Audit Watchdog Issues Subprime Alert

In response to the subprime mortgage mess, the PCAOB sounds a fair-value siren to guide auditors.

The Public Company Accounting Oversight Board has issued a so-called practice alert to help auditors navigate financial statements affected by actual and expected losses brought on by the credit crisis.

Specifically, the alert, which was released on Monday, focuses on issues related to Financial Accounting Standard Board’s rule FAS 157, Fair Value Measurement, said Marty Baumann, director of the PCAOB’s Office of Research and Analysis.

The alert restates how auditors should evaluate fair-value measurements. The notice was issued over concerns that the subprime mortgage crisis will increase the volume of fair-value recalculations companies will be forced to make after accounting for losses from the subprime collapse.

Issued in September 2006, FAS 157 is effective for fiscal years beginning after November 14, 2007 and for interim periods within those fiscal years. The rule, which was adopted early by some companies, defines fair value, establishes a framework for measurement, and expands disclosures. The alert, however, focuses mainly on transition issues affecting the remeasurement of assets and liabilities.

It discusses, among other issues, classifying the measurements within the hierarchy established by FAS 157 and the use of valuation specialists and pricing services to calculate the measurement. “This alert does not create any new auditing requirements,” noted Tom Ray, the PCAOB’s chief auditor. “We issued the alert because we believe it will be helpful to the auditors as they gear up to complete their year-end auditing work.”

The alert also revisits the hierarchy prescribed by FAS 157, noting that since different consequences are associated with each of the three levels, companies may be tempted to “inappropriately classify fair value measurements” to produce a desired accounting effect.

Under FAS 157, a company must determine where assets and liabilities fall with respect to the fair-value hierarchy system. The hierarchical slots range from the so-called Level 1 category, which are openly traded assets with an observable fair value, to Level 3 assets, which are valued by using unobservable estimates based on the value the company believes a hypothetical third party would place on them.

Further, the alert reemphasizes factors auditors should consider when deciding whether to call in a specialist to help out with the review of fair-value measurements. Those factors includes whether the audit includes significant use of unobservable inputs, the complexity of the valuation techniques, and the materiality of the fair-value measurement.

Over the past several years, the fair-value concept has been championed by FASB chairman Robert Herz and others who believe the principle will help financial statements better reflect economic reality. As a result, fair-value measurement is being methodically introduced into new and revised accounting rules when appropriate. For example, last week, FASB released FAS 141(R), a rewrite of its rule on business combinations. “The most difficult part of implementing FAS 141(R) is coming to grips with fair value principles that were never required before,” said McGladrey & Pullen’s Jay Hanson.

However, Hanson told CFO.com that the PCAOB has criticized accounting firms for not doing enough work to verify fair-value calculations provided by specialists. As a result, the board has cited audit firms for not testing the numbers, models, and management assumptions to their liking. For instance, in its 2006 inspection report, the PCAOB took the Big Four firm Deloitte & Touche to task for trusting management’s assertions and not properly testing its clients’ fair-value calculations.

In June, the PCAOB considered adjusting its auditing standards to compensate for companies’ increased use of fair-value accounting. But the group’s advisory board discouraged the watchdog from creating new auditing standards. Instead, the advisors suggested a long-term solution: getting to the root of the problem by enhancing education programs. No short-term fix was recommended.

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