In recent years, accounting rules have changed, and certain balance sheet items—such as asset retirement obligations, derivatives, and intangible assets acquired in a business combination—must now be reported at “fair value” rather than historical cost. Reporting at fair value brings your company’s financial statements into better alignment with today’s market values, but estimating fair value can require subjective judgment.
What is fair value?
Fair value is defined under U.S. Generally Accepted Accounting Principles (GAAP) as “the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.” Available, quantifiable market-based data should be used to estimate the fair value of assets and liabilities according to Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures.
Topic 820 classifies valuation inputs under a three-tier valuation hierarchy:
- Quoted prices for identical assets or liabilities in active markets
- Any information derived from publicly quoted prices, such as prices of comparable stocks and older prices from inactive markets
- Management’s estimates and nonpublic information
Measurements of fair value may require a high degree of subjectivity, especially when based on the third level of inputs, and this can make them susceptible to misstatement. As such, these estimates usually require more focus from auditors.
Approaches for making fair value estimates
Under current auditing standards, auditors are generally required to select one (or a combination of) these approaches in order to substantively test their fair value measurements:
- Developing an independent estimate. Auditors come up with an estimate using management’s assumptions (or alternate assumptions). This estimate is then compared to what’s reported on the internally prepared financial statements.
- Reviewing subsequent events or transactions. Events or transactions that occur after the balance sheet date but before the date of the auditor’s report are used to gauge the reasonableness of fair value estimates.
- Testing management’s process. The reasonableness and consistency of management’s assumptions is evaluated by auditors, who also test to ensure that the underlying data is complete, accurate and relevant.
Contact us today
Measuring fair value may be outside the comfort zone of your in-house accounting personnel—but an outside valuation expert can support the fair value of assets and liabilities with objective, market-based evidence. For more information, contact us today.