Recent interactions with your auditors have likely resulted in greater audit scrutiny as a result of the Public Company Accounting Oversight Board (PCAOB). The PCAOB issued a report last September, Report on Observations of PCAOB Inspectors Related to Audit Risk Areas Affected by the Economic Crisis, in which it identified areas where auditors failed to comply with PCAOB auditing standards. According to the report, “As the effects of the economic crisis spread to the broader economy the Board’s inspection staff considered additional audit risk factors, as well as audit risk factors previously considered that had become more significant, during the 2009 inspection cycle, which generally involved reviews of firms’ 2008 audits.” These additional or “heightened” risk factors identified in audit areas were as follows:

• fair value measurements
• consideration of an issuer’s ability to continue as a going concern
• accounting for special purposes entities
• contingencies
• complex derivatives
• compliance with debt obligations
• valuation of deferred tax assets
• valuation of goodwill
• valuation of other intangibles and long-lived assets
• valuation of inventory
• determination of other-than-temporary impairment of certain investments, pension and other post-employment benefit obligations
• valuation of receivables
• valuation of restructuring liabilities
• revenue recognition

The PCAOB goes on to say in its report that audit committees might want to consider, and discuss with financial reporting management, how the issuer addresses such matters as fair value measurements, among others. Under paragraphs .20 and .23 of AU 328, Auditing Fair Value Measurements and Disclosures, auditors are required to test management’s fair value measurements and disclosures and consider using the work of a specialist in performing audit procedures related to fair value. In addition, under paragraph .09 of AU 328, the auditor must obtain an understanding of the entity’s process for determining fair value measurements and disclosures of the relevant controls sufficient to develop an effective audit approach.

Valuation Impact

Due to the increased scrutiny from the PCAOB, the valuation industry has experienced a significant increase in time allocated to auditors in the review process. The current focus on independence and avoiding conflicts of interests has prompted more companies to engage outside specialists for non-audit services, such as valuation work. However, the use of a specialist does not allow a company’s auditor to delegate his or her responsibilities. Auditors need to have an in-depth understanding of the approaches and assumptions used by valuation professionals. Given the complexity of many valuation assignments, communication between a company’s audit team and its outside valuation experts has become critical.

In order to make the audit review process as efficient as possible, we have identified a list of items on which management will want to make sure all parties (i.e., management, accounting firm’s audit and valuation teams, and outside valuation professionals) are in agreement at both initiation and throughout the valuation engagement.

Identify assets. Identify all real estate, personal property, and intangible assets which will be valued in the engagement. Consider all forms of intangible assets including trade names, noncompete agreements, leasehold interests, and customer-related intangibles, such as customer lists and customer relationships.

Clarify assumptions. According to AU 328, Auditing Fair Value Measurements and Disclosures, auditors do not function as appraisers, but they are required to review the valuation model and evaluate the reasonableness of the assumptions used in the valuation.

Determine valuation approaches/methodology. This issue is particularly important in the case of unusual assets, such as the program agreement previously mentioned. For “typical” assets, methodologies have been accepted and refined. On the other hand, if the assets are less common, the methodology often has not yet been established. In these situations, it is particularly important for all parties to be clear on the approaches which will be utilized to arrive at the value conclusion.

Discuss timing and deliverables. Clarify the manner in which the value conclusions will be delivered as well as when the deliverables are due. Although management letters typically outline these considerations, discussions relative to timing and deliverables may uncover potential problems which can often be resolved if they are addressed upfront.

As previously mentioned, the valuation industry has experienced a significant increase in the time allocated to auditors in the review process. In many instances, client management is also an active participant in the review. For the most effective use of time, prior to a scheduled meeting, a comprehensive list of the auditor’s questions should be sent to the client and the valuation firm. All involved parties should recognize that a more thorough review process provides a greater degree of comfort and assurance against any perceived conflict of interest. For more information, contact your Valuation Research representative.