The current audit cycle has shown a significant uptick in the level of audit scrutiny in part due to the Public Company Accounting Oversight Board (PCAOB) scrutiny of auditor work files. Over the past several years, PCAOB audits and the resulting inspection reports have identified areas in which audit firms have been deficient in terms of compliance with PCAOB auditing standards. PCAOB’s comments identified risk areas around a number of audit deficiencies including fair value measurements (FVM). In a recent Wall Street Journal article, “Delving Into the Value Riddle,” Emily Chasen says, “PCAOB inspection reports released in the past two years found a threefold increase in valuation-related audit problems, spurring securities and audit regulators to alert managers and auditors that they are personally responsible for understanding the assumptions that underlie third-party value estimates.”

The PCAOB’s remarks, as well as those of the Center for Audit Quality, at the AICPA National Conference on Current SEC and PCAOB Developments held last December, focused on the need for auditors to apply greater professional skepticism. In our experience, the application of professional skepticism on FVM results in increased scrutiny on the methodologies, inputs and assumptions used in FVM. Registrants have also noted a significant increase in scrutiny of management-generated FVMs. A key area of emphasis is documentation. The PCAOB notes: “It is important for a firm’s quality control system to establish policies and procedures that cover documenting the results of each engagement. Although documentation should support the basis for the auditor’s conclusions concerning every relevant financial statement assertion, areas that require greater judgment generally need more extensive documentation of the procedures performed, evidence obtained, and rationale for the conclusions reached. In addition to the documentation necessary to support the auditor’s final conclusions, audit documentation must include information the auditor has identified relating to significant findings or issues that is inconsistent with or contradicts the auditor’s final conclusions.”

The PCAOB has increased its staff significantly over the past few years. At year-end 2008, the PCAOB employed 481 people, including 258 inspection staff members. At year-end 2011, the PCAOB had 690 staff after adding 90 during the year, including 73 new inspections staff members. More than 60 percent of PCAOB staff work in registration and inspections.

In this issue of the VRC Alert, we provide an overview of some of the key areas of auditor emphasis on FVM in response to the PCAOB.

Over the past year, auditors have increased scrutiny around management forecasts which provide the foundation for valuation methods based on an income approach (such as the discounted cash flows model). Goodwill impairment testing and the valuation of assets and liabilities acquired in a business combination often rely heavily upon forecasted financial data supplied by management as well as professional experience and judgment in the application of various valuation assumptions. Third-party valuation specialists are faced with the challenge of evaluating management forecasts for reasonableness. The audit review process involves significant questioning around the specialist’s process of testing and gaining comfort with management’s assumptions, as well as support for the specialist’s own assumptions and professional judgment.

Goodwill Impairment Testing. In FVM relating to testing goodwill for impairment (ASC 350), key areas of scrutiny are as follows:

• Material shifts in management’s forecast, year-over-year and/or failure to achieve previously forecasted results;
• Long-term growth rates and profit margins;
• Discount rates and the underlying inputs such as the risk free rate, equity risk premium, debt to equity structure and beta;
• Market multiples and the related adjustments; and
• Control premiums, if applicable.

Business Combinations. The key areas of scrutiny when determining the FVM of assets acquired and liabilities assumed in a business combination (ASC 805) are as follows:

• Reasonableness of the buyer’s forecast and consideration of market participant assumptions;
• Discount rate reconciliation between the WACC and the IRR;
• Selection of appropriate discount rates for individual intangible assets and overall reconciliation of individual asset discount rates with the entity’s discount rate;
• Long-term growth rates;
• Contributory asset charges used in the excess earnings method;
• Estimates of customer attrition, a key input in the valuation of customer relationships;
• Royalty rates used in the valuation of trademarks, technology and other assets; and
• Estimates of technology life and obsolescence, both key inputs in the valuation of technology.

It is important to note that inputs and assumptions must be supported by the appropriate level of documentation. The inputs do not necessarily need to be free of professional judgment; however, they must be defendable in case of a challenge. Companies must be prepared for the heightened auditor focus on fair value including increased documentation and evidence of compliance with standards. Lack of documentation and support for FVM could lead to longer and more expensive audits. Given the complexity of many FVM assignments, communication between management, the auditor and the valuation specialist is critical to a successful project.

For more than 37 years, VRC has been providing independent valuations that withstand scrutiny from the IRS, SEC and other regulatory bodies. For more information, contact your VRC representative.