12.4 Auditing fair value measurements
7 min read•august 19, 2024
Fair value measurements are crucial in mergers and acquisitions, as many assets and liabilities are valued at fair market prices. Auditors play a key role in evaluating these measurements, ensuring they're appropriate and reasonable for financial reporting.
Auditors assess inputs, valuation techniques, and management assumptions when reviewing fair value estimates. They also consider estimation uncertainty, required disclosures, and may use specialists to help evaluate complex valuations. Common challenges include lack of observable inputs and potential management bias.
Fair value measurement overview
- Fair value is 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
- Relevant to accounting for mergers and acquisitions as many assets and liabilities are measured at fair value in business combinations
- Auditors play a crucial role in evaluating the appropriateness and reasonableness of fair value measurements used in financial reporting
Inputs to valuation techniques
Observable vs unobservable inputs
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- Observable inputs are based on market data obtained from sources independent of the reporting entity (quoted prices for similar assets)
- Unobservable inputs reflect the entity's own assumptions about the assumptions market participants would use in pricing the asset or liability
- Observable inputs are preferred as they provide more reliable evidence of fair value
Input hierarchy levels
- : Quoted prices (unadjusted) in active markets for identical assets or liabilities
- : Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly (quoted prices for similar assets, interest rates)
- : Unobservable inputs for the asset or liability (company's own data or assumptions)
- The fair value hierarchy prioritizes the inputs used in valuation techniques, with Level 1 inputs being the most reliable and Level 3 inputs being the least reliable
Valuation approaches and techniques
Market approach
- Uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities, or a group of assets and liabilities (market multiples derived from a set of comparables)
- Relies on the principle of substitution, where the value of an asset is determined by the price that would be paid to acquire a substitute asset of comparable utility
Income approach
- Converts future amounts (cash flows or income and expenses) to a single current (discounted) amount
- Reflects current market expectations about those future amounts (present value techniques, option-pricing models)
- Commonly used for valuing intangible assets, such as customer relationships or trade names
Cost approach
- Reflects the amount that would be required currently to replace the service capacity of an asset (current replacement cost)
- Based on the principle that a buyer would not pay more for an asset than the cost to obtain an asset of equivalent utility
Valuation technique selection
- The selection of an appropriate valuation technique depends on the availability of sufficient data, the nature of the asset or liability being measured, and the reliability of the inputs
- Multiple valuation techniques may be used to measure fair value, with the results evaluated considering the reasonableness of the range of values indicated
- In some cases, a single valuation technique may be appropriate (matrix pricing for debt securities with similar maturities and credit ratings)
Management's assumptions
Reasonableness of assumptions
- Auditors should evaluate whether the assumptions used by management are reasonable and supportable based on the best information available
- Assumptions should be consistent with the company's business plans, historical performance, and industry trends
- Overly optimistic or pessimistic assumptions may indicate management bias and require further investigation
Consistency with external evidence
- Auditors should consider whether management's assumptions are consistent with observable market data or other external evidence
- Assumptions that deviate significantly from market consensus or industry benchmarks may indicate a higher risk of material misstatement
- Independent sources of information (economic reports, industry publications) can be used to corroborate management's assumptions
Estimation uncertainty
Degree of uncertainty
- Fair value measurements often involve significant estimation uncertainty, particularly for Level 3 inputs that are not observable in the market
- The degree of uncertainty can vary depending on the nature of the asset or liability, the valuation technique used, and the reliability of the inputs
- Higher levels of estimation uncertainty require more extensive audit procedures and may necessitate the use of specialists
Sensitivity to changes in assumptions
- Auditors should assess the sensitivity of fair value measurements to changes in key assumptions
- Small changes in assumptions can have a material impact on the resulting fair value, particularly for complex financial instruments or intangible assets
- Sensitivity analysis can help identify the assumptions that have the greatest impact on the fair value measurement and focus audit efforts on those areas
Disclosures related to fair value
Required disclosures by level
- Entities are required to disclose the fair value hierarchy level for each class of assets and liabilities measured at fair value
- Additional disclosures are required for Level 3 fair value measurements, including a reconciliation of the opening and closing balances, and quantitative information about significant unobservable inputs
Quantitative vs qualitative disclosures
- Quantitative disclosures provide numerical information about the inputs and assumptions used in fair value measurements (discount rates, growth rates)
- Qualitative disclosures describe the valuation techniques used, the inputs and assumptions applied, and the sensitivity of the fair value measurement to changes in unobservable inputs
- A combination of quantitative and qualitative disclosures is often necessary to provide users with a comprehensive understanding of the fair value measurements
Audit procedures for fair value
Testing management's process
- Auditors should test the effectiveness of management's process for determining fair value measurements
- This includes evaluating the appropriateness of the valuation methods, the reasonableness of significant assumptions, and the completeness and accuracy of the underlying data
- Auditors may perform procedures such as inspecting relevant contracts, agreeing inputs to supporting documentation, and testing the mathematical accuracy of the valuation models
Developing independent estimates
- In some cases, auditors may develop an independent estimate of fair value to corroborate management's estimate
- This involves selecting and applying an appropriate valuation technique, determining the relevant inputs and assumptions, and calculating the fair value independently
- Comparing the auditor's estimate to management's estimate can provide evidence about the reasonableness of management's estimate and identify potential sources of misstatement
Reviewing subsequent events and transactions
- Auditors should review events and transactions occurring after the balance sheet date but before the issuance of the financial statements
- Subsequent events or transactions may provide evidence about the fair value measurement at the balance sheet date (sales of similar assets, changes in market conditions)
- Auditors should evaluate whether the subsequent events or transactions confirm or contradict the fair value measurements and determine if any adjustments are necessary
Use of specialists in auditing fair value
Management's specialists
- Management may engage valuation specialists to assist in determining fair value measurements for complex or illiquid assets and liabilities
- Auditors should evaluate the competence, capabilities, and objectivity of management's specialists and the appropriateness of their work as audit evidence
- Auditors may communicate with management's specialists to understand their methods, assumptions, and findings
Auditor's specialists
- Auditors may also engage their own valuation specialists to assist in evaluating the reasonableness of management's fair value measurements
- The auditor's specialist should have the necessary expertise and independence to provide objective and reliable assistance
- Auditors should evaluate the adequacy of the specialist's work, including the appropriateness of the methods and assumptions used, and the relevance and reasonableness of the specialist's findings
Common issues in auditing fair value
Lack of observable inputs
- The lack of observable market inputs can make it challenging to verify the reasonableness of management's assumptions and the resulting fair value measurements
- Auditors may need to perform additional procedures, such as evaluating the appropriateness of the valuation techniques, testing the underlying data, and assessing the sensitivity of the fair value to changes in assumptions
- In some cases, the lack of observable inputs may result in a higher risk of material misstatement and require more extensive audit evidence
Complexity of valuation techniques
- Complex valuation techniques, such as option-pricing models or analyses, can be difficult to understand and evaluate
- Auditors may need to obtain specialized training or engage valuation specialists to assist in assessing the appropriateness of the valuation techniques and the reasonableness of the inputs and assumptions used
- The complexity of the valuation techniques may also increase the risk of errors or manipulation, requiring more robust audit procedures
Management bias in assumptions
- Management may have incentives to use assumptions that result in favorable fair value measurements, particularly for performance-based compensation or debt covenants
- Auditors should be alert to indicators of management bias, such as assumptions that are inconsistent with market data, overly optimistic projections, or frequent changes in valuation methods
- Auditors should challenge management's assumptions and perform sensitivity analyses to assess the impact of alternative assumptions on the fair value measurements
- In some cases, management bias may result in a material misstatement and require the auditor to express a qualified or adverse opinion on the financial statements
Key Terms to Review (20)
ASC 820: ASC 820, also known as the Fair Value Measurement standard, provides a framework for measuring fair value under generally accepted accounting principles (GAAP). This standard emphasizes transparency in financial reporting by establishing a clear definition of fair value, outlining the methods for measuring it, and requiring disclosure of the inputs used in the valuation process.
Asset impairment testing: Asset impairment testing is a process used to determine whether the carrying value of an asset exceeds its recoverable amount, indicating that the asset may be impaired. This assessment helps ensure that assets are accurately valued on financial statements, reflecting their true worth and potential future cash flows. When impairment is identified, it requires a write-down of the asset's value, impacting the financial performance of the entity.
Audit sampling: Audit sampling is the process of selecting a subset of items from a larger population to evaluate the characteristics or outcomes of that entire population. This technique allows auditors to make informed decisions and draw conclusions without examining every single item, ultimately increasing efficiency and effectiveness in the audit process.
Benchmarking: Benchmarking is the process of comparing a company's performance metrics to industry bests or best practices from other companies. This practice allows businesses to identify areas for improvement by measuring their operations against those of leading firms in their sector, leading to enhanced decision-making and strategy formulation.
Comparable Company Analysis: Comparable Company Analysis is a valuation technique used to evaluate the value of a company by comparing it to similar companies in the same industry. This method focuses on key financial metrics and ratios to assess how the company stacks up against its peers, providing insight into its relative valuation. It is often employed in various financial evaluations, including assessing potential mergers, acquisitions, and investment opportunities.
Cost approach: The cost approach is a method used to estimate the value of an asset based on the cost of replacing or reproducing it, minus any depreciation. This approach focuses on determining what it would cost to replace an asset with a new one, taking into account factors like wear and tear, functional obsolescence, and economic obsolescence. It is often utilized in fair value measurements, especially for tangible assets, as well as for assessing identifiable intangible assets and their worth during auditing processes.
Discounted Cash Flow: Discounted cash flow (DCF) is a financial valuation method used to estimate the value of an investment based on its expected future cash flows, which are adjusted to their present value using a specific discount rate. This approach is crucial for making informed financial decisions, especially when analyzing mergers, acquisitions, and other complex financial structures, as it provides a comprehensive view of the investment's profitability over time.
External auditor: An external auditor is an independent professional who examines an organization's financial statements and compliance with regulations to provide an objective assessment of its financial health. This role is crucial in ensuring that the financial reports presented by management are accurate and free from material misstatement, enhancing the credibility of the organization’s financial disclosures.
Goodwill impairment: Goodwill impairment occurs when the carrying value of goodwill on a company's balance sheet exceeds its fair value, indicating that the asset has lost value and needs to be written down. This situation often arises after an asset acquisition when the expected synergies or future cash flows from the acquired entity do not materialize as anticipated, leading to a reassessment of the goodwill's value. Understanding this concept is crucial as it also affects equity method investments and fair value measurements in audits.
IFRS 13: IFRS 13 is an International Financial Reporting Standard that provides a framework for measuring fair value and establishing disclosure requirements for fair value measurements. It aims to enhance consistency and comparability in fair value measurements across different entities, which is crucial for users of financial statements to understand the financial position and performance of a company.
Income Approach: The income approach is a valuation method that estimates the value of an asset based on its expected future income streams, discounted back to their present value. This method is especially relevant in contexts where cash flows generated by the asset can be reliably projected, providing insights into the asset's fair value in various financial scenarios, including mergers, acquisitions, and the valuation of intangible assets.
Independence verification: Independence verification is the process used to ensure that the fair value measurements of an asset or liability are accurate and unbiased, typically by confirming that the valuation has been performed by an objective third party. This practice is critical in auditing, as it helps to mitigate potential conflicts of interest and ensures the integrity of financial reporting. By validating the independence of the valuation source, auditors can provide greater assurance regarding the reliability of the financial statements.
Internal auditor: An internal auditor is a professional responsible for evaluating and improving the effectiveness of risk management, control, and governance processes within an organization. They provide independent assurance that the organization’s risk management processes are functioning effectively and help in ensuring compliance with laws and regulations, which is crucial in maintaining strong internal controls and accurate financial reporting.
Level 1 inputs: Level 1 inputs are the most reliable and observable inputs used in fair value measurements, consisting of quoted prices in active markets for identical assets or liabilities. These inputs provide the highest quality evidence of fair value because they reflect actual market transactions, ensuring that the measurements are accurate and relevant. Level 1 inputs form the foundation for establishing fair values in various financial reporting contexts, making them crucial for transparency and consistency.
Level 2 Inputs: Level 2 inputs are inputs used in fair value measurements that are derived from observable market data for similar assets or liabilities, rather than being directly quoted from active markets. These inputs can include prices from similar transactions or market quotes, which help in estimating the fair value of an asset or liability when market prices are not readily available. This level of input provides a more reliable basis for valuation compared to unobservable inputs, thus enhancing the accuracy of financial reporting.
Level 3 Inputs: Level 3 inputs are unobservable inputs used in fair value measurements that rely on an entity's own assumptions about what market participants would use to price an asset or liability. These inputs are crucial when there is no active market for the asset or liability and therefore rely heavily on subjective judgment. They reflect the least reliable data compared to Level 1 and Level 2 inputs, making them a significant focus in the assessment of fair value measurements and auditing practices.
Market approach: The market approach is a valuation method that estimates the fair value of an asset based on the prices of similar assets in the marketplace. This approach relies on the principle of substitution, which suggests that a knowledgeable buyer would not pay more for an asset than the price of a comparable asset in a similar condition and location. It is particularly useful for assessing the value of identifiable intangible assets and plays a critical role in fair value measurements, bargain purchase gains, hedges, and corporate reorganizations.
Public Company Accounting Oversight Board (PCAOB): The Public Company Accounting Oversight Board (PCAOB) is a nonprofit corporation established by the Sarbanes-Oxley Act of 2002 to oversee the audits of public companies in order to protect investors and ensure the preparation of informative, fair, and independent audit reports. It sets auditing standards, inspects audit firms, and enforces compliance with its rules, aiming to improve the accuracy and reliability of financial reporting and enhance public confidence in the capital markets.
Securities and Exchange Commission (SEC): The Securities and Exchange Commission (SEC) is a U.S. government agency responsible for enforcing federal securities laws, regulating the securities industry, and protecting investors. It ensures that companies provide transparent and accurate information about their financial performance, which is crucial for informed investment decisions and maintaining fair markets.
Substantive testing: Substantive testing refers to the audit procedures used to obtain evidence regarding the completeness, accuracy, and validity of the information presented in financial statements. It is a crucial aspect of the audit process, as it helps auditors assess the risk of material misstatement in financial records. Through substantive testing, auditors can gather sufficient and appropriate evidence to support their opinion on whether the financial statements are free from significant error or fraud.