It’s been said that the fair value of assets and liabilities (like beauty) is in the eye of the beholder. This is categorically not true when it comes to counseling clients as they prepare financial reports.

Companies are required to record certain assets and liabilities on their books at “fair value” — the amount that the asset could be sold for or liability settled with a third party in an orderly transaction. Something is worth what someone will pay is straightforward in concept, but can be difficult to determine when active markets do not exist.

More scrutiny on the way for fair value calculations

The credit crisis brought the concept of fair value into the mainstream as many of the issues perpetuated the uncertainties and difficulties companies had in valuing financial instruments. Fair-value calculations became critically important to investors, regulators and auditors.

A recent report issued by the Public Company Accounting Oversight Board (PCAOB), an agency created by Congress to oversee the auditing profession, points to even more scrutiny that will be placed on fair-value determinations in the coming audit season. To wit: Every year the PCAOB provides reports on the quality of audits of the major accounting firms. A public report issued in mid-August on the audits of one of the “Big 4″ accounting firms detailed numerous deficiencies by the firm on the audit procedures performed on its clients’ fair-value determinations. (It is expected that similar reports on additional auditing firms are forthcoming.)

The PCAOB said that more audit testing should have been performed on fair value, and a greater understanding of the assumptions and methodologies used should have been obtained. This report is a wake-up call to the auditors and by extension their clients’ audit committees and counsel that greater scrutiny must be placed on fair-value determinations.

What impact will this increased auditor focus have on your corporate clients? The answer is plenty if your clients are not prepared for heightened auditor focus on fair value including increased evidence of compliance with standards. Unprepared companies will surely face longer audits and higher audit fees. In addition, they will have a heightened risk for internal control deficiencies and financial statement adjustments. Prepared company management and their counsel will have support ready for the inputs used in determining fair value of hard-to-value assets and liabilities, the inputs not used, and explanations for both. Additionally, they will have reviewed and documented their understanding of any third-party valuations, including the internal controls in place at the third parties, to ensure that they can provide documentation that satisfies their auditors.

To be sure, this is not solely an audit issue as the SEC has voiced similar concerns. However, this focus by the PCAOB will surely drive immediate changes this audit cycle.

Determining Fair Value

Fair value is calculated by gathering and analyzing information or inputs. Inputs can come from a variety of sources and current accounting standards provide a three-level hierarchy:

• Level 1 consists of price quotes for an identical item directly from an active market. This type is the easiest to assess and gives the most straightforward valuation. An example would be a price quote for a stock from TheWall Street Journal, Reuters or Bloomberg.

• Level 2 uses inputs of prices for similar items in active or inactive markets. These prices must be observable even if they are not for an identical item. An example would be valuing a corporate bond based on comparable bond transactions and spreads.

• Level 3 valuations are for assets or liabilities where there are no active markets or observable inputs for the exact item or for a similar item so unobservable inputs must be used. It requires looking at a broader range of inputs and using informed professional judgment. An example would be performing a discounted cash flow analysis of a complex, unique financial instrument. Another would be valuing the shares of a nonpublic closely held commercial business.

The hierarchy must be followed in sequence. If Level 1 inputs are available, they trump any Level 2 or Level 3 inputs and company management must support their determinations. Importantly, companies must be able to support why there are no observable inputs for an asset or liability that they have classified as a Level 3.

While valuing assets and liabilities falling within Level 1 is straightforward, Level 2 and Level 3 items can be tricky owing to the lack of identical comparables. In these instances, companies often utilize third-party pricing services or outside valuation experts. While these services can be helpful in determining fair value, company management must ensure that they have sufficient understanding to take ownership of the calculation and be able to explain and support it to their auditors. If multiple pricing services are used, differences in valuations may be present due to different assumptions or comparable employed. Management must understand and document the differences in these cases and be able to explain the fair-value amount they ultimately assigned. The SEC has referred to this as the need for companies to obtain justifiable reliance, a higher bar than reasonable reliance.

Questions to ask your clients

Based on the inherent difficulties of assessing fair value along with the expected increase in auditor scrutiny, there are plenty of potential pitfalls your clients could face. The following are questions that you should consider asking your client’s audit committee members and management:

• Does the company have sufficient bandwidth and expertise to meet increased scrutiny?

The increased attention on fair value will elevate the demands on company management, shifting precious time and focus from management away from other areas that may need attention. Outside assistance may be necessary in instances where there are not sufficient company resources either from a manpower or technical perspective to summarize and document conclusions. However, management and counsel cannot subordinate their judgment to others and someone inside the company must take ownership for inputs and conclusions.

• Does sufficient documentation exist to support the fair-value determination?

Companies can count on a higher threshold of acceptable documentation to support fair-value conclusions than in the past. While previously they may have been able to orally explain their methodology to the auditors, this will be more than likely no longer good enough. Management should ensure a thorough review of the sufficiency of their documentation is completed prior to audit commencement.

• Are the fair-value calculations objective and free of bias?

Level 2 and 3 assets and liabilities call for the use of informed professional judgment. Clients and counsel will be called to defend, with facts and rationale, selections made. Here again, effective documentation is critical. The most common scenario occurs when the fair value from two sources differ. At a minimum, companies must document the reason for the difference and how the appropriate value was ultimately determined.

• Are the fair-value calculations using the most up-to-date information?

A firm’s fair-value assumptions must be reviewed periodically to ensure that critical factors have not changed. It can be tempting for expediency to simply roll forward assumptions made in prior periods and perform only a cursory update documenting the lack of assumption changes. In the face of PCAOB criticism this approach may no longer fly with outside auditors. Financial markets are dynamic and where in the prior year there was no observable input, in the current year one may exist. This must be reviewed and thoroughly documented. Additionally, it may be warranted to bring in an outside fresh set of eyes to review complex valuations and ensure the methodology being used in past periods is still reasonable going forward.

There are ample opportunities for counsel to assist clients to prepare for the upcoming audit season. You can and should expect much discussion of this topic in audit committees and board rooms. Consider this a fair warning on fair value. •

Anthony B. Creamer III is a certified public accountant and the Philadelphia office managing director for Navigant Consulting. He assists legal counsel, boards, audit committees and management in navigating financial reporting issues and business disputes. He is accredited in business valuation and certified in financial forensics by the AICPA.