PCAOB Chair Examines Double-Edged Sword of Fair Value Accounting

Fair value accounting presents the promise of making financial statements more relevant, said PCAOB Chair Mark Olson, but at the same time poses heightened audit risk, especially in illiquid markets. In remarks at the Institute for International Bankers, he pledged that the PCAOB will continue to monitor fair value accounting in order to understand how audit firms are addressing this potential risk.

Fair value accounting was adopted by the FASB in Standard No. 157, which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Last December, the Board issued a practice alert on auditing the fair value measurements of financial instruments.

Fair value accounting for certain securities is being implemented in the US and elsewhere based on a belief that this standard more rationally reflects management's intent for the use of those assets and thereby offer investors more relevant information. Chairman Olson observed that current market conditions have cast into stark relief the challenges that determining fair value measurements can pose. As companies make the transition to fair value accounting, he continued, the auditors of their financial statements face three basic challenges.

First, many auditors may not have the extensive training in the valuation techniques needed to measure fair value. Second, since financial statement preparers can be biased in their assessments of fair values, auditors have to be sure that preparers have considered alternative valuation scenarios. Third, the internal controls surrounding fair value measurements may be different from controls over typical business transactions.

As the growing market turmoil engulfed asset-backed securities and collateralized debt obligations, he noted, the PCAOB reached out to auditors to discuss the emerging potential audit risks. This dialogue continues as credit risks deepen and spread to a number of other complex instruments. Questions have emerged as preparers and their auditors struggle over the need to measure the fair value of complex securities in an increasingly thin market. Throughout this dialogue, the PCAOB has communicated to auditors the need to ``stay the course,’’ reminding them to adhere to existing requirements. To that end, the Board has discussed the approaches to determining fair value provided for in accounting standards and the relevant requirements for auditors.

The chair emphasized that the Board’s message to auditors throughout this rapidly changing economic environment has consistently been to obey existing requirements. Specifically, auditors should get behind the prices or estimates provided by brokers and other specialists. Also, auditors and preparers must understand where the quoted value of the financial instrument is coming from; that is, whether it is a quote based on an active market, a price based on observable inputs, or an estimate based on a model. If the value is produced from a model, he said, preparers and auditors must understand the model and assess the reasonableness of its significant assumptions. More broadly, he emphasized that the nature of how the fair value measurement was derived will drive the work that preparers and auditors must undertake.