ASA 545 - Auditing Fair Value Measurements and Disclosures - April 2006
Audit Procedures Responsive to the Risk Audit Procedures Responsive to the Risk of Material Misstatement of the Entity’s Fair Value Measurements and Disclosures
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Audit Procedures Responsive to the Risk of Material Misstatement of the Entity’s Fair Value Measurements and Disclosures
40 The auditor shall design and perform further audit procedures in response to assessed risks of material misstatement of assertions relating to the entity’s fair value measurements and disclosures.
41 ASA 330 The Auditor’s Procedures In Response to Assessed Risks, discusses the auditor’s responsibility to design and perform further audit procedures whose nature, timing and extent are responsive to the assessed risk of material misstatement at the assertion level. Such further audit procedures include tests of control and substantive procedures, as appropriate. Paragraphs 42-63 below provide additional specific guidance on substantive procedures that may be relevant in the context of the entity’s fair value measurements and disclosures.
42 Because of the wide range of possible fair value measurements, from relatively simple to complex, the auditor’s procedures can vary significantly in nature, timing and extent. For example, substantive procedures relating to the fair value measurements may involve:
(a) testing management’s significant assumptions, the valuation model, and the underlying data (see paragraphs 47-57);
(b) developing independent fair value estimates to corroborate the appropriateness of the fair value measurement (see paragraph 60); or
(c) considering the effect of subsequent events on the fair value measurement and disclosures (see paragraphs 61-63).
43 The existence of published price quotations in an active market ordinarily is the best audit evidence of fair value. Some fair value measurements, however, are inherently more complex than others. This complexity arises either because of the nature of the item being measured at fair value or because of the valuation method required by the applicable financial reporting framework or selected by management. For example, in the absence of quoted prices in an active market, some financial reporting frameworks permit an estimate of fair value based on an alternative basis such as a discounted cash flow analysis or a comparative transaction model. Complex fair value measurements normally are characterised by greater uncertainty regarding the reliability of the measurement process. This greater uncertainty may be a result of:
(a) length of the forecast period;
(b) the number of significant and complex assumptions associated with the process;
(c) a higher degree of subjectivity associated with the assumptions and factors used in the process;
(d) higher degree of uncertainty associated with the future occurrence or outcome of events underlying the assumptions used; and
(e) lack of objective data when highly subjective factors are used.
Section Audit Procedures Responsive to the Risk - ASA 545 - Auditing Fair Value Measurements and Disclosures - April 2006 - Audit Procedures Responsive to the Risk of Material Misstatement of the Entity’s Fair Value Measurements and Disclosures | Zoe
44 The auditor’s understanding of the measurement process, including its complexity, helps guide the auditor’s determination of the nature, timing and extent of audit procedures to be performed. The following are examples of considerations in the development of audit procedures:
Using a price quotation to obtain audit evidence about valuation may require an understanding of the circumstances in which the quotation was developed. For example, where quoted securities are held for investment purposes, valuation at the listed market price may require adjustment under the entity’s applicable financial reporting framework if the holding is significantly large in size or is subject to restrictions in marketability.
When using audit evidence provided by a third party, the auditor ordinarily considers its reliability. For example, when information is obtained through the use of external confirmations, the auditor considers the respondent’s competence, independence, authority to respond, knowledge of the matter being confirmed, and objectivity in order to be satisfied with the reliability of the evidence. The extent of such audit procedures will vary according to the assessed risk of material misstatement associated with the fair value measurements. The auditor complies with ASA 505 External Confirmations in this regard.
Audit evidence supporting fair value measurements, for example, a valuation by an independent valuer, may be obtained at a date that does not coincide with the date at which the entity is required to measure and report that information in its financial report. In such cases, the auditor ordinarily obtains audit evidence that management has taken into account the effect of events, transactions and changes in circumstances occurring between the date of fair value measurement and the reporting date.
Collateral often is assigned for certain types of investments in debt instruments that either are required to be measured at fair value or are evaluated for possible impairment. If the collateral is an important factor in measuring the fair value of the investment or evaluating its carrying amount, the auditor obtains sufficient appropriate audit evidence regarding the existence, value, rights and access to or transferability of such collateral, including consideration of whether all appropriate liens have been filed, and considers whether appropriate disclosures about the collateral have been made under the entity’s applicable financial reporting framework.
In some situations, additional audit procedures, such as the inspection of an asset by the auditor, may be necessary to obtain sufficient appropriate audit evidence about the appropriateness of a fair value measurement. For example, inspection of an investment property may be necessary to obtain information about the current physical condition of the asset relevant to its fair value, or inspection of a security may reveal a restriction on its marketability that may affect its value.
Testing Management’s Significant Assumptions, the Valuation Model, and the Underlying Data
45 The auditor’s understanding of the reliability of the process used by management to determine fair value is an important element in support of the resulting amounts and therefore affects the nature, timing, and extent of further audit procedures. A reliable process for determining fair value is one that results in reasonably consistent measurement and, where relevant, presentation and disclosure of fair value when used in similar circumstances. When obtaining audit evidence about the entity’s fair value measurements and disclosures, the auditor ordinarily evaluates whether:
(a) the assumptions used by management are reasonable;
(b) the fair value measurement was determined using an appropriate model, if applicable; and
(c) management used relevant information that was reasonably available at the time.
46 Estimation techniques and assumptions and the auditor’s consideration and comparison of fair value measurements determined in prior periods, if any, to results obtained in the current period may provide audit evidence of the reliability of management’s processes. However, ordinarily the auditor also considers whether such variances result from changes in economic circumstances.
47 Where the auditor determines there is a significant risk related to fair values, or where otherwise applicable, the auditor shall evaluate whether the significant assumptions used by management in measuring fair values, taken individually and as a whole, provide a reasonable basis for the fair value measurements and disclosures in the entity’s financial report.
48 It is necessary for management to make assumptions, including assumptions relied upon by management based upon the work of an expert, to develop fair value measurements. For these purposes, management’s assumptions also include those assumptions developed under the guidance of those charged with governance. Assumptions are integral components of more complex valuation methods, for example valuation methods that employ a combination of estimates of expected future cash flows together with estimates of the values of assets or liabilities in the future, discounted to the present. Under paragraph 47 of this Auditing Standard, auditors need to pay particular attention to the significant assumptions underlying a valuation method and evaluate whether such assumptions are reasonable. To provide a reasonable basis for the fair value measurements and disclosures, assumptions need to be relevant, reliable, neutral, understandable and complete.
49 Specific assumptions will vary with the characteristics of the asset or liability being valued and the valuation method used (e.g. replacement cost, market or an income-based approach). For example, where discounted cash flows (an income-based approach) are used as the valuation method, there will be assumptions about the level of cash flows, the period of time used in the analysis, and the discount rate.
50 Assumptions ordinarily are supported by differing types of audit evidence from internal and external sources that provide objective support for the assumptions used. The auditor ordinarily assesses the source and reliability of audit evidence supporting management’s assumptions, including consideration of the assumptions in light of historical information and an evaluation of whether they are based on plans that are within the entity’s capacity.
51 Audit procedures dealing with management’s assumptions are ordinarily performed in the context of the audit of the entity’s financial report. The objective of the audit procedures is therefore not intended to obtain sufficient appropriate audit evidence to provide an opinion on the assumptions themselves. Rather, under paragraph 47 of this Auditing Standard, the auditor needs to perform audit procedures to consider whether the assumptions provide a reasonable basis in measuring fair values in the context of an audit of the financial report taken as a whole.
52 Identifying those assumptions that appear to be significant to the fair value measurement requires the exercise of judgement by management. The auditor, under paragraph 47 of this Auditing Standard, needs to focus attention on significant assumptions. Generally, significant assumptions cover matters that materially affect the fair value measurement and may include those that are:
(a) sensitive to variation or uncertainty in amount or nature. For example, assumptions about short-term interest rates may be less susceptible to significant variation compared to assumptions about long-term interest rates; and
(b) susceptible to misapplication or bias.
53 The auditor ordinarily considers the sensitivity of the valuation to changes in significant assumptions, including market conditions that may affect the value. Where applicable, the auditor encourages management to use such techniques as sensitivity analysis to help identify particularly sensitive assumptions. In the absence of such management analysis, the auditor ordinarily considers whether to employ such techniques. The auditor also ordinarily considers whether the uncertainty associated with a fair value measurement, or the lack of objective data may make it incapable of reasonable estimation under the entity’s applicable financial reporting framework (see paragraph 14).
54 The consideration of whether the assumptions provide a reasonable basis for the fair value measurements relates to the whole set of assumptions as well as to each assumption individually. Assumptions are frequently interdependent, and therefore, need to be internally consistent. A particular assumption that may appear reasonable when taken in isolation may not be reasonable when used in conjunction with other assumptions. The auditor, under paragraph 47 of this Auditing Standard, needs to consider whether management has identified the significant assumptions and factors influencing the measurement of fair value.
55 The assumptions on which the fair value measurements are based (for example, the discount rate used in calculating the present value of future cash flows) will ordinarily reflect what management expects will be the outcome of specific objectives and strategies. To be reasonable, such assumptions, individually and taken as a whole, also need to be realistic and consistent with:
(a) the general economic environment and the entity’s economic circumstances;
(b) the plans of the entity;
(c) assumptions made in prior periods, if appropriate;
(d) past experience of, or previous conditions experienced by, the entity to the extent currently applicable;
(e) other matters relating to the financial report, for example, assumptions used by management in accounting estimates for financial report accounts other than those relating to fair value measurements and disclosures; and
(f) if applicable, the risk associated with cash flows, including the potential variability of the cash flows and the related effect on the discounted rate.
Where assumptions are reflective of management’s intent and ability to carry out specific courses of action, the auditor ordinarily considers whether they are consistent with the entity’s plans and past experience (see paragraphs 28 and 29).
56 If management relies on historical financial information in the development of assumptions, the auditor ordinarily considers the extent to which such reliance is justified. However, historical information might not be representative of future conditions or events, for example, if management intends to engage in new activities or circumstances change.
57 For items valued by the entity using a valuation model, the auditor is not expected to substitute the auditor’s own judgement for that of the entity’s management. Rather, the auditor ordinarily 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.
58 The auditor shall perform audit procedures on the data used to develop the fair value measurements and disclosures and evaluate whether the fair value measurements have been properly determined from such data and management’s assumptions.
59 Under paragraph 58 of this Auditing Standard, the auditor needs to evaluate whether the data on which the fair value measurements are based, including the data used in the work of an expert, are accurate, complete and relevant; and whether the fair value measurements have been properly determined using such data and management’s assumptions. The auditor’s procedures also may include, for example, audit procedures such as verifying the source of the data, mathematical recalculation and reviewing of information for internal consistency, including whether such information is consistent with management’s intent to carry out specific courses of action discussed in paragraphs 28 and 29.