Approaches to Determine Fair Value and Its Fraud Risks

Methods to Determine Fair ValueA discussion of the fair value accounting rules would be incomplete without at least providing an overview of some of the key principles involved in determining the fair value of an asset or a liability. After all, fraudulent financial reporting can involve misapplication of an accounting rule, misapplication of a valuation methodology, or a combination of both.  Most fair value measurements utilize one of three approaches to determining fair value: (1). Market approach; (2). Income approach; and (3). Cost approach. Each approach is explained in SFAS 157, and these explanations are provided in this post.

This post isn’t intended to be a comprehensive guide to determining fair values. Rather, it is designed to be a guide to the numerous complex accounting rules that rely on fair valuations for the measurement of various assets, liabilities, revenues, and expenses. It is these rules that are often violated in connection with fraudulent financial reporting. Enjoy

 

Market Approach

The market approach uses prices and other information generated by market transactions involving identical or comparable assets or liabilities. As noted in SFAS 157, use of the market approach sometimes involves estimating where within a range of multiples or other inputs an appropriate multiple or input should be. This requires the use of judgment, and all factors that are specific to the asset or liability being measured should be considered.

Some of these factors may be quantitative, but they are often qualitative. One of the most significant benefits of using the market approach is that it is based primarily on actual data. The data are often in the form of well-documented, publicly available prices recorded in active markets, such as with stock trades. Other data used in the market approach may not be as readily available as prices from stock markets, but are nonetheless objective and useful, such as the prices at which specific entities, lines of business, operating divisions, or locations are sold.

Fraud Risk
Drawing inappropriate conclusions about an asset’s fair value based on consideration of a range of prices or other inputs available from transactions in a market.

 

Of course, an important potential downside to the market approach is often that either active markets do not exist for a particular item or the comparison of the item in question with the known transactions in the market is complicated.

Often, there are known transactions in a market, but none are for assets or liabilities that are identical to the one for which a value is needed. The process of drawing this comparison can be extremely complex.

 

 

Income Approach

The income approach uses valuation techniques to convert future amounts (e.g., cash flows or earnings) to a single present amount (discounted). Consideration of future amounts can extend for many periods into the future or only a few. This requires much judgment. In some industries or for certain assets, specific time periods have become standard. But in most cases, the number of future periods to consider is a matter of judgment. Fair value determined using the income approach varies based on three primary factors:

  • The amount of cash flow—the higher the cash flow, the higher the value.
  • The timing of the cash flows—the sooner the cash flow, the higher the value.
  • The risks associated with the cash flows—the lower the risk, the higher the value.

Each of these three factors can be a target for misrepresentation in a fraudulent determination of fair value under the income approach. Within the income approach, valuation experts frequently utilize three distinct methods to value businesses or individual assets:

1. Discounted cash flow
2. Capitalized cash flow
3. Excess cash flow

Each of these three methods is explained in this section.

Fraud Risk
Misapplication of the income approach by using improper amounts for cash flows, manipulating the timing of future cash flows, or using an inappropriate discount rate, resulting in an inaccurate present value.

 

1. Discounted Cash Flow Method

The discounted cash flow method is the most commonly used application of the income approach. It is applied by calculating the present value of estimated future cash flows. This method can be applied to a single asset, a group of assets, a division, region, or an entire company. Cash flows may be estimated for a very short period of time or very long periods, up to infinity if an income stream is expected to continue forever.

The discount rate used in the income approach represents the rate of return that an investor would require. This rate considers three elements:

  • A basic rate of return without any consideration of risk, or how much of a return an investor desires in exchange for the use of the investor’s money
  • Anticipated rates of inflation, which corresponds to the expected depreciation in purchasing power while funds are invested
  • Risk associated with the uncertainty regarding the amount or timing of the estimated future cash flows

Each of these three elements requires the use of judgment and estimation, making them prone to potential manipulation in the perpetration of a fair value accounting fraud.

 

2. Capitalized Cash Flow Method

The capitalized cash flow method is a shortcut version of the discounted cash flow method. Unlike the discounted cash flow method, under the capitalized cash flow model, both the discount rate and the rate of growth in cash flow are assumed to remain constant in perpetuity.

Under the discounted cash flow model, separate cash flow projections can be developed for each future period, rather than assuming a particular growth rate over time. Then, if appropriate, different discount rates can be applied to each future period’s cash flow. For example, different discount rates may be utilized to factor in the greater uncertainty in cash flows that are further into the future than those that are in the very near future.

 

3. Excess Cash Flow Method

The excess cash flow method, also known as the excess earnings method, is sometimes used to value the intangible assets of a business rather than an entire business. It is referred to in the Internal Revenue Service’s Revenue Ruling 68-609 as having application to intangible asset valuation. The basic steps involved in the excess cash flow approach are as follows:

  • Step-1. Determine the fair value of net tangible assets of an entity.
  • Step-2. Determine normalized future cash flows in total (the concept of normalization is explained shortly), and break those cash flows down becomes: (a). Cash flows attributable to net tangible assets; and (b). Cash flows attributable to intangible assets, which is simply the difference between total cash flows and cash flows attributable to net tangible assets (i.e., separate determination of cash flows from intangible assets is not done)
  • Step-3. Determine what an appropriate rate of return on net tangible assets would be (also referred to as the weighted average cost of capital).
  • Step-4. Determine an appropriate rate of return on the intangible assets.
  • Step-5. Determine the fair value of intangible assets based on the capitalization rate determined in step 4.
  • Step-6. Determine a total fair value by adding the fair value of the net tangible assets to the fair value of the intangible assets.
  • Step-7. Determine the fair value of the entity’s equity by subtracting any interest-bearing debt obligations from the amount determined in step 6.

 

To properly apply the income approach, future cash flows must be normalized. Normalization represents the process of making projections of future cash flows most representative of what can be expected of the future. In other words, certain items that have historically impacted cash flows and that may be considered in estimates of future cash flows may need to be eliminated in order to get a true picture of what future cash flows will be like. For example, one of the more common adjustments necessary to normalize cash flows is for nonrecurring items, such as one-time expenditures.

Generally, there are many more considerations in normalizing the cash flows when valuing an entire business than there would be for valuing a single asset. In valuing an entire business, adjustments may be necessary for a variety of ownership, capitalization, debt, income tax, and other factors that may not be necessary when valuing a single asset.

 

4. Expected Cash Flow

A fourth possible approach to determining present values of future cash flows takes a different approach to measuring risk. This method, referred to as the expected cash flow approach, is described in SFAC 7, Using Cash Flow Information and Present Value in Accounting Measurements. In the three methods of applying the income approach explained so far, the various risks associated with future cash flows are considered in developing a single discount rate that is applied to those future cash flows. Under the expected cash flow approach, risk is handled in a different manner.

Instead of incorporating it into the discount rate, it is handled by determining multiple expectations of future cash flows and assigning probabilities to each. The element of risk is removed from the discount rate, leaving a much more reliable discount rate based primarily on an expected rate of return.

Under the expected cash flow approach, a weighted average of the various present values is calculated, based on the probabilities assigned to each calculation.

 

Cost Approach

The cost approach to determining fair value is based on assessing what the cost would be to replace an asset, or the service capacity of an asset, and then making adjustments to that cost figure. The primary adjustment to the cost figure is for obsolescence.

Fraud Risk
Using inappropriate replacement cost estimates or making inaccurate adjustments for obsolescence in determining fair value under the cost approach.

 

The obvious risks associated with the cost approach concern the replacement cost estimate and adjustments for obsolescence and any other relevant factor. Replacement cost estimates may in some cases be fairly easy, such as in cases in which an asset was purchased fairly recently and the same model of that asset is still being sold. Estimating replacement cost of unusual or custom-designed, custom-built assets becomes much more complicated and may require external assistance.

Adjustments for obsolescence can also be very easy or very difficult. But these adjustments, as well as other adjustments to the initial replacement cost, are an easy target for manipulation.

 

Internal versus Externally Developed Valuations

Fair values can be determined internally or externally:

  • When they are determined internally, management should make sure that the personnel involved in the process have the proper expertise for the specific valuation issues involved.
  • Externally developed valuations should be prepared by independent valuation experts with experience in valuing the specific types of assets, liabilities, or businesses in question. Management should determine that external valuation specialists are properly credentialed and experienced in the specific types of valuations needed. References should be checked and licenses and certifications verified.

 

Fraud Risk
Obtaining a tainted valuation report in support of a fraudulent fair value measurement used in the financial statements, using any of five techniques.

 

But in other cases, including some involving fair value accounting fraud, management doesn’t want the best valuation specialist. Instead, management wants to find a valuation specialist willing to provide a report that supports what management wants to use as a fair value in the financial statements.

Unscrupulous members of management may go to great lengths to obtain a report in support of a preferred fair value, all to dupe auditors and others who may question a particular value in the financial statements.

Improper valuations used in support of a fair value accounting fraud can be generated internally or may come from third-party experts. When third-party valuation experts are involved, there are five situations in which a fraudulent valuation can result:

  • Bribed appraiser. In a worst-case scenario, an outside party may be bribed in order to issue a valuation report that supports a fair value accounting position of management. This is the most egregious offense in this area and also one of the most difficult to detect.
  • Conflict of interest. If there is a concealed financial or other relationship between either the entity or a member of management and the outside valuation specialist, the specialist is not independent and the report may support a fraudulent valuation preferred by management.
  • Unwitting accomplice. In the first two cases, the appraiser is an accomplice to the fraud and he/she knows it. In other cases, a third-party valuation specialist may unwittingly prepare a valuation report in support of a fraud, as a result of pressures applied by management, suppression of information by management, reliance on phony data provided by management, or other tactics. This is most likely to occur when the outside party is either inexperienced or careless in his/her work.
  • Sham valuation specialist. Another method that could be used to perpetrate fraud is the preparation of a completely fictitious valuation report from a nonexistent valuation specialist. This approach is similar to any other phony/sham vendor scheme in that the perpetrator prepares false documentation that makes it appear that an actual vendor exists.
  • Altered report. Management may have arranged for and received a valuation report from a respected professional valuation expert. But the report does not support the position preferred by management. Could it be possible for management to make alterations to the report prepared by the valuation expert in order to make it appear that the expert supported the fraudulent valuation reflected in the financial statements of the entity? Reports should be reviewed carefully for signs of altered text, missing pages, additions inserted into the report, or other signs of alteration.

 

Other than the obvious signs of alteration described in the last situation, there are other signs that a valuation report may be flawed. Those flaws may be a sign of fraud, not merely carelessness by an appraiser. Here are 10 signs to watch out for in valuation reports:

  • Mathematical and clerical errors, including cross-references that don’t agree, grammatical mistakes, and similar careless errors
  • Apparent exaggeration and excessive reliance on positive factors, or downplaying negative factors
  • A report that lacks a sufficient level of detail, especially details involving the data used in support of the valuation (interest rates, cash flow assumptions, etc.) and descriptions of valuation methodologies utilized
  • Misrepresentation of the specialist’s licenses, education and training, or credentials—don’t be fooled by a specialist with a lot of certifications after his/her name—verify those licenses and other credentials
  • The use of unusual valuation methods or methods that are not known as being commonly accepted for a particular type of valuation (or making unexplained modifications to a commonly accepted method)
  • A report that does not contain a statement certifying the valuation specialist’s independence from the entity
  • Use of data that would not be known to prospective buyers of an asset—remember that the SFAS 157 definition of fair value is based on what market participants would pay for the asset
  • Evidence that there was an extremely short turn-around time on the report—this could be a sign that not much effort was put into the valuation, that the report was prepared quickly to satisfy an urgent need of management
  • Evidence that the report was cut and pasted from other reports—we’ve seen reports that had the name of the wrong client, clearly a sign that the report was prepared using a “cookie cutter” mentality
  • Excessive reliance on mathematics and formulas, without adequate narrative explanation

 

Valuation reports should be reviewed carefully for these warning signs. Just because a fair value is supported by a professional-looking report is not a justification for blindly accepting it as accurate.

 

Inputs to Valuation Methods

SFAS 157 establishes a hierarchy of inputs that may be used in determining fair values. Inputs are the various pieces of data that are utilized in arriving at a fair value. In some cases, only a single input is necessary. In other cases, many different inputs are used in arriving at a value.

Inputs can be classified as either observable or unobservable. Observable inputs are inputs that reflect the assumptions that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the reporting entity.

Examples of observable inputs include the following seven:

  • Market prices from active markets for identical securities (e.g., publicly traded stocks and mutual funds)
  • Market prices for similar assets or liabilities
  • Historical rates of interest
  • Historical rates of inflation
  • Default rates
  • Business valuation multiples used in recorded sales of other businesses
  • Real estate market prices based on square feet and location

 

Unobservable inputs are inputs that reflect the reporting entity’s own internal assumptions about the assumptions that market participants would use in pricing the asset or liability based on the best information available in the circumstances.

Examples of unobservable inputs include the following three:

  • Projections of future cash flows, revenues, expenses, earnings, volume of production, and so on
  • Self-assessed risk factors (e.g., default risk, etc.) that are applied in connection with valuing certain items (e.g., valuing one’s own debt)
  • Other extrapolations of historical or verifiable information, such as growth rates

 

Some inputs may fall into either the observable or unobservable category, depending on whether market participants would likely have access to the information. For example, terms of licenses, contracts, and Methods of Determining Fair Value 37 other agreements may or may not be publicly available for market participants. Availability to market participants affects the classification of the input.

SFAS 157 requires the classification of all inputs used in determining fair values into one of three levels. Which level(s) of inputs were used in arriving at fair values are required financial statement disclosures under SFAS 157. Those levels are explained in the next section. Read on…

 

Understanding The SFAS 157 Hierarchy of Inputs

Paragraphs 24, 28, and 30 of SFAS 157 provide the following explanations of the three-level hierarchy of inputs used in determining fair value of assets and liabilities:

Level-1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available. SFAS 157 notes that Level 1 inputs should not be used when quoted prices are not representative of fair value.

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—that is, markets in which there are few transactions for the asset or liability, the prices are not current, or price quotations vary substantially, either over time or among market makers (e.g., some brokered markets), or in which little information is released publicly (e.g., a principal-to-principal market)
  • Inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates)
  • Inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs)

 

Level-3 inputs are unobservable inputs for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that 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. However, the fair value measurement objective remains the same—that is, an exit price from the perspective of a market participant that holds the asset or owes the liability.

Therefore, unobservable inputs shall reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk). Unobservable inputs shall be developed based on the best information available in the circumstances, which might include the reporting entity’s own data. In developing unobservable inputs, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions.

However, the reporting entity shall not ignore information about market participant assumptions that is reasonably available without undue cost and effort. Therefore, the reporting entity’s own data used to develop unobservable inputs shall be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions.

Adjustments to Level 2 quoted prices and other inputs should be tailored to the specific asset or liability. These adjustments should customize any Level 2 quoted prices or other inputs to arrive at an appropriate fair value for the asset or liability.

Examples of adjustments to Level 2 prices or other inputs that may be necessary include these six:

  • The condition of the asset or liability
  • The degree to which the inputs are comparable to the asset or liability
  • The volume and level of activity in the market(s) within which the inputs were observed
  • The amount of time that has lapsed since the observed transaction or other input
  • The terms of the instruments subject to the transaction
  • The existence and nature of any transactions that are related to transaction(s) being evaluated or used as inputs (i.e., is the transaction one of several related transactions, which could impact the input)

 

An adjustment to a Level 2 input that is significant to the final fair value measurement in its entirety can result in the conclusion that the measurement should be classified as Level 3, depending on the level in the fair value hierarchy within which the inputs used to determine the adjustment fall. For example, if significant internally developed adjustments were used to adjust a Level 2 market quote, the end result is likely a Level 3 input.

 

Fair Value Guidance under IFRS

As noted earlier, IFRS is not as detailed in its discussion of the methods used to determine fair value (although more detailed guidance is due out in final form in 2010). IAS 39, Financial Instruments: Recognition and Measurement, provides some general guidance about fair valuation techniques.

The IFRS guidance is generally consistent with U.S. GAAP in that it expects fair values to be determined using the following four principles:

Principle-1. The objective is to establish what the transaction price would have been on the measurement date in an arm’s length exchange motivated by normal business considerations (i.e., not a distressed transaction).

Principle-2. Valuation techniques should incorporate all factors that market participants would consider in setting a price and be consistent with accepted economic methodologies for pricing similar financial instruments.

Principle-3. In applying valuation techniques, an entity should use estimates and assumptions that are consistent with available information about the estimates and assumptions that market participants would use in determining a price.

Principle-4. The best estimate of fair value at initial recognition of a financial instrument that is not quoted in an active market is the transaction price, unless the fair value is evidenced by other observable market transactions or is based on a valuation technique whose variables include only data from observable markets.