New Tips for Testing Fair Value amid Turmoil

The international standard-setter for auditors gives guidance on reviewing mark-to-market assumptions.

Another standard-setter has entered the fray to try helping accountants and auditors deal with fair-value rules during the credit crisis. The guidance — from the International Auditing and Assurance Standards Board (IAASB) — is the latest in a rush of advice geared to dealing with the intricacies of marking assets to market. And it comes as critics increasingly are calling fair-value a major culprit behind the current financial turmoil.

Monday evening, the IAASB issued a practice alert for auditors as they review financial-asset valuations that are based on companies’ assumptions — without an existing market to measure against. “While estimation of fair values has proved to be extremely difficult in light of market uncertainty, it has not proved impossible to obtain sufficient information to record these fair values in financial statements,” says the board, which sets standards for the International Federation of Accountants.

The IAASB acknowledges that auditors will have their work cut out for them, since reliable information has been hard to come by during a down market. For assets whose value cannot be easily ascertained — because of a lack of active trading — companies base their estimates on “unobservable inputs,” and may rely on the work of valuation experts. “The degree of estimation uncertainty therefore increases and affects, in turn, the risks of material misstatement,” the IAASB says. “What may in the past have been a routine valuation problem may become the source of a significant risk.”

IAASB’s 11-page alert reminds auditors to make sure clients have evidence to support their estimates, and to assure that they have been consistent with their fair-value disclosures. In addition, IAASB encourages auditors to inquire whether clients have reviewed their valuation practices and processes in light of the Financial Stability Forum’s request to do so. Earlier this year, FSF recommended that international standard-setters consider the problems that led up to the financial turmoil and give guidance on auditing the valuations of complex or illiquid financial products.

Last year, the U.S. regulator of audit firms issued its own practice alert on fair value in response to the subprime mortgage mess. The Public Company Accounting Oversight Board’s alert highlighted how auditors should evaluate mark-to-market measurements and the issues they should consider regarding unobservable inputs.

The PCAOB’s guidance is still relevant, says Marty Baumann, director of the board’s Office of Research and Analysis. “It’s very hard to value complex financial instruments especially with thin trading going on or sometimes no trading whatsoever,” he says. The PCAOB has no immediate plans to issue new guidance on fair value. However, the board regularly meets with the Securities and Exchange Commission and auditors to discuss current issues, and fair value has been “top of mind,” Baumann says.

The IAASB alert came out soon after the International Accounting Standards Board published its own response to the credit crisis. Last week, IASB vowed to make sure its fair-value standard is consistent with U.S. GAAP after the Financial Accounting Standards Board and the SEC gave companies guidance on following FAS 157, which explains how to measure fair value. In addition, on Friday, FASB’s staff proposed an amendment to FAS 157, which gives a specific example of evaluating a financial asset in an inactive market. (The deadline for comments on that proposal is Thursday.)

FAS 157, issued in 2006, did not create a new concept but rather gave companies guidelines on how to mark their financial assets to market based on a three-step hierarchy, with the levels based on how much market information is available. However, it’s been blamed by the leaders of financial institutions for the large write-downs they made over the past year.

In written testimony to the House Committee on Oversight and Government Reform today, Martin Sullivan, former CEO of American International Group, claimed that the adoption of the rule eventually led to his company’s needing to be saved by the federal government. “However well FAS 157 operates under any reasonably foreseeable market conditions, in the unprecedented credit crisis which began in the summer of 2007, FAS 157 had, in my opinion, unintended consequences,” he said.

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