value measurement, the next step is to test management’s assumptions, the valuation model, and underlying data used in the model. Some considerations in auditing fair value measurements are:
- Management’s assumptions are reasonable and are consistent with assumptions made by market participants.
- Management uses an appropriate valuation model to estimate the fair value measurement.
- Management uses known or knowable market participant assumptions that are available on the measurement date.
One simple way to determine the reliability of management’s processes, at least the indication, is by comparing the current fair value measurement to prior periods. Significant swings in value might be evidence that management’s process is unreliable. Therefore, the auditor should also take into consideration that the estimate of fair value may be impacted by market or economic changes from the prior period.
All valuation methods, however, are based on assumptions. The report has to thoroughly disclose and support all the significant assumptions underlying each adopted method under one of three approaches: market, income and cost. This will allow the auditor to evaluate whether the significant assumptions, individually and together, seem reasonable and realistic.
The value conclusions based on the underlying assumptions are influenced mainly by the method selected. Therefore, the valuation model, its parameters, and its input data have to be thoroughly described so that the auditor can recalculate the valuation step by step. As well, the report should include, possibly in appendixes, calculations of the sensitivity of the valuation to changes in each significant assumption.
The auditor should evaluate the appropriateness and the applicability of the valuation model. The latter may be limited by the relevant standard. For example, it is required for business valuations to be determined by means of a discounted cash flow method under the Income Approach; the use of the Market Approach is allowed only to assess the plausibility of such values. In contrast, IFRS 3 and, in particular, IAS 39, Financial Instruments: Recognition and Measurement, express a clear preference for the Market Approach in estimating fair values of assets and liabilities. The Cost Approach, which assumes the value of an asset or entity is its replacement costs, is inappropriate in many cases, as it looks to the past, not to the future.
Testing the Reliability of Management’s Assumptions
Assumptions are an essential component of valuation methods, particularly in detailed valuation models. Irrespective of the approaches used, all significant assumptions have to be explained in detail and reviewed carefully by the auditor.
The key assumption of the Market Approach is that the selected guideline is really comparable to the subject. Only in rare circumstances will there be quoted prices from active markets, which are the best audit evidence of fair value. In the context of the global financial crisis, many markets are no longer active, and information from inactive or illiquid markets is not reliable; in those cases, the valuation has to be done by using other techniques, using market data as support.
For example, a discounted cash flow analysis under the income approach is commonly used to measure fair value. A discounted cash flow model incorporates assumptions about expected future cash flows within a discrete forecast period, assumptions about the cash flows after the discrete forecast period, and even more assumptions about the rate of return required to compensate for the uncertainty associated with the future receipt of those cash flows. Auditors should pay particular attention to the assumptions incorporated into a discounted cash flow model and evaluate whether those assumptions are reasonable and are consistent with market participant information.
The crucial factor in computing present value of forecast cash flows is the discount rate, which has to reflect a suitable term and risk-adjusted yield curve. The discount rate typically consists of two components: the basic risk-free interest rate for various maturities of zero-coupon government bonds and the term-related credit spread. In illiquid markets, a third component, the liquidity premium has to be considered as well. These factors should be based on objective market information, which is more relevant and reliable than subjective management estimates.
All input data and its sources have to be disclosed in the valuation report so that the auditor may evaluate their accuracy, completeness, and relevance. He or she will review the assumptions for internal consistency, including whether the management’s intent and ability to carry out specific courses of action is consistent with the entity’s plans and past achievements.
For corroborative purposes, the auditor should prepare independent value estimates by comparing the results in the valuation report with those obtained by using an internally developed version of the valuator’s model. Instead of management’s assumptions, the auditor may apply his or her own in the course of the audit to test the sensitivity of the valuation. These help the auditor to understand better the influence of particular factors on the value.
When testing management’s assumptions, the auditor should evaluate whether significant assumptions used by management in measuring fair value provide a reasonable basis for the fair value measurements.
In evaluating evidence to support the assumptions used by management in fair value measurement, the auditor must consider the source and reliability of the evidence and take into consideration historical and market information related to the evidence. Management should identify assumptions that are significant to the fair value measurement. The auditor then focuses on the evidence that supports the significant assumptions that management has identified. Significant assumptions are those that materially affect the fair value measurement, such as:
- Assumptions that are sensitive to variation or are uncertain in amount or nature – For example, assumptions about a discount rate may be susceptible to significant variation compared to assumptions about longterm growth rates in cash flow.
- Assumptions that may be susceptible to misapplication or bias and can be easily manipulated in the fair value measurement – An example would be the selected royalty rate in the relief from royalty method used to estimate the fair value of a trade name.
In considering the sensitivity of the fair value measurement to variation in significant assumptions, the auditor may ask management to use techniques such as sensitivity analysis to help identify sensitive assumptions. If management has not identified particularly sensitive assumptions, the auditor should consider whether to employ sensitivity analysis to identify those assumptions that may be significant to the measurement.
Assumptions used in fair value measurements should have a reasonable basis individually and when used with other assumptions. An assumption may appear to be reasonable individually but many may not be reasonable when used in combination with other assumptions.
For example, in a fair value measurement that use a discounted cash flow valuation method, management may assume that the company’s revenue will grow 5 percent each year for the next five years. If the company has historically grown 5 percent per year, this assumption may appear to be reasonable, at first. However, the forecast may also assume that management is curtailing certain operating expenses and capital expenditures for the next year due to borrowing constraints. The assumption of 5 percent growth may not be reasonable if management does not have the cash available to support growth in revenue as it had in the past.
To test the reasonableness of assumptions in a fair value measurement, the assumptions have to be reasonable individually and in combination with other assumptions. For the fair value measurement to be considered reasonable, SAS 101, AU 328, “Auditing Fair Value Measurements,” suggests that assumptions have to be consistent with these factors as well:
- General economic environment
- Situation of the specific industry
- Entity’s particular circumstances
- Existing market information
- Strategic plans of the entity, including what management expects will be the outcome of specific objectives and activities
- Assumptions made in previous valuation assignments, if appropriate
- Past conditions experienced by the entity to the extent they are currently applicable
- Risks associated with future cash flows, including potential variability in their amounts and timing together with any related effects on the selected discount rate
A fair value measurement generally has two types of assumptions. The first type of assumption is based on historical information such as past financial performance. If a company’s revenue has grown at 5 percent per year for the past five years, it may be reasonable to forecast 5 percent growth for the next five years. However, the reasonableness of this assumption should be considered in conjunction with other assumptions. The second type of assumption used in a valuation model is not based on historical information.
In auditing the reasonableness of an assumption, the auditor should also consider whether the assumption is consistent with management’s plans and past experience. For example, management may rely on historical financial information as a basis for the assumption in the fair value measurement. If overall conditions remain consistent with the past then this assumption may be reasonable. If management changes strategies or other conditions change, the assumption may not be reasonable.
In a fair value measurement based on a valuation model, the auditor should first review the model and evaluate whether the model is appropriate for the fair value measurement. If it is appropriate, then the auditor should evaluate the significant assumptions used in the model for reasonableness.
For example, it may be inappropriate to use the guideline company method under the market approach to estimate the fair value of an early-stage equity investment when there are limited revenues to support normalized earnings and cash flow due to the company’s stage of development.
Finally, if the auditor believes that the valuation model and the assumptions used in the model are appropriate, then the auditor should test the underlying data used in the valuation model. For example, if the guideline company method is used to estimate the fair value of a reporting unit, the auditor should test the data by comparing it to similar data from publicly traded guideline entities. The comparison should test data for accuracy, completeness and relevancy. Significant differences between management’s and the auditor’s estimate have to be settled within the audit procedures.