Finding the best method of measuring assets and liabilities has been both elusive and controversial.

From original (historical) cost, which offers verifiability, to various measures of fair value, which offer increased relevance, the interpretation and use of value information has been confusing. For example, in a business combination a target company may revalue at fair value (with some exceptions, such as recorded goodwill), but the buyer would continue without revaluation.

For some measures, judgment and estimation are required by the parties evaluating them, increasing risk implications and the possibility of material misstatements. Managers potentially could misuse their knowledge by selecting methods and estimation processes in financial reporting for the sole purpose of benefiting the firm.

Estimation cannot be avoided, and is absolutely required in many cases where there are uncertainties, such as estimating liabilities for future warranty services. Auditors must, therefore, design and use fieldwork procedures to assess risk and provide reasonable assurance of the absence of material error. Their job requires special expertise when they are faced with subjective valuations.



SFAS 157 (ASC 820), issued in 2008, presents a somewhat controversial definition of fair value. Instead of purchase price, the pronouncement uses a market-based (or exit-price) approach, which can be expressed in three tiers. Level 1, which is preferred, uses quoted exit prices for identical assets in an active market. Assets that fall into Level 1 include marketable investments, inventory and equipment. Level 2 is called adjusted market value, and uses market value (or possibly other inputs) for similar assets, which can then be adjusted for asset-specific information such as condition or environmental factors. Examples are land, land improvements and buildings (productive assets).

Level 3, the most subjective and open to error in estimation, is called the income approach to valuation. Some of these may be customer lists (which cannot be recorded as an asset by an acquiree because they are internally developed, but must be valued and recorded by an acquirer) and various other intangible assets that are identified usually as separable (during the business combination process) or arising from a contractual or legal arrangement. In valuing customer lists, cash-flow models may be employed using the present value of discounted estimated future cash flows. Independent appraisals may be useful in some circumstances. Certain liabilities, such as warranties payable, also fall into the category requiring estimation and judgment. As Level 3 valuations are subject to the most risk of measurement problems, they will be discussed at some length herein.

Cash, current liabilities, and bonds payable may be acquired at book or face values, generally. Any problems with valuation for these accounts are usually considered less serious, and are examined with long-accepted substantive auditing procedures. For estimated liabilities, however, a new fair value may replace the existing recorded value. Long-term liabilities may require adjustment because of material change in interest rates.

SFAS 159 (ASC 825) gives a fair-value option for financial assets, including certain investments in stock that had been valued using the cost or equity method. Election of this option is irrevocable, and may result in increased income because of market adjustments.

One report concluded that chief financial officers of large but less-profitable companies with compensation plans are more willing to choose the irrevocable fair value option of SFAS 159 than those who do not have compensation plans. Therefore, the CFOs of more profitable firms also might choose SFAS 159, being motivated to make accounting choices that benefit profits - and thereby management compensation.

Because of this, some argue for the traditional position that only realized gains and losses should be reported. Other studies suggest that companies defer income when deemed unnecessary for the bonus pool, or defer losses in periods of declining earnings. Some studies reached similar conclusions using the variables of depreciation methods, inventory methods, receivables policies, discretionary charges (such as maintenance), reversal of prior accruals, analysts' forecasts, and levels of R&D spending.

Critics argue that companies that are acquisition targets may make adjustments solely to improve the appearance of their financial position. They cite Tyco as an example of a company that did this (previous to SFAS 157 and SFAS 159). When losses were subsequently reported, stockholders sued, claiming loss of value. Auditors must be aware of and test for these various problems that result in earnings manipulation or material misstatement of financial statements.

The International Accounting Standards Board is developing International Financial Reporting Standards, ultimately with the goal to converge IFRS and U.S. GAAP. Fair value for asset valuation as expressed by IFRS is not based on exit prices, but uses a more traditional position of value reached in a marketplace by willing participants acting at arm's length. The definition of liabilities also varies. Agreements would need to be reached by a target date if global standards are to enhance international understanding and use of financial information. International auditing standards then can be developed and accordingly revised.



Using the acquisition method in business combinations, acquired accounts are valued with the guidance provided for Level 1, Level 2 and Level 3. If the acquisition cost (excluding transaction costs, such as outside legal and accounting, and restructuring costs) exceeds the determined fair values of the acquirer's net assets, goodwill results.

Goodwill becomes the residual portion of an acquisition price (or implied value) after all acquired assets and liabilities have been valued (if the acquisition cost is less than fair values, there is an immediate gain that is treated as part of continuing or normal operations). Goodwill no longer is amortized, and is subject to annual impairment tests for loss of value. If there is a forecast of lower growth, for example, and after subjectively considering risk and long- versus short-term projection periods for the unit, the impairment estimate may be affected, and adjustments can become volatile from period to period. This may actually serve managerial plans and earnings targets.

Critics suggest that reliability, because of illiquid market information and subjective cash-flow models, is in question, and the impact on earnings may be serious enough to require auditors to achieve some satisfaction through alternative means, such as using market multiples and price-earnings ratios of similar companies.

An acquiring company does not have to determine fair value on the specific acquisition date. Temporary or provisional values may be used, and adjusted to fair value during a measurement period, which generally would not exceed one year from date of acquisition. Changes after the measurement period would be reported as part of income.

Another intangible that may be created in a business combination is the acquisition of in-process research and development.

Prior to 2008, ongoing research acquired in a business combination was expensed as incurred, in accordance with the treatment of internally generated research and development. Now, SFAS 157 requires IPRD to be treated as an acquired asset at fair value, but it is subject to subsequent impairment, amortization or write-off as its usefulness ends (another subjective decision). Research costs after acquisition are to be expensed as incurred according to GAAP. Reversal of impairment losses is not allowed under GAAP, but may occur with IFRS under some circumstances. The capitalization of IPRD at acquisition is in accordance with IFRS, however, and one more step toward congruence. IFRS requires adherence to standards for capitalization of IPRD, some of which are technical feasibility to complete, the ability to use or sell the intangible asset, and the ability of the research to generate future benefits.

Contingencies - if the acquiree, for example, is the plaintiff in an unsettled lawsuit - may create a contingent asset if legal counsel believes the amount can be determined or is determinable and reasonably estimated during the measurement period. Again, changes arising from information after the measurement period would be included in income. Contingent liabilities also would be evaluated. Outside professional help in valuations may be necessary.

When buyer and seller cannot agree on a price, they may agree on the issuance of stock in the future by charging additional paid-in capital and crediting common stock at par value for the additional shares issued at that later time; or they may agree to additional payment in the future, contingent upon levels of future earnings - called an earnout. This contingency is not the same as pre-acquisition contingencies, described above.

If earnout adjustments come from changes that arise after the measurement period, these value changes are reported in income of that subsequent period. Big Four firm PricewaterhouseCoopers suggests that earnings inconsistencies may result from earnout adjustments, which may be an area of additional audit concern. Changes in the expected value of stock price contingencies, however, should not affect income; only equity accounts are adjusted as described above.



Auditing is the process of gathering evidence that enables the formation of an opinion on the fairness of management's representations. During fieldwork, through questionnaires and observations, the independent auditor will assess the risk of material misstatement of financial statements.

Informational efficiency includes reliability of both developed data and relevant market information. Physical inspections to assess the condition of property may be relevant to valuation - although auditors are not appraisers of value. Any source of market information should be timely and coincide with the date of measurement. The choice of interest rates also affects cash flow and the measurement outcome. Any audit of fair value must also consider if data is routine or unusual in nature; if the company used outside service organizations that are qualified and comply with stated objectives effectively; if the technology used was efficient; and if the computer science, math models, and underlying accounting and finance theory all produce a result in compliance with GAAP.



Auditors must remember that uncertainty increases as the forecast period increases and objective data decreases. Disclosures are necessary to inform users of uncertainty. If internal control is limited, risk increases and fair value measurement becomes more complex. Be aware of management interference with controls. Management's written representations and assumptions must be reasonable and express intent of proper actions and valuations that lead to financial statements that are not materially misstated.

Auditors of fair value measurement in fieldwork are not responsible for predicting the future, but they must use a similar approach to auditing that would be used when evaluating risk and auditing estimates in general.


Alvino J. Massimini, CPA, is an assistant professor of accounting at La Salle University in Philadelphia. Reach him at Reprinted with permission from The Pennsylvania CPA Journal, a publication of the Pennsylvania Institute of CPAs.

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