Auditing Fair Value Measures

Financial Accounting Standards Board (FASB) pronouncements that address financial reporting of business combinations (FASB Statement of Accounting Standards No. 141, Business Combinations,) and the recognition of the continued validity of reported goodwill (FASB Statement No. 142, Goodwill and Other Intangible Assets) require assets to be recognized at their respective fair values. Measuring assets after a business combination to state their fair values on the balance sheet is a complex process. Consequently, the acquiring entity often retains valuation specialists to assist management with the estimate of the fair value of each asset, particularly intangible assets, for the allocation of purchase price. As part of the requirement of obtaining sufficient competent audit evidence to provide reasonable assurance that the stated fair values conform to generally accepted accounting principles (GAAP), the acquiring company’s auditor has to gain competency in evaluating the qualifications of the valuation specialists and their work product. As such, auditors must understand the concept of fair value and how it is measured.

To provide guidance for auditing fair value measurement and disclosures, the Auditing Standards Board (ASB) recently issued Statement on Auditing Standards (SAS) 101, Auditing Fair Value Measurements and Disclosures (AICPA, Professional Standards, vol. 1, AU sec. 328), which is effective for auditing financial statements on or after June 15, 2003.

SAS No. 101 provides guidance to auditors on how the management of an entity determines fair value and whether it conforms to GAAP. The statement provides broad guidance for auditing fair value measurements, one of which is using the work of a valuation specialist. As such, auditors should become familiar with certain fair value concepts that a valuation specialist may use.

Estimating fair value may seem complex. However, just four basic concepts are involved in a valuation related to fair value for financial reporting:

The standard of value
Market participants
The three basic approaches to value
Working with a valuation specialist

The standard of value: Fair value
The first concept in auditing fair value measurements that an auditor should understand is the standard of value. The standard of value in financial reporting is one of fair value, which is defined in FASB Statement No. 141 as “the amount at which the asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” The standard of value controls the appropriateness of assumptions and methodologies in estimating value.

Fair value in financial reporting is often confused with other more established standards of value. Fair value is not investment value, which is the value to a particular buyer, nor is it fair market value, which describes the value when there is a hypothetical buyer and seller and is also the standard of value for tax reporting requirements.

Although the concept of the fair value standard is still evolving in authoritative accounting literature, several characteristics have been established. Fair value is:

Generally established on an asset-by-asset and a
situation-by-situation basis.
Always a control value.
Not associated with individual assets that include buyer’s synergies. Synergies are part of goodwill.
Inclusive of tax amortization benefits.
Net of cost to sell.
Only considers market participants in the assumptions.

Market participants
A second concept that an auditor should understand is that under the standard of fair value for financial reporting, the FASB emphasizes that the assumptions used in the valuation should include market participants. Although still evolving in general, the market participants concept requires the valuation specialist to use assumptions that encompass all potential buyers with the following characteristics, namely, those who:

Actively manage businesses.
May or may not be engaged in negotiations with seller.
Are not buyers without current operating and market data available such as financial buyers or passive investors.

The market participants concept is important because the assumptions used by valuation specialists in their approaches to estimating value, particularly in projected financial information, should only include those that a market participant could realize. (For further discussion, see AICPA Practice Aid, Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices, and Pharmaceutical Industries, page 4.)

Approaches to value
A third concept that auditors should understand about valuation in general is the three basic approaches to value. Although many different valuation methods may be used to determine fair value, all methods fall under one of the three basic approaches to value, namely, the cost, market, and income approaches.

The concept underlying the cost approach is that the fair value of an asset or even an entire business is estimated by the current replacement cost of the asset or the entire business. The replacement cost of the asset is what it would cost currently to replace the asset or an entire business with an asset or group of assets of comparable utility. The cost approach is often used to estimate the value of specific assets, such as a building or machinery and equipment, or certain intangible assets such as customer relationships. Because of its nature, however, the cost approach is difficult to apply in estimating the fair value of an entire operating business.

The market approach estimates fair value by comparing a financial measurement or other metric of the subject company to a multiple of similar financial measurement or metric of a similar guideline company whose shares are transacted in the market place. For example, a commonly used financial measurement is a multiple of price to earnings or the P/E ratio. The market approach is easily understood in that it estimates value through transactions of similar assets or business interests in the market. The difficulty in applying the market approach, particularly in estimating the value of intangible assets, is in identifying guideline assets or business interests similar enough to support a valid comparison.

The income approach estimates value through the expectation of future cash flows that the asset or business interest will generate, discounted to the present at a risk-adjusted rate of return commensurate with the risk of actually receiving the cash flows.

One method commonly used under the income approach is the discounted cash flow analysis. The discounted cash flow method can also be used to estimate the fair value of a specific intangible asset by estimating cash flows that can be generated by the entire business and deducting fair returns on all of the other assets that contribute to the generation of the cash flow. This method is sometimes also referred to as the multiperiod excess earnings method. The residual cash flow after deducting returns on all of the other assets is what is generated by the specific intangible asset. The present value of the residual cash flow is discounted at a rate reflective of the risk of the intangible asset in order to estimate the fair value of the specific intangible asset.

These three approaches, in theory, should all point to similar indications of fair value. In reality, however, only one or two approaches may be appropriate given the type of intangible asset or business interest.

In spite of the theory that all approaches should provide a similar indication of value, the FASB has expressed a preference for the use of observable market prices under the market approach as a primary indication of fair value wherever sufficient information is available. Consequently, the valuation specialist should focus on the market approach as a primary method where appropriate, supported by the cost and income approaches. In any event, valuation specialists should use assumptions in their analyses that reflect overall market participants in each of the methods under the three approaches of estimating fair value. (For further discussion of approaches to value, see the AICPA’s Auditing Fair Value Measurements and Disclosures, A Toolkit for Auditors, Appendix I, “Valuation Approaches to Estimating Fair Value.”)

Working with a valuation specialist
The changes brought by these new standards have affected the relationships between company’s management, the company’s auditors, and outside valuation specialists. Even with an outside valuation specialist, management is still responsible for the fair value measurements in its financial statements. These responsibilities even extend to the data used in the valuation, the assumptions used by the specialist, and the valuation methods used to determine fair value.

Previously, auditors relied on the work product of the valuation specialist based upon the specialist’s qualifications and experience. While these are obviously still important, auditors and valuation specialists are now held to a higher standard to test the reasonableness of management’s assumptions behind the valuation. One such test is to perform sensitivity analysis on management’s assumptions that underly the valuation. Additionally, auditors should understand the methods and assumptions used by valuation specialists and not just rely upon their conclusions.

Auditing fair value measurements requires a new level of cooperation between auditors, management, and valuation specialists. Although a valuation specialist is retained by management, the auditor should be comfortable with the valuation specialist selected before the engagement begins. The auditor should carefully review the specialist’s résumé and statement of qualifications. The valuation specialist should have experience not just with valuation issues in general, but also with valuations specifically related to financial reporting. The auditor should make sure the valuation specialist fully understands the concept of fair value under GAAP and has experience with these types of engagements. The valuation specialist should provide comfort to the auditor about the methods and assumptions during the course of the engagement rather than at the end of it.

Mark L. Zyla, CPA/ABV, CFA, ASA is a Managing Director of Acuitas, Inc. , Atlanta. He is a coauthor of Valuation for Financial Reporting: Intangible Assets, Goodwill and Impairment Analysis, SFAS 141 and 142 (New York: John Wiley & Sons, 2002.) He can be reached at mzyla@acuitasinc.com or 1-404-898-1137.