Fair Value Measures: What One Needs to Know When Working with a Valuation Specialist

The FASB pronouncements which address financial reporting of business combinations (SFAS 141) and the recognition of the continued validity of reported goodwill (SFAS 142) require assets to be recognized at their respective fair values. The requirement of stating assets at their fair values on the balance sheet after a business combination is complex. Often the acquiring entity to retains the services of valuation specialists to assist management with the estimate of the fair value each of the assets, particularly the 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 GAAP, the acquiring company’s auditor has to become more fully competent in evaluating the qualifications of the valuation specialist 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 has recently issued SAS 101, “Auditing Fair Value Measurements and Disclosures”1 which is effective for auditing financial statements on or after June 15th of this year.

NSAS 101 provides guidance to auditors on how management of an entity determines fair value and whether it confirms to GAAP. The statement provides broad guidance for auditing fair value measurements, one of which is using the work of a valuation specialist.2 As such, there are certain fair value concepts that a valuation specialist may utilize that an auditor should become familiar.

Estimating fair value concept may seem complex, however there are just four basic valuation concepts of fair value for financial reporting that are helpful for you to understand when working with management’s valuation specialist. These concepts are:

• the standard of value
• “market participants”
• the three basic approaches to value
• working with a valuation specialist.

The standard of value is fair value. Fair value is defines 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”.3

Market participant concept is still evolving, however the assumptions in the valuation should included only those that a “market participant” could realize.

Under the three traditional approaches to value; the cost, market and income approaches, the FASB has a preference for market based data.


Working with a Valuation Specialist
The changes brought by these new statements have affected the relationships between company’s management, the company’s auditors and outside valuation specialists. Even when management uses 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 the valuation specialist 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 underlie the valuation. Additionally, you should understand the methods and assumptions used by the valuation specialist and not just rely upon the specialist’s conclusions.

Auditing fair value measurements requires a new level or cooperation between auditors, management and valuation specialists. Although the valuation specialist is retained by management, the auditor should gain comfort with the selection of the valuation specialist before the engagement commences. The auditor should carefully review the specialists resume and statement of qualifications. The valuation specialist should have experience not just with valuation issues in general, but have specific experience with valuations 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.

Conclusion
The latest pronouncements from the FASB relating to the financial statement presentation of business combinations and the accounting treatment of goodwill requires an auditor to have an increasing level of understanding of estimating fair value. The complexities involved in estimating fair value often require management of an acquiring company to retain the services of a valuation specialist. As such, the auditor must understand several basic valuation concepts related to measuring fair value that the specialist may utilize. These concepts involve several issues. One issue is understanding the standards of fair value and how that impacts the methods and assumptions underlying the valuation. A second is knowing how the concept of market participants impacts assumptions. A third is the three basic approaches to value and a fourth is knowing how to work closely with a valuation specialist.

1 “The Auditor’s Approach to Fair Value”, Journal of Accountancy, June 2003, Pg. 73.
2 The AICPA also has a non-authoritative tool kit for auditors to help with fair value concepts, “Auditing Fair Value Measurements and Disclosures, A Toolkit for Auditors”, www.aicpa.org
3 Statement of Financial Accounting Standards No. 141, Appendix F, Page 123.

Mark L. Zyla, CPA/ABV, CFA, ASA is a valuation specialist and a Managing Director of Acuitas, Inc. in Atlanta, Georgia. He is co-author of Valuation for Financial Reporting: Intangible Assets, Goodwill and Impairment Analysis, SFAS 141 and 142; John Wiley & Sons; 2002 and Financial Valuation: Applications and Models; John Wiley & Sons; 2003. He can be reached at mzyla@acuitasinc.com or (404) 898-1137.