Fair-Value Storm; SEC Nails 69 Auditors

With filing deadlines approaching, companies holding dramatically devalued securities as a result of sub-prime mortgage failures are bracing to disclose their current market values, according to new cues emerging from regulators and auditors.

The American Institute of Certified Public Accountants recently issued a brief reminder to auditors to get good evidence for valuations of alternative investments, pointing auditors to advice contained in a practice aid, “Alternative Investments—Audit Considerations.” Meanwhile, the Center for Audit Quality, an affiliate of the AICPA, is drafting some guidance for auditors based on recent conversations with staff members at the Securities and Exchange Commission. The guidance is expected to say auditors should look for current values, rather than model pricing, as of the balance sheet date.

A draft whitepaper being written by the CAQ reminds the audit community that Financial Accounting Standard No. 157, Fair Value Measurements, states that “the use of an entity’s own assumptions about future cash flows is compatible with an estimate of fair value, as long as there are no contrary data indicating the marketplace participants would use different assumptions. If such data exist, the entity must adjust its assumptions to incorporate that market information … The reporting entity may not ignore information about market participant assumptions that is reasonably available without undue cost and effort.”

A spokesman for the CAQ confirmed the center is drafting guidance (currently in circulation for review and revision) to address audit considerations tied to sagging investment values. He declined to discuss it any further.

In the draft materials, Samuel Ranzilla, chairman of the Professional Practice Executive Committee at the CAQ, notes that the liquidity crisis in subprime mortgages has spread to other areas of the credit markets, such as high-yield junk bonds, debt issued in leveraged buyout transactions, and even short-term asset-backed commercial paper. “It is not possible at this time to predict how long investors will stay on the sidelines or which markets will be most affected, but it is not unreasonable to expect—especially for subprime mortgage-related assets—that current conditions could persist for an extended period of time until the uncertainty is reduced,” he writes.

While the AICPA practice aid focuses on alternative investments such as financial instruments that do not have readily determinable market values, Mike Glynn, technical manager at the AICPA, says auditors face similar issues in auditing valuations of investments that have tumbled in the markets.

Glynn

“We’re reminding auditors that the job of valuing these securities doesn’t fall to you as auditor,” Glynn explains. “That’s management’s responsibility. We’re reminding folks that they have to have enough evidence to support the valuations in the financial statements. Sub-prime is really just another variation of this same issue that we continue to have with alternative investments.”

Lewis Ferguson, a partner with the law firm Gibson, Dunn & Crutcher and former counsel to the Public Company Accounting Oversight Board, says the challenge for auditors will be to judge management’s assertions when the market for securities has become inactive. “The market has become so illiquid that you don’t know if these securities have any value at all,” he says. “Sometimes they’re simply not saleable. Auditors are being asked to attest to the judgments by management as to the value of a portfolio when the normal yardstick for measuring these things has gone out the window.”

Ferguson says auditors will be expected to follow current accounting rules, especially FAS 157, which establishes a three-tier hierarchy for valuations. The statement specifically emphasizes that fair value “is a market-based measurement, not an entity-specific measurement,” according to FASB’s own summary of FAS 157. “A fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability,” the summary says.

Auditors are likely to require plenty of evidence on valuations in the upcoming audit season, Ferguson says, in part because of the spotlight on subprime mortgage failures. “It’s going to be volatile. Anytime you have tremendous volatility in the market, the risk goes up for both those preparing financial statements, and for those auditing them,” he says. “Auditors will be very careful about this because they could turn out to be wildly wrong in hindsight.”

SEC Censures Auditors on Faulty Registration

Regulators sent a wake-up call to small audit firms that may be overlooking or dismissing the significance of being registered to audit public companies before issuing an opinion.

The Securities and Exchange Commission took action against 69 auditors—37 unregistered audit firms and 32 unregistered audit partners—for issuing audit opinions without registering in advance with the Public Company Accounting Oversight Board, as required by Sarbanes-Oxley.

The SEC said it has settled 29 orders, but another 10 are being contested—and that those settlements included censures and repayment of audit fees. The 69 firms and partners issued a total of 60 audit reports for 53 companies between November 2003 and October 2005, according to the SEC.

Although the PCAOB is responsible for registering audit firms to permit them to audit public company financial statements, the SEC must issue enforcements against unregistered auditors, PCAOB spokeswoman Colleen Brennan says. “Because they had not registered, they did not yet come under our jurisdiction,” she explains.

The PCAOB says many of the censured firms requested registrations after the fact. “In those cases, the Board disapproved registration and provided for terms on which those firms might later seek to reapply for registration,” Brennan says.

For example, in the case of Beckman Kirkland & Whitney, the firm and two of its partners, James Kirkland and Robert Whitney, are charged with filing an audit report for Flamemaster Corp., a California company traded on the Pink Sheets, when not registered with the PCAOB. According to a PCAOB order denying the firm’s registration, the audit firm applied for registration on Dec. 30, 2003, nearly a month after filing an audit report for Flamemaster.

The PCAOB order says the registration was denied because the firm failed “to exercise the degree of care that the Board would expect of a public accounting firm under the circumstances.” The order says the firm could re-register with the board after Oct. 1, 2005, but it is not currently registered, nor does it have a pending request.