Fair Value Measurements Vexing PCAOB

An approach tried and rejected in the auditing of internal control over financial reporting may now be considered as a method for auditing the use of fair value measurements in public company accounting.

In the tumultuous early years of internal control auditing under Sarbanes-Oxley’s Section 404 and Auditing Standard No. 2, auditors were ordered to assess the process a company used to determine whether its internal control over financial reporting was sound. Amid widespread criticism that mandating an assessment of management’s assessment helped drive auditors to excessive procedures, the Public Company Accounting Oversight Board ultimately dropped that requirement from the revised internal control auditing rules it enshrined in Auditing Standard No. 5 at the end of May.

With the long debate over internal control audits resolved and AS5 headed for the rulebooks, the PCAOB now is turning its attention to new rules for how to audit fair value accounting. The PCAOB has dispatched its Standing Advisory Group to discuss the topic at a meeting this Thursday in Washington, D.C., a common preliminary step in the Board’s rulemaking process.

On the agenda, the PCAOB asks the SAG to consider how it should direct auditors to audit fair value measurements, given the number of new fair value accounting rules that have emerged in recent years. It also wants the group to discuss whether the board should direct auditors to focus on the numbers and assumptions management produces or on the process management follows to reach its conclusions.

In a discussion paper to preview the meeting, the Board describes how existing auditing standards provide different approaches for the audit of accounting estimates and the audit of fair value measurements. “The standards on auditing fair value measurements and accounting estimates describe how an auditor might evaluate management’s process and assumptions,” the Board says. “However, the two standards have different requirements for this evaluation.”

Audit rules regarding fair value measurements contain considerable direction for evaluating assumptions, but more limited direction for evaluating the process, the Board said; on the other hand, rules for accounting estimates offer considerable direction for evaluating the process but more limited direction for evaluating the reasonableness of the assumptions. So the Board wants the SAG to consider whether the approaches should be more synchronized.

Martin

Roger Martin, a professor at the University of Virginia who has researched fair value auditing for the PCAOB, noted the parallels in the history of internal control audits—where auditors had to assess management’s process and issue an opinion on it—and now the developing debate over how to audit fair value and other accounting that is based on management estimates.

“The original way we thought of Section 404 was to look at the process management had in place regarding controls,” Martin says. “Now the debate with fair value is which of those audit techniques gets auditors closest to being comfortable to say, ‘We think management got it right.’ Do we examine the process management uses? Or do we think about whether the answer management got is close to the answer I would have gotten if I’d done it myself?”

Auditing estimates of accounting has always been tricky because of the judgment involved, so the tension between management and auditors has always been present, but practice is established, Martin says. With the movement away from historical cost accounting and the increasing number of rules calling for fair value measurements, the uncertainties are growing, so the PCAOB must figure out how fair value measurements should be audited and whether the two similar but historically distinct areas should be linked, Martin says.

“There’s so much subjectivity involved in both areas,” he explains. “The auditing really hinges on how to audit a company’s judgments, and that’s so different from other things we do in auditing where we’re verifying facts. There’s nothing factual to verify. You’re trying to give an opinion that management’s judgments are reasonable.”

Olson

In a speech he delivered at Compliance Week 2007, PCAOB Chairman Mark Olson said the movement toward fair value accounting with Financial Accounting Standard No. 157, Fair Value Measurement and FAS 159, The Fair Value Option for Financial Assets, present some auditing challenges. “We must be mindful that any apparent improvement gained by providing investors with more relevant, fair value information, will be lost if that information is not also reliable,” he said. “In this regard, the increased use of fair value accounting poses a challenge for auditors and the PCAOB.”

Olson said auditors need more training in valuation techniques and must remember that preparers can be biased, even unintentionally, in making their fair value assessments. Finally, Olson said, auditors must consider that internal controls around fair value measurements may be different than internal controls over other areas of financial reporting.

FAIR VALUE FAQs

Below are the questions the PCAOB has asked its Standing Advisory Group to discuss this week on fair value accounting.

How does the market respond to accounting estimates and fair value

measurements? Does the market respond differently to risks associated

with fair value measurements as compared to other accounting estimates?

Should the auditor’s responsibilities for accounting estimates and fair value measurements be combined into a single standard or do the

differences between them warrant that they continue to be stated within

separate auditing standards?

Should the procedures for auditing fair value measurements and other

accounting estimates be the same? If not, what unique circumstances

require that the procedures be different?

Are there circumstances that might indicate that the auditor should use a particular approach or combination of approaches rather than leaving the determination to the auditor's professional judgment?

What types of accounting estimates and fair value measurements warrant

the auditor performing additional audit procedures? Are there any specific

accounting estimates or fair value measurements that always pose a

higher risk?

Should the auditing procedures to review and test the process used by

management, including a review of the reasonableness of assumptions,

be similar for accounting estimates and fair value measurements? If not,

what is the reason for the difference in the approach?

Are the development of independent estimates and the review of

subsequent events effective procedures for auditing accounting estimates

and fair value measurements and disclosures? Are there situations for

which these approaches are ineffective?

Source

PCAOB (June 21, 2007)

“Fair value accounting, while presenting the promise of greater relevance, represents an area of potential audit risk,” Olson said. “Thus, we are monitoring this area to understand how firms are addressing this potential risk.”

Other Business: Related-Party Rules

In addition to fair value auditing, the Board also is asking the SAG to discuss how to tackle the challenges of auditing related-party transactions and whether audit roles should be more carefully assigned to audit team members.

Henry

Elaine Henry, an accounting professor at the University of Miami who has researched related-party transactions for the PCAOB, says such transactions have been at the core of some of the major accounting scandals in recent history. Historically, more than 80 percent of companies disclose at least one transaction with a related person or a related party annually, she says, but providing specific audit procedures around such transactions is difficult because such a variety of circumstances surrounds them.

“When you look closely at audit failures, there’s often a related-party transaction involved,” she says. “Either it isn’t identified properly, it isn’t examined correctly, or it isn’t disclosed correctly.”

Such failures stem from an inadequate examination of transactions, especially to understand the economics behind the transaction, Henry contends. When such failures have been examined by the Securities and Exchange Commission, they also typically occur when smaller audit firms are involved, she says.

DeLoach

Jim DeLoach, managing director for Protiviti, says when parties are not independent of one another (as with related-party transactions), the traditional checks and balances function less effectively, creating greater risk of fraud or misstatement. “It’s important for auditors to understand the business motivations around them,” he says. “In general, that’s what investors want to know. Do they have a valuable business purpose? If a related-party transaction has the nature and appearance of financial engineering, meaning they’re entered to impact financial reporting results, they’re definitely a higher risk.”

In engagement team performance, the PCAOB is asking the SAG to consider whether the Board should give more guidance than current standards provide about who in an audit engagement should be responsible for specific audit duties. The Board especially wonders whether it should be more specific about an audit partner’s responsibilities regarding planning and supervising the audit engagement and about the audit partner’s duty to get involved with higher-risk areas, complex issues, or issues requiring extensive professional judgment.

“Historically, the level of auditor time spent up front in planning the engagement and evaluating the risk has always been a quality indicator when evaluating the quality of the work,” DeLoach says. “The momentum toward principles-based and fair value accounting would certainly drive an argument toward sharper focus on assessing risk, bringing to bear the greatest experience in the engagement up front in the audit.”