Keeping Accountable With Fair Value Measurement

Users of financial statements believe that the measurement of assets acquired, and liabilities assumed at their relative fair values enable better investment decisions. Yet one of the challenges of measuring fair value, either internally by management or through the services of a valuation specialist, is that fair value measurement  (FVM) often requires heightened judgment by preparers and auditors. This increased level of judgement is drawing greater scrutiny from regulators.

For example, the Securities and Exchange Commission (SEC) has recently imposed an enforcement action against a prominent CPA firm relating to a FVM issue arising from a business combination. Additionally, SEC staff members have also voiced concerns about outside valuation specialists who assist management in determining FVMs in several speeches about fair value.

Staying compliant with ongoing PCAOB inspections

The Public Company Accounting Oversight Board (PCAOB) is mandated to inspect registered public accounting firms to identify any potential deficiencies in an audit firm’s engagements and assess their compliance with the Act and the SEC.

My firm, Acuitas, Inc., conducts an annual review of PCAOB inspection reports, particularly as they relate to fair value measurements. The Survey of Fair Value Audit Deficiencies is intended to assist financial statement preparers, auditors, and valuation specialists in understanding the underlying causes of FVM and impairment audit deficiencies, as reported by the PCAOB.

This year’s report highlights several trends, including:

• Overall, audit deficiencies declined in 2015 for the second year in a row – but are still quite high. The PCAOB considered 31.6 percent of the inspected audits for annually inspected firms to be deficient in 2015, which is down from 39.2 percent in 2014 and 42.9 percent in 2013.
• Key areas of concern continue to be the internal control process; assessing and responding to the risk of material misstatement by management; and lastly, auditing accounting estimates including fair value measurements.
• PCAOB findings of deficiencies attributable to FVM and impairment engagements make up approximately 31 percent of all audit deficiencies. The three primary causes of FVM-related deficiencies are failures to assess audit risks, test internal controls and test assumptions underlying prospective financial information.
• The auditing of financial statements, which include business combinations, are also contributing to the audit deficiencies related to FVM. The increased level of merger and acquisition activity is perceived to be an economic risk in auditing that may increases the risk of material misstatement.

Corroborating the conclusions found in our study, the PCAOB issued additional draft guidance on auditing estimates, including fair value through PCAOB Release No. 2017-002 and on the use of valuation specialists as part of the auditing process through PCAOB Release No. 2017-003 on June 1^st of this year.

What financial executives need to know about fair value measurements

The good news is that audit deficiencies overall have declined due to better preparation and training within the audit profession. Yet CFOs, valuation professionals and regulatory agencies must continue to work towards increasing accountability and transparency around financial reporting obligations.

As companies move into 2018, financial executives should keep the following in mind:

• The consensus among financial information users is that fair value measurement provides a better level of information for investment decision-making.
• The assumptions behind prospective financial information (projections or forecasts) is an area of increased scrutiny. Regulators have expressed concerns as to how fair value measurements have been developed for financial reporting purposes.
• Three key areas of PCAOB concern continue to be auditing internal control, assessing and responding to the risk of material misstatement and auditing accounting estimates including fair value measurements.
• The PCAOB noted the decline and attributed improved audit quality to the use of practice-aids, checklists, coaching, support teams and efforts to monitor the quality of audit work.
• The valuation profession has addressed the concerns of regulators through the development of the CEIV credential and establishment of a Mandatory Performance Framework which provides guidance on how much work needs to be done to measure fair value.
• International Valuation Standards (“IVS”) published by the IVSC are another mechanism to address the concerns of regulators globally.

Regulators have recently increased the level of scrutiny of fair value measurements in financial reporting.  However, both the auditing and valuation professions have addressed the concerns of regulators resulting in higher-quality and more informative financial information for users of financial statements.

Mark Zyla CPA/ABV, CFA, ASA is a managing director of Acuitas, Inc.