1. Auditing Fair Value Measurements

2. 2 General Challenges presented to auditors:  Obtain a sufficient understanding of the entity’s processes and relevant controls for determining fair value measurements to develop an effective audit approach.  Evaluate whether the entity’s methods of measurement and significant assumptions are appropriate and are likely to provide a reasonable basis for the fair value measurements and related disclosures in the entity’s financial statements.

3. Auditing Fair Value Measurements AU Section 328 (SAS No. 101)  Mandates that auditors sufficiently understand the process and relevant controls for determining how fair value measurements are derived.  Evaluate conformity of fair value measurements and disclosures with GAAP. How a particular fair value measurement should be derived in order to determine whether the client’s approach is reasonable.

4. Definition of Fair Value (ASC 820) “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.” Must consider:  Price  Principal (or most advantageous market)  Market participants  The asset or liability

5. Fair Value Measurement & Market Price Fair Value – based on hypothetical transaction as of the date of measurement The objective is to determine the “Exit Price” Market price is generally equal to or close to fair value – however, this could diverge in troubled markets No adjustment for transaction costs

6. Principal or Most Advantageous Market Fair value measurement assumes that the transaction to sell an asset or transfer a liability either:  Occurs in the principal market for that asset or liability  In the absence of a principal market, occurs in the most advantageous market for that asset or liability.

7. Market Participants Fair Value should be based on assumptions used by market participants. Should Consider factors relating to:  The asset or liability  The principal or most advantageous market  Market participants

8. Assets Fair Value assumes the highest and best use of an asset  Use of the asset must be: Physically possible Legally permissible Financially feasible Highest and Best Use – determination based on use by market participants

9. Highest and Best Use “In-Use” – asset would provide maximum value through its use in combination with other assets as a group. “In-Exchange” – asset would provide maximum value on a standalone basis.

10. Liabilities Fair Value measurement assumes:  Liability is transferred to a market participant at the measurement date.  The related nonperformance risk is the same before and after the transfer. Maximize use of observable inputs Minimize use of unobservable inputs

11. Valuation Techniques Under ASC 820 Market Approach  Uses prices and other information generated by market transactions involving identical or comparable assets or liabilities Income Approach  Uses valuation techniques to convert future amounts (cash flows, earnings) to a present value amount Cost Approach  Uses current replacement cost – amount currently required to replace the service capacity of an asset. Note: Multiple techniques may be used.

12. Fair Value Hierarchy Fair value of an asset or liability should be grouped by hierarchy level for disclosure. The level within the hierarchy is based the type of input:  Observable  Unoberservable The hierarchy refers to the reliability of the inputs relative to the a valuation technique

13. Level 1 Level 1 – (Preferred) – uses quoted exit prices for identical assets in an active market. Examples:  Marketable Investments  Inventory  Equipment

14. Level 2 Adjusted Market Value – uses market value (or possibly other inputs) for similar assets, which are then adjusted for asset-specific information. Examples:  Land  Land Improvements  Buildings

15. Level 3 Income approach to valuation Most subjective and open to error in estimation Examples:  Customer lists  Various other intangible assets Independent appraisals may be useful

16. Auditor’s Objective “Obtain sufficient appropriate audit evidence to provide reasonable assurance that fair value measurements and disclosures are in conformity with GAAP.”

17. Fair Value Measurement - Accounting Estimate Many fair value measurements result from approximations, rather than exact measures, and involve numerous estimates, classifications, judgments, and allocations. Objective of auditing fair value measurements – enhance their reliability through the elimination of bias.

18. Fair Value Measurement – Accounting Estimate Observable market price not available Can be imprecise due because based on assumptions about future conditions, transactions, or events. Use information available to auditor at time of audit Measurements rely on valuation techniques  Use inputs and outcomes which cannot be directly verified by the auditor Auditor must:  Exercise Due Care  Use of Professional Skepticism

19. Risk Assessment Procedures “When performing risk assessment procedures and related activities to obtain an understanding of the entity and its environment, including the entity’s internal control,… the auditor should obtain an understanding of the following in order to provide a basis for the identification and assessment of the risks of material misstatement for accounting estimates (including fair value measurements)”

20. The Fair Value 2 Step Step 1 – Understand the process for determining fair value measurements and relevant controls (this prepares you to develop your audit approach) Step 2 – Evaluate the conformity of the measurements and disclosures with GAAP (execution of your planned approach)

21. Step 1 - Identifying & Assessing the Risks of Material Misstatement Evaluate degree of estimation uncertainty/complexity Determine if estimates identified as having high estimation uncertainty give rise to significant risks Define and understand assumptions used Design your plan

22. Step 2 - Responding to Assessed Risks of Material Misstatement (Evaluate) For fair value measurements with observable inputs, this is a fairly straight forward process. For measurements with unobservable inputs:  Consider the appropriateness of the valuation method (including management rationale for using method)  Test the client’s valuation (including assumptions, the model, and the underlying data)  Review subsequent events and transactions to corroborate valuation

23. Appropriateness of the Method Based on individual circumstances Requires professional judgment Must understand management’s reasons for selecting method 3 questions:  Has management sufficiently evaluated and appropriately applied the criteria provided by GAAP?  Is the method appropriate given the nature of the item being valued?  Is the method appropriate in relation to the client and its business?

24. Test the Valuation Test procedures used by management to develop an fair value and the data on which it is based. In doing so, auditor should evaluate whether: i. Assumptions used by management are reasonable in light of measurement objectives ii. The model used is valid iii. Data on which the estimate is based is sufficiently reliable for auditor’s purposes.

25. Sub Events Events and transactions that occur after the balance sheet date but before issuance date may provide audit evidence regarding fair value measurements.

26. Other Considerations in Testing Develop a point estimate to evaluate management’s point estimate. Auditor should obtain an understanding of management’s assumptions or methods If auditor concludes use of a range is appropriate, range should be narrowed until all values within the range are considered reasonable.

27. Other Considerations in Testing Use of a Specialist:  Follow AU section 336 – Using the Work of A Specialist  Consider whether the specialist’s understanding of fair value and the method used to determine fair value are consistent with those of management and GAAP  Still must obtain an understanding of the assumptions and methods used.

28. Valuation Techniques Auditors are not expected to be valuation experts However, a solid understanding of various valuation techniques will enhance your effectiveness as an auditor.

29. The Market Approach Uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. Based on the economic principle of efficient markets. Often use market multiples – judgment required.

30. Income Approach Based on the economic principle of “anticipation” Investor “anticipates” the expected economic income to be earned from the investment. The expectation of future income is converted to a present value. Can involve use of subjective variables.

31. SPECIFIC EXAMPLES, QUESTIONS AND COMMENTS