Changes in accounting standards have increased the magnitude of auditors’ exposure to fair value measurement, especially during the last five years. SFAS 157, Fair Value Measurement (subsequently codified as ASC 820), effective in late 2007, provided additional clarity regarding the definition of fair value. For example, SFAS 157 clarified the definition of a “market participant,” emphasized that fair value should consider characteristics similar to the subject asset and confirmed that fair value excludes transaction costs. In addition, the fair value option, permits entities to elect to measure many different types of financial instruments and other items at fair value. As anticipated by FASB, a significant result of the new pronouncements has been to increase the number of fair value measurements subject to audit.
Traditionally, financial statements involved primarily tangible assets and historical cost accounting; in the past decade, fair market accounting has gained in prominence due to rapid advances in technology and the development of more complex business models.1 As fair value measurements have become more prominent, so has scrutiny regarding the audit process for such measurements. There exist numerous concerns related to the challenges auditors face when dealing with fair value. The Public Company Accounting Oversight Board (PCAOB), a private-sector organization created by the Sarbanes-Oxley Act for the purpose of overseeing the auditors of public companies, performs annual inspections of public company audits. The Board’s recent investigations signal increasing scrutiny on audit procedures and findings related to fair value measurement.2
In his June 7, 2012 speech at the AICPA’s Fair Value Measurements and Reporting Conference, PCAOB board member Jay Hanson identified a series of recurring audit deficiencies discovered by the PCAOB. Cited instances included auditors’ failures to evaluate sufficiently the fair value assumptions used by issuers in a variety of circumstances. According to Mr. Hanson, auditors failed to test adequately such assumptions as forecasted revenue growth rates, operating margins, discount rates, implied control premiums, and weighted average cost of capital measures. Also, the Board identified some instances in which auditors failed to take into account the effects of contradictory evidence with regard to the reasonableness of certain significant assumptions. Other such findings reported by the PCAOB involved auditors’ failure to assess the adequacy of financial statement disclosures for hard-to-value financial instruments and to respond appropriately to valuation risk.3
A 2009 paper issued by the PCAOB highlights challenges faced by auditors in properly navigating the complexities of fair value. The paper points to the inherent uncertainties related to certain business activities and the heightened degree of judgment and subjectivity that accompany fair value measurements, especially those that are based on models.4 While balance sheets used to be dominated by “solid numbers,” they now commonly include valuation estimates that are far more difficult for accountants, auditors, and investors to comprehend. According to Hanson in his 2012 speech, “management and their accountants increasingly must tackle fair value measurements and management estimates, consistent with new accounting standards in connection with derivatives, securitizations, consolidations, debt/equity issues, revenue recognition, leases and other issues.”5 Further, the persistent challenges in the economic environment make accurate “marking to market” even more challenging. “With respect to fair value, “ the PCAOB explains, “especially in the current economic environment in which markets for certain financial instruments are not active, it may be more challenging for auditors to obtain observable evidence that supports an estimate of what a hypothetical market participant would pay for an asset at the measurement date.”6
One important takeaway is the increased importance and relevance of valuation specialists who are experts in fair value. As the use of fair value measurement has expanded, so has the need for professionals who have specialized capabilities related to the measurement of fair value and the resolution of fair value issues. According to the PCAOB, “the need for professionals with specialized skills or knowledge has increased in response to the challenges of auditing certain fair value measurements.”7 Mercer Capital has a long history of providing fair value services and has the institutional capacity to tackle even the most uncommon or complex fair value issues. Feel free to contact Mercer Capital for assistance regarding fair value measurement or fair value reporting.
1 “Auditing the Future,” Jay D. Hanson, AICPA Fair Value Measurements and Reporting Conference, June 7,2012.
4 “Auditing Fair Value Measurements and Using the Work of a Specialist,” PCAOB Standing Advisory Group Meeting, October 14-15, 2009.
5 “Auditing the Future,” Jay D. Hanson, AICPA Fair Value Measurements and Reporting Conference, June 7, 2012.
7 “Auditing Fair Value Measurements and Using the Work of a Specialist,” PCAOB Standing Advisory Group Meeting, October 14-15, 2009.