Supporting estimations of fair value

On May 12, the Financial Accounting Standards Board (FASB) issued new standards for public and private companies on fair value measurement and disclosures. The new requirements, found in Accounting Standards Update (ASU) 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value, provide direction on how fair value accounting should be applied. Although ASU 2011-04 will have little effect on the measurement of fair value by most companies, the Update by the Financial Accounting Standards Board once again highlights fair value accounting and disclosures as matters of significant importance and pertinence to preparers and users of financial statements today.

In an environment in which a growing number of financial statement values and disclosures are driven by fair value measurements, the estimation of fair values has become increasingly important. Perhaps not coincidentally, fair value estimation has also becoming increasingly complex due, in more than a small part, to the volatile and unstable market environment currently faced by business. Despite this, however, little guidance exists surrounding the responsibilities of management with regard to supporting estimations of fair value. Although Accounting Standards Codification Topic 820 as amended by ASU 2011-04 provides guidance on the measurement of fair value, it does not provide guidance on compiling and maintaining appropriate support for those measurements. As such, the question of the nature and extent of documentation that should be maintained by management to support fair value estimates exists.

Supporting estimations of fair value

The question of the best manner of supporting estimates is not a new concept. It’s likely that most companies are faced with this challenge on a daily basis. However, the complexity of many fair value estimates makes this challenge more difficult. With this in mind, perhaps the best way to ensure that sufficient and appropriate support for fair value measurements is maintained is by considering the auditor’s responsibility with respect to management’s fair value estimates. Although comprehensive guidance surrounding management’s responsibilities for supporting fair value measurements does not exist, parallel guidance surrounding the auditor’s responsibilities for testing fair value measurements does exist. Both the American Institute of Certified Public Accountants (AICPA) and the Public Company Accounting Oversight Board (PCAOB) provide professional guidance related to auditing fair value.

Audit approach to testing fair values

AU Section 328 Auditing Fair Value Measurements and Disclosures provides guidance to the auditor for obtaining sufficient, appropriate audit evidence with respect to fair value measurements. Although the guidance contains several other points, there are three primary stages of an appropriate audit approach to testing fair values. Each of these stages should be considered by management to ensure that appropriate support is maintained for the fair value measurements themselves.

The first requirement of the auditor is to obtain an understanding of the company’s process for determining fair value measurements and disclosures and the related controls. This involves consideration by the auditor of a number of things, including any controls in place surrounding fair value measurements, the types of accounts or transactions requiring fair value measurements and disclosures, the role of information technology in the company’s fair value measurements, the process used to develop and apply management assumptions, and the extent to which service organizations and specialists are involved in measuring fair values. Based on this guidance, it would be appropriate for management to consider these factors in a parallel fashion. Management should ensure that appropriate documentation exists supporting each these considerations. Depending upon the complexity of a company’s fair value measurements, a simple process narrative may serve as adequate documentation. In other cases, more complex documentation may also be required, including detailed process flow charts, risk-control matrices, or standard operating procedure documentation. The key in most cases would be to ensure that sufficient documentation exists such that the company’s process or approach to fair values could be applied consistently and on a rational basis in accordance with such documentation for all accounts and transactions requiring fair value measurement.

The second stage of the auditor’s requirements with respect to auditing fair value measurements is evaluating conformity of fair value measurements and disclosures with accounting principles generally accepted in the United States of America (US GAAP). This would involve a determination of which accounts or transactions are measured at fair value and the appropriateness thereof, an evaluation of whether management’s process of fair value measurement is appropriate for each type of account or transaction class, and whether management has sufficiently and appropriately applied US GAAP criteria for the selected methodology of fair value measurement. It would also involve consideration of the appropriateness of the measurement methodology in relation to the company’s business and industry. Management should consider these points and ensure that appropriate documentation exists evidencing the valuation methodology used for each account or class of transaction and that it was applied consistently. If judgments were made during the process of selecting and applying a valuation model, documentation supporting these judgments should be retained in all cases. In situations in which a fair value measurement is dependent upon management’s assertion that a particular course of action will be taken, documentation supporting that course of action should also be held, including minutes, budgets, and evidence of the ability of the company to carry out such action.

The third stage of a general approach to fair value measurements is testing the company’s fair value measurements and disclosures, including significant assumptions, the valuation model, and the underlying data. While it may seem obvious, it is important to consider individual fair value measurements on a case-by-case basis, as a wide range of complexity exists with respect to varying fair value measurements. For example, minimal supporting documentation would be required for fair value estimates of an investment with a quoted price in an active market. In contrast, an estimate of an investment’s fair value using the discounted cash flow method might require significant supporting documentation, as it would presumably include management assumptions and other underlying data. In any case, management should consider the fact that it is the auditor’s responsibility to test data underlying fair value measurements, to ensure that significant assumptions used are reasonable and consistent with market data, and to ensure that any data points included the company’s valuation models are supported by internal and external sources. In addition, the auditor should evaluate management’s historical ability to develop estimates used in fair value measurements.

Maintenance

Considering these points, it would be appropriate for management to obtain and maintain support for all data points included in any fair value measurements. This would include internal reports on which the measurement is based, such as historical figures or forward-looking budgets, market data used to develop assumptions, such as market discount rates or industry censuses, and supporting evidence of any other facts considered in reaching the fair value measurement. Management should also provide evidence of the historical ability to develop estimates used in assessing fair values.

As fair value measurements continue to play a significant role in financial statements and disclosures, they will continue to receive scrutiny from auditors and regulators. Keeping that in mind and considering the auditor’s requirements with respect to fair values will provide a strong basis for ensuring that fair value measurements are appropriately supported.