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.
