Fair Value Measurements
In the Crosshairs of Regulators
In this article, Mark Zyla of Acuitas discusses trends in fair value measurements in financial reporting and enforcement actions. Mr. Zyla notes that financial reporting is increasingly scrutinized by regulators. He observes that recent inspection reports of accounting firms that audit publicly traded entities by the Public Company Accounting Oversight Board (PCAOB) have indicated an increasing focus on the audit procedures related to fair value. The Securities and Exchange Commission (SEC) has also showed concerns regarding outside valuation specialists who assist management in determining fair value measurements. The increased scrutiny has put a spotlight on the process of measuring fair value in financial reporting.
Fair value measurements in financial reporting are becoming increasingly scrutinized by regulators.¬† Recent inspection reports of accounting firms that audit publicly traded entities by the Public Company Accounting Oversight Board (PCAOB) have indicated an increasing focus on the audit procedures related to fair value.¬† The Securities and Exchange Commission (SEC) has also showed concerns regarding outside valuation specialists who assist management in determining fair value measurements. ¬†The increased scrutiny has put a spotlight on the process of measuring fair value in financial reporting.
Fair value in financial reporting is defined by the Financial Accounting Standard Board (FASB) as ‚Äúthe 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.‚ÄĚ¬† The objective of fair value measurement is to estimate a transaction price from the perspective of a market participant for a particular asset, liability, or equity instrument. ¬†There are well over three dozen accounting standards which require fair value as the unit of measurement in financial reporting.¬† The accounting standards most commonly requiring fair value are those that govern the financial reporting of business combinations and subsequent testing of acquired assets for impairment.¬† Additionally, certain accounting standards allow entities to report various financial assets and liabilities at their relative fair values.
Fair value is a unit of measurement in accounting which requires or permits entities to report assets and liabilities at prices other market participants would pay for those assets or paid to transfer the liabilities. ¬†In other words, fair value is an exit or market based notion.¬† Since many individual assets and liabilities are not sold or transferred in active markets, their fair value measurements are often determined using assumptions as if they were to be sold or transferred to a market participant. ¬†Market participants generally are those buyers and sellers that have certain defined characteristics and are willing and able to transact for the asset or liability. ¬†Since fair value measurements require special expertise, management often uses outside valuation specialists to assist with the measurement.
The benefit of fair value measurements is that it allows the users of the financial statements to better understand the actual financial position of the entity. ¬†The challenge with fair value measurements is that the measurement often increases judgment in the financial reporting process.¬† The challenge extends to auditing fair value measurements.
The PCAOB conducts inspections of registered public accounting firms as required by the Sarbanes-Oxley Act of 2002.¬† The inspections are designed to identify and address deficiencies in a firm‚Äôs audit engagements and to determine whether deficiencies indicate a weakness or defect in the firm‚Äôs system of quality control over audits.¬† The annual inspection process encompasses a review of selected audits and a review of the firm‚Äôs system for quality control.
PCAOB reviews of selected audits are intended to identify financial statement misstatements, including failures to comply with disclosure requirements and failures to perform applicable audit procedures. ¬†When a deficiency reaches a level of significance that appears to indicate the firm failed to obtain sufficient audit evidence to support its audit opinion on the financial statements or on the effectiveness of internal control over financial reporting, the deficiency is described in the PCAOB‚Äôs inspection report, which is publicly available.
The individual PCAOB inspection reports themselves do not define deficiency.¬† However, Auditing Standard No. 7 Engagement Quality Review provides a description, saying that a significant audit engagement deficiency ‚Äúexists when: 1) the engagement team failed to obtain sufficient appropriate evidence in accordance with the standards of the PCAOB; 2) the engagement team reached an inappropriate overall conclusion on the subject matter of the engagement; 3) the engagement report is not appropriate in the circumstances; or 4) the firm is not independent of its client.‚ÄĚ
My firm, Acuitas, Inc. conducts an annual review of the PCAOB‚Äôs inspection reports, particularly as they relate to fair value.¬† Acuitas Inc.‚Äôs Survey of Fair Value Audit Deficiencies is intended to assist financial statement preparers, auditors, and valuation specialists in understanding the underlying causes of fair value measurement (FVM) and impairment audit deficiencies, as reported by the PCAOB.¬† There are a number of key findings and trends that were noted from the 2008 to 2013 inspection reports.¬† At the time of our most recent survey, the 2013 inspection reports were the most currently available.
The PCAOB inspections for annually inspected firms from 2008 through 2013 indicate several trends.¬† First, the percentage of all audit engagements with deficiencies has increased dramatically since 2009 and remains high.¬† In connection with the 2013 annual inspections, the PCAOB found deficiencies in 132 issuers, or 42.9% of audits and other engagements examined, which is similar to 2012 inspections.¬† Comparatively, in 2009, the inspection reports for the same firms cited deficiencies in 61 issuers, or 16.0% of audits examined.
A second trend indicates that audit deficiencies involving fair value measurements and testing for impairment remains relatively high.¬† In 2010, fair value and impairment deficiencies were 48.4% of all deficiencies. ¬†In 2013, fair value and impairments issues represented 31.0% of total audit deficiencies.¬† The focus of the fair value measurement in prior years involved primarily the auditing of financial instruments.¬† However, the focus changed dramatically in 2013 to almost half of fair value deficiencies involved the audits of business combinations, reflecting the increased level of transactions.
Our analysis of PCAOB inspection reports indicates that the number of audits with deficiencies remains fairly high.¬† A significant number of these deficiencies relate to the auditing of fair value measurements and impairment testing.¬† In prior years, audit failures were primarily attributable to deficiencies in the fair value measurement of financial instruments caused by pricing problems and failure to adequately test the value.¬† However, the most recent inspection reports indicate an increase in the number of deficiencies related to the fair value measurements in business combinations. ¬†The inspection reports indicate that the PCAOB considers audit failures related to fair value measurements are primarily attributable to failures to assess risk of proper measurement and test internal controls related to the measurement.
The PCAOB is also expected to issue additional guidance on auditing estimates, including fair value and the use of valuation specialists as part of the auditing process in the Fourth Quarter of 2016.
SEC and Fair Value Measurements
The SEC also has had some concerns as to proper measurement of fair value.
In prepared remarks to the 2011 AICPA National Conference on Current SEC and PCAOB Developments, the then Deputy Chief Accountant of the U.S. Securities and Exchange Commission, Paul A. Beswick, commented on the SEC‚Äôs observations of the valuation profession, particularly as the profession relates to the development of fair value measurements.
Beswick commented on:
- A ‚Äúlack of unified identity‚ÄĚ, meaning, there are numerous organizations that provide valuation credentials, unlike the accounting profession.
- The market confusion, as well as ‚Äúidentity void,‚ÄĚ for the profession. This feeling that the profession have a ‚Äúsingle set of qualifications with respect to education level and work experience, a continuing education curriculum, standards of practice and ethics, and a code of conduct.‚ÄĚ
- A need for a disciplinary mechanism to enforce rules in the public interest.
Since Mr. Beswick‚Äôs initial remarks, the valuation profession led by several valuation professional organizations, leaders of the valuation practices in international accounting firms, the Appraisal Foundation and the International Valuation Standards Council has begun working on a fair value quality initiative within the valuation profession to respond to the SEC‚Äôs concerns.¬† These groups are currently working on a process to develop common education and experience requirements for a credential for valuation specialists focusing on fair value measurements, as well as establishing governance and oversight for professionals who work in this area.¬† The fair value credential is expected to be introduced sometime in 2016.
The Enforcement Division of the SEC has also brought actions in the past several years against three investment funds alleging that fair value measurements were improperly applied to certain assets in their funds, particularly during the credit crisis.¬† These enforcement actions reflect the commission‚Äôs concerns as to proper controls and measurement procedures related to fair value.
Fair value measurements provide more relevant information to the users of financial statements as to the current financial position of the entity.¬† However, the measurement often requires professional judgment.¬† Best practices as to proper fair value measurements continue to evolve both within the accounting and valuation professions.¬† In the interim, regulators such as the PCAOB and the SEC have increased their scrutiny of fair value measurement in financial reporting.¬† Management, auditors, and valuation specialists should be aware of and understand the particular focus of the regulatory scrutiny of fair value measurements in financial reporting.
This article was originally published in the June 2016 issue of the PLUS Journal.
 Financial Accounting Standards Board Master Glossary www.fasb.org
 PCAOB Auditing Standard No. 7 Engagement Quality Review.
 Acuitas, Inc.‚Äôs The Survey of Fair Value Audit Deficiencies can be found at www.acuitasinc.com.
 The percentage of audit engagements with deficiencies is not available for 2008.
 Source: Beswick, Paul A. Prepared Remarks for the 2011 AICPA National Conference on Current SEC and PCAOB Developments December 5, 2011, Washington D.C.¬† www.sec.gov
 Bartholomew, Christian and Jill Baisinger ‚ÄúSEC Turns Focus to Valuation Issues‚ÄĚ Bloomberg BNA Accounting Policy & Practice Report¬† March 29, 2013 pages 234-236. http://www.bna.com/sec-turns-focus-to-valuation-issues/
Mark L. Zyla CPA, ABV, CFA, ASA is Managing Director of Acuitas, Inc., an Atlanta, Georgia based valuation and litigation consultancy firm. Mr. Zyla is the author of Fair Value Measurements: Practical Guidance and Implementation 2nd ed. published by John Wiley & Sons in 2013.
Mr. Zyla can be reached at (404) 873-9800 or by e-mail to firstname.lastname@example.org.