Over the past year and a half, the Securities and Exchange Commission has fielded a slew of questions from companies about the fair-value measurement of financial assets and liabilities. Many requests for guidance have involved auditing the assumptions and estimates used to determine fair value. But few questioners have focused on management’s responsibility in the fair-value audit process, according to Marc Panucci, a senior associate chief accountant at the SEC.
The dearth of such questions is surprising, Panucci told an audience last week at an audit-industry conference sponsored by Baruch College and the National Association of State Boards of Accountancy. That’s because “everybody agrees” that management — including company CEOs and CFOs who are required by law to certify that financial statements are fairly presented — is the primary group responsible for supporting the fair-value assertions that are reported in financial results, the SEC accountant explained.
Noting that management is also generally held responsible for establishing effective internal controls over financial reporting, Panucci said top executives must become comfortable with assumptions and estimates provided by third-party valuation specialists. Companies typically hire such specialists to determine the worth of hard-to-value items, including thinly traded financial instruments, complex securities, and goodwill.
Most of the issuers and auditors that have approached the SEC looking for guidance in this area were concerned with two issues, said Panucci. First, what kind of evidential matter is required by the SEC and the Public Company Accounting Oversight Board to back up assertions made about securities traded in illiquid markets? Second, what evidence is required to assure regulators that management understands the basis for fair-value estimates provided by third-party specialists?
The catalyst for such queries, said Panucci, likely was the PCAOB’s requirement that auditors must “obtain an understanding of [management's] process for determining fair-value measurements and disclosures,” as well as the fact that there is no bright-line definition of an “understanding.” Indeed, to render an opinion, an auditor must be comfortable with management’s level of understanding with regard to the assumptions made by third parties, he noted.
Some valuation specialists, recognizing the demand for more information around fair-value estimates, are obtaining SAS 70 Type II audits, noted Panucci. A Type II audit examines the controls around the work of an outside vendor that will be fed into the issuer’s financial statements, such as estimates. It’s another means of assuring that management is comfortable with the third party, said Panucci.
“I am not saying that management has to recalculate [estimates] or understand everything the specialist is doing,” added Panucci. But the SEC does expect management to understand how fair value is being determined, how fair value affects the financial statements, and whether the company is “truly managing the risk of restatement.”
If the company can’t support its fair-value assertions, then, Panucci advised, “management, the auditors, and outside counsel at least have to take a step back and ask the question: How does that impact the assessment on internal controls over financial reporting, and how does that impact [Sarbanes-Oxley] certifications?”