New guidance on auditing fair value Handbook Section 5306 brings together in one place the approach and procedures to be followed when auditing fair value measurements and disclosures By Don Cockburn and Eric Turner Assumptions used in fair value measurements are similar, in general, to those required when developing other accounting estimates. However, if observable market prices are not available, generally accepted accounting principles (GAAP) requires that valuation methods incorporate assumptions that marketplace participants would use in their estimates of fair value. This unique feature, combined with the growing use of fair value measurements and disclosures in financial statements prepared in accordance with GAAP has increased the need for specific auditor guidance in this area. In July, the Auditing & Assurance Standards Board (AASB) approved the issuance of new Handbook Section 5306, "Auditing fair value measurements and disclosures." Until now, the source of general auditing guidance has been Section 5305, "Audit of accounting estimates." The new section brings into the Handbook International Standard on Auditing (ISA) 545, which has the same title as new Section 5306, with limited changes to fit the material within the context of the Handbook and to be consistent with the American Institute of Certified Public Accountants (AICPA) Statement on Auditing Standards (SAS) 101, which also has the same title as Section 5306. As a result, there are no significant differences between Section 5306, ISA 545 and SAS 101: an auditor complying with Section 5306 will also be in compliance with ISA 545 and SAS 101. Guidance on auditing fair values Section 5306 provides guidance to the auditor of financial statements containing fair value measurements and disclosures. It requires the auditor to obtain sufficient appropriate audit evidence that fair value measurements and disclosures are in accordance with GAAP. The auditor must understand the GAAP requirements for the particular fair value estimate. This can be a challenge because GAAP does not specify methods or processes for measuring items at fair value. Rather, GAAP indicates that, where possible, fair values must be based on observable market prices. If observable market prices are not available, the techniques used by management for estimating fair value measurements should incorporate assumptions that individuals in the marketplace would use. If that information is not available, then GAAP permits an entity to use its own assumptions as long as there is no indication marketplace participants would use different ones. It is important to note that the new section provides a general framework for auditing fair value measurements and disclosures by bringing together in one Handbook section the approach and procedures to be followed when auditing fair value measurements and disclosures. The new section does not establish detailed guidance for auditing specific types of fair value estimates. Instead, it provides guidance on understanding management's process for developing fair value estimates and evaluating whether the measurement conforms to GAAP. Because no new material is introduced into the Handbook, no conforming amendments are required to other sections. Following is an overview of the guidance in the new section: • Obtain an understanding of the entity's process, including relevant controls, for determining fair value measurements and disclosures sufficient to develop an effective audit approach. In so doing the auditor would consider the extent to which management relied on a service organization or made use of specialists in determining fair value measurements and disclosures. • Assess inherent and control risk related to fair value measurements and disclosures to determine the nature, extent and timing of audit procedures. • Evaluate whether the fair value measurements and disclosures are in accordance with GAAP. • Obtain evidence, usually through enquiries (the responses to which would be appropriately corroborated) about management's intention to carry out specific courses of action when relevant to fair value measurements and disclosures under GAAP and evaluate its ability to do so. • Evaluate, by, among other things, discussing with management its reasons for the selection of the valuation method, whether the method of measurement is appropriate under GAAP when alternative methods are available under GAAP or when the method is not prescribed. • Evaluate whether the entity's method for measuring fair values is applied consistently. • Determine the need to use the work and findings of a specialist. In doing so the auditor would consider the matters discussed in Section 5049, "Use of specialists in assurance engagements." • Test the entity's fair value measurements and disclosures by, for example, testing management's significant assumptions, the valuation model and underlying data, developing independent fair value estimates or considering subsequent events. • When applicable, evaluate whether the significant assumptions used by management in measuring fair values, taken individually and as a whole, provide a reasonable basis for fair value measurements and disclosures. • Test data used to develop fair value measurements and disclosures and evaluate whether fair value measurements have been properly determined from such data and management's assumptions. • Consider the effect of subsequent events on fair value measurements and disclosures. • Evaluate whether disclosures about fair values are in accordance with GAAP. • Evaluate the sufficiency and appropriateness of audit evidence obtained and the consistency of that evidence with other evidence obtained during the audit. • Obtain written representations from management regarding the reasonableness of significant assumptions, including whether they appropriately reflect management's intent and ability to carry out specific courses of action when relevant to the use of fair value measurements and disclosures. • Finally, consider what matters, if any, should be communicated with the audit committee or equivalent. Testing the entity's fair value measurements and disclosures Section 5306 indicates that because of the wide range of possible fair value measurements, from relatively simple to complex, the auditor's planned audit procedures can vary significantly in nature, timing and extent. Complex fair value measurements normally are characterized by greater uncertainty regarding the reliability of the measurement process. This greater uncertainty, which should be assessed by the auditor, may be the result of any one or more of the following: • The length of the forecast period (for example when fair value is being estimated using a discounted cash flow method). • The number of significant and complex assumptions associated with the process. • A higher degree of subjectivity associated with the assumptions and factors used in the process. • A higher degree of uncertainty associated with the future occurrence or outcome of events underlying the assumptions used. • Lack of objective data when highly subjective factors are used. Auditors use the above assessment, combined with their understanding of management's fair value estimation process and relevant GAAP requirements, to design their audit procedures. In evaluating significant assumptions, the auditor considers whether they are reasonable and consistent with the general economic environment, the entity's economic circumstances and existing market information. When assumptions are reflective of management's intent and ability to carry out specific courses of action, the auditor considers whether they are consistent with the entity's plans and past experience. For items valued by the entity using a valuation model, the auditor is not expected to substitute his or her judgment for that of management. Rather, the auditor reviews the model and evaluates whether the model is appropriate and the assumptions used are reasonable. For example, it may be inappropriate to use a discounted cash flow method in valuing an equity investment in a start-up enterprise if there are no current revenues on which to base the forecast of future earnings or cash flows. When management has determined, in accordance with circumstances required or permitted by GAAP, that the fair value of an asset or liability cannot be determined with sufficient reliability, the auditor obtains sufficient appropriate audit evidence to support that fact and whether that fact and other information are properly disclosed in the financial statements under GAAP. Future guidance The AASB notes that the AICPA issued a toolkit in late 2002 dealing with, among other things, auditing fair value measurements and disclosures in a business combination and is working on a guide to supplement SAS 101 on auditing fair value measurements and disclosures of certain specific assets, liabilities, components of equity or transactions. The AASB has approved a project to produce an audit technique study based on these two AICPA documents. The study will address the need for guidance on auditing specific fair value measurements and disclosures. All in one place The new Handbook Section 5306 brings together guidance on the audit of fair value measurements and disclosures in one place. This is particularly relevant in view of the greater focus that is being placed on fair value measurements and disclosures in financial statements. In addition, the issue of the section makes the Handbook guidance on this topic consistent with the guidance in both ISA 545 and SAS 101. Note, however, the effective date for ISA 545 is for periods ending on or after December 31, 2003, while the effective date of SAS 101 is for periods commencing on or after June 15, 2003. The effective date for 5306 is for periods ending on or after June 30, 2004.  Don Cockburn, FCA (don.cockburn@cica.ca); is a consultant in the Assurance Standards department at the CICA. Eric Turner (eric.turner@cica.ca) is a principal in the same department.