PCAOB Ponders How to Audit Fair Value

The challenges of auditing the fair value estimates that companies make have the PCAOB seeking help from its advisory board, and possibly contempla...
Sarah JohnsonJune 14, 2007

The Public Company Accounting Oversight Board is considering whether to adjust its auditing standards to compensate for companies’ increased use of fair value accounting.

Members of the board’s advisory group will discuss issues related to the standards for auditing accounting estimates and fair value measurements at their meeting on June 21. The staff has asked the group to think about whether the PCAOB should combine its corresponding rules into one. Doing so could also put the new standard in line with a proposed international rule.

As companies consider whether they will apply a new fair-value method of accounting for measuring certain assets and liabilities, the PCAOB and audit firms are thinking about how to keep auditors fully trained on the various valuation methods used by companies and prepared to give such methods the scrutiny they will require. In its briefing paper for next Thursday’s meeting, the PCAOB’s staff notes that the increased use of estimates based on market value — rather than historical cost — adds uncertainty and subjectivity to financial reporting and an added risk of material misstatements.

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For that reason, accounting experts told, auditors will be on especially high alert as companies begin applying the Financial Accounting Standard Board’s new guidance for fair-value accounting. They will need more time to evaluate how companies come up with their fair value estimates for those assets and liabilities that are thinly traded or not traded at all.

The new FASB standard, FAS 159, Fair Value Option for Financial Assets and Liabilities, will also test the knowledge of auditors, many of whom do not have specialized training. Indeed, PCAOB chairman Mark Olson recently expressed concerns that auditors may not be fully prepared to evaluate how companies came up with their calculations under FAS 159. “The increased use of fair value accounting poses a challenge for auditors and the PCAOB,” he said.

Indeed, in a 2006 academic research report solicited by the PCAOB, the authors warned that the level of technical knowledge of valuation tools among auditors is both sparse and hard to maintain as new models are created. “No auditor can keep up with all this stuff,” Jay Rich, associate accounting professor for Illinois State University and a co-author of the report, told “[The audit firms] need to have someone who specializes in valuation in place.”

Audit firms generally do have in-house staff or access to fair-value specialists, notes Center for Audit Quality executive director Cynthia Fornelli. The concept of fair-value is not new, she notes, and many firms have been preparing to deal with the expanded use of fair-value accounting for some time.

To be sure, while many U.S. GAAP standards are based on historical cost, FASB increasingly relies on fair value, as it did most recently with FAS 159, which is effective for most companies on November 15 and applies to measurements for stocks, bonds, loans, warranty obligations, and interest rate hedges.

If there is widespread use of the new standard, auditors will have their work cut out for them. Under the PCAOB’s existing standards, auditors need to understand management’s process for developing their estimates and test those assertions as part of their audit of internal controls over financial reporting.

That will be particularly difficult for auditors evaluating how companies derived estimates based on assumptions made internally, according to Rita Piazza, chair of the SEC committee for the New York State Society of Certified Public Accountants. Most companies do not have internal controls established for how they came up with those estimates based on instruments that are not traded on market, giving auditors little evidence for testing. Auditors need to make sure their clients have formal procedures in place to document how they derived their fair value estimates, Piazza says. Auditors then must develop audit procedures to properly test that information, she adds.

Auditors shouldn’t just look at the documentation and draw their conclusion that management made the right choices, despite what current auditing guidance prescribes, Rich’s report noted. “Auditors must be careful not to simply search for evidence that corroborates management’s assertions,” the report warns.

At the same time, auditors are in the awkward position of having to avoid using hindsight. Because they look at financial statements retrospectively, auditors often may review estimates that management ultimately got wrong because of unforeseen events, Rich says. But an incorrect estimate is not evidence of a poor valuation — auditors will need to look beyond the fact that a valuation was wrong to determine whether or not management made an appropriate judgment call.

To make their determination, the PCAOB staff notes, auditors may need to develop their own independent estimate to see how closely their prediction would match management’s. However, this isn’t always practical because the auditor won’t have independent data to compare the company’s assumptions.