Companies can expect to see some shifting in how valuation specialists produce and document valuations underpinning financial statement assertions as the profession adapts to increasing demands for consistency.
Whether companies employ valuation experts inside or rely on third-party services, valuation professionals are starting to steer toward new standards and new expectations for how they arrive at their conclusions and how they present their findings. New standards, a new performance framework, and a new professional credential, for example, are expected to help narrow the guardrails around how valuations are produced and make them more audit-ready.
That’s good news for companies that have been caught in the crossfire between an unorganized, unregulated valuation profession and increasingly aggressive regulators demanding more management ownership over valuation outcomes and more audit evidence. It’s also just in time as regulators seem poised to raise the bar a little higher on what auditors will be expected to do to arrive at their audit opinions.
On the valuation side, fair-value measurement is common in accounting for business combinations, financial instruments, and impairments, and it will get even more common as new accounting standards come on board in the next few years. A growing number of accounting standards have called for more valuation work to get more current values into financial statements, and scrutiny on estimates and judgments have risen across the board.
Valuation professionals are not regulated. They’re not even brought together by a predominant professional organization. Dozens of professional groups, globally and domestically, provide different standards and credentials that are not compulsory for anyone.
“What we’re really doing here is asking professionals to show their work. It allows someone who wasn’t involved in the engagement to review and understand the process. An auditor can look at the documentation and know what was done.”
Eva Simpson, Director of Valuation Services, AICPA
Yet, valuation professionals have felt increasing pressure for several years as the Securities and Exchange Commission and the Public Company Accounting Oversight Board have raised their expectations on companies and auditors to scrutinize valuations. The SEC, in fact, brought the problem to the American Institute of Certified Public Accountants in 2011 and asked the profession to get more organized and more proactive on creating better-supported valuations that could stand up to a skeptical audit.
That prompted the AICPA to join forces with two valuation groups, the American Society of Appraisers (ASA) and the Royal Institution of Chartered Surveyors (RICS), to collaborate. The result is a new mandatory performance framework and new certification observed by all three groups as the global baseline for how much work is necessary to produce a supportable, auditable fair-value measurement.
The framework is not a new standard for how to perform valuations. Accounting rules already have a chapter in GAAP for how to perform fair-value measurements. “It’s guidance to substantiate what valuation professions are doing to arrive at their conclusions,” says Eva Simpson, director of valuation services at the AICPA. “What we’re really doing here is asking professionals to show their work. It allows someone who wasn’t involved in the engagement to review and understand the process. An auditor can look at the documentation and know what was done.”
DOCUMENTATION REQUIREMENTS FOR FAIR-VALUE ENGAGEMENTS
Below is an excerpt from AICPA Mandatory Performance Framework.
2.3 The valuation professional must conduct and document each engagement or part of an engagement to estimate fair value of a subject interest to assist in management’s preparation of financial statements for financial re porting purposes in accordance with the applicable guidance within this framework. Composition of Valuation Documentation
2.4 Documentation is the written record within the final valuation report, supporting working papers, or both, used to support a valuation conclusion used by management in their assertions of fair value and their preparation of financial statements issued for financial reporting purposes.
2.5 Appropriate documentation provides evidence that the valuation engagement was completed in accordance with this framework.
2.6 Written documentation may include paper, electronic files, or other forms of recorded media. Examples include, but are not limited to, letters of engagement, correspondence with clients (for example, email, recordings of calls, voice messages), client-provided documents, representation letters, field notes, electronic spreadsheets, and internally prepared memoranda to the work file. 2.7 Documentation comprises two key components:
2.7.1 Source documents include, but are not limited to, data and information (including interview notes) collected from both company sources and external third-party data accumulation resources relating to the company, its financial position, its competitors, the industry it competes in, its customers and suppliers, the state of the economy, financial markets, and risk factors.
2.7.2 Analysis documents include, but are not limited to, exhibits, schedules, and working papers that numerically set forth the analysis that was performed, and memos to file or other narratives that document and explain the valuation professional’s reasoning behind such matters as the selection of methods, selection of inputs used in applying methods, and judgments made regarding valuation assumptions.
2.8 Source documents should be included in the work file to the extent that they provide evidential support to an input, process, or output required to arrive at a conclusion of value.
2.8.1 Identification of source documents and specific selection criteria used to identify information used to support the final valuation report is appropriate when inclusion of source documents in the work file is not feasible or practicable (for example, all 10K filings for a particular industry, historical risk free rates for the last 30 years).
2.8.2 Source documents that are relevant to the analysis and indicate contrary evidence to the conclusion of value, along with the valuation professional’s explanation of how this information was considered, should be included in the final valuation report (and such source documentation should be identified in accordance with MPF section 2.8.1 if not included in the work file because not feasible or practicable to do so).
2.9 Analysis documents generally fall into two subcategories:
2.9.1 Computational analysis (for example, spreadsheets, database use). To the extent that this type of analysis provides evidential support (or contradictory indications) to an input, process, or output, it is required to be included in the work file (that is, supporting work papers, final valuation report). This analysis demonstrates “what” the valuation professional did and how they did it.
2.9.2 Narrative-based documents. These documents complement the computational analyses by providing commentary on “why” the valuation professional elected certain methods, inputs, and judgments within the work product. For example, narrative-based documents could be included in the following (this list is not all-inclusive):
The narrative of the report
The analysis documents (for example, footnotes, narrative fields)
Memoranda to the work file
Gary Roland, managing director at Duff & Phelps and one of the earliest to earn the new CEIV (Certified in Entity and Intangible Valuations) credential, says he expects auditors to look for the credential on valuation work that is relied on for financial statement assertions. “It’s broadly considered a best practice in the profession, so the general expectation from auditors is that the mandatory performance framework should be followed,” he says.
At the same time the AICPA, ASA, and RICS have joined forces to launch their new framework and certification, the International Valuation Standards Council—which represents a number of valuation and accounting groups globally. The 2017 edition provides revised standards for valuing intangible assets and new guidance on the selection of approaches and methodologies and the application of frequently used methods.
With dozens of technical groups issuing different standards and credentials, the IVSC sought with its 2017 updates to establish some common ground across all those groups. “We are trying to issue a set of standards that everyone can agree on,” says Andreas Ohl, a partner at PwC who chairs the IVSC.
Particularly for the sake of audits performed in the United States, where the PCAOB flags one-fourth or more of the audits it inspects for problems with valuation work, Ohl is hopeful new standards will lead to greater consistency. “Maybe it was the model that didn’t make sense, or maybe there was not enough critical thinking around the inputs,” he says. “What we’re trying to get to is to improve the quality of valuations.”
Travis Harms, senior vice president at Mercer Capital and head of the firm’s financial reporting valuation group, says Big 4 audit firms have been heavily invested in the work taking place to make valuations more consistent, so he expects auditors to raise their demands as new expectations for valuation professionals fall into place. “I expect it will become a requirement,” he says. “It may take a little bit of time but it will become an expected component of doing this valuation work.”
On the audit side, the PCAOB is finally moving forward with new rules it began pondering several years ago to give auditors new direction on how to audit accounting estimates, including fair-value measurements. The board began kicking around the idea of new guidance amid increasing findings through inspections that auditors were not doing an adequate job scrutinizing accounting estimates, including fair-value measurements.
Now a proposed new standard would give auditors new requirements for how to audit estimates including fair-value measurements. The standard would require auditors to get more skeptical and devote more attention to the potential for management bias when auditing accounting estimates. A companion proposal would change the requirements for auditors when they use the work of specialists, like valuation experts, to arrive at audit opinions.
While it typically takes a few years for the PCAOB to move from proposals to final requirements, the new direction on auditing estimates and using the work of specialists can reasonably be expected to give auditors even more reason to ask for more documentation of the assumptions and estimates that valuation experts use to arrive at valuations.
And if rising valuation and auditing standards aren’t enough, there is the question of whether accounting rules should require companies to say more in financial statements about the value of their homegrown intangible assets.
Accounting rules do not contain a provision for valuing intangible assets that are developed within the company, like brand names, patents, copyrights, customer lists, and other similar assets. Such assets do appear on corporate balance sheets, however, when they change hands in a business merger or acquisition.
When Tom Linsmeier departed the Financial Accounting Standards Board at the end of his term in 2016, he implored his fellow board members to consider requiring companies to at least disclose the cost and fair value associated with such assets. “Organizations with business models that focus on intangible assets are a growing and increasing part of our economy,” he wrote. “Yet, the current accounting model fails to provide much information on most internally developed intangible assets, resulting in an often-increasing market to book ratio for these organizations and leaving users with little financial reporting information to make their valuation assessments.”