Transparency and reliability are critical in financial reporting. Recent guidance from the Financial Accounting Standards Board increasingly relies on fair value measurements and management estimates, reflecting a shift toward principles-based standards. While this change enhances flexibility, it has introduced some gray areas in financial reporting that could increase the risk of misstatement.
Today, fair value estimates are used to report various assets, such as share-based payments, goodwill and other intangible assets acquired in business combinations, impairments of long-lived assets, and valuations of financial and nonfinancial assets. Here are answers to common questions about fair value reporting.
What’s fair value in financial reporting?
Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures, defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly market transaction, as opposed to a fire sale or other unusual circumstance.” Fair value measurements are separated into the following three-tier hierarchy, depending on the judgment used:
Level 1. Public stock prices for the company’s stock.
Level 2. Inputs other than quoted prices in active markets, such as quoted prices for similar assets, interest rates, yield curves or other market data.
Level 3. Nonpublic information and management’s estimates.
This hierarchy gives the greatest weight to quoted prices in active markets, less weight to comparable market data, and the least weight to internal models or unobservable inputs. Fair value should be based on quantifiable market data when it’s available. However, market data may be limited for some assets, such as intangibles, thinly traded stocks or private companies. In those situations, valuation professionals or other specialists are usually brought in to determine fair value.
How does fair value differ from fair market value?
The definition of fair value under U.S. Generally Accepted Accounting Principles is similar to the definition of fair market value, with some subtle differences. The fair market value standard is commonly used to value businesses or business interests for sale and tax purposes. The IRS defines “fair market value” in Revenue Ruling 59-60 as “[T]he price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
Fair market value is determined based on the expected price in an open and unrestricted market. This standard isn’t the same as “strategic” or “investment” value, which refers to a business’s perceived value to a specific investor. But under U.S. Generally Accepted Accounting Principles (GAAP), fair value considers only participants in the principal, or most advantageous, market — rather than an open and unrestricted market.
How do auditors evaluate fair value estimates?
There are seldom “right” answers when calculating fair value. Two well-informed people could analyze the situation and arrive at somewhat different conclusions.
Because fair value measurements often involve a high degree of subjectivity and judgment, they may be susceptible to misstatement. Therefore, they require more auditor focus. During an audit, the objectives are to evaluate whether the assumptions that underlie a fair value accounting estimate are based on reliable market data and whether management’s analysis of that information results in a reasonable conclusion.
Auditing standards generally provide the following three approaches for substantively testing fair value measurements:
1. Testing management’s process. Auditors may evaluate the reasonableness and consistency of management’s assumptions. They may also test whether the underlying data is complete, accurate and relevant.
2. Developing an independent estimate. Using management’s assumptions (or alternate assumptions), auditors come up with an estimate to compare to what’s reported on the internally prepared financial statements.
3. Reviewing subsequent events or transactions. The reasonableness of estimates can be gauged by looking at events or transactions that happen after the balance sheet date but before the date of the auditor’s report.
When auditors fail to adequately test fair value measurements prepared by third parties, it heightens the risk of fraudulent reporting and misstatements.
What’s impairment?
Impairment occurs when events or changes in circumstances indicate that an asset’s carrying amount (book value) exceeds the amount expected to be recovered through use or sale. Under GAAP, impairment testing applies to certain long-lived assets, goodwill and other intangible assets.
Certain intangibles, such as goodwill, must be tested at least annually for impairment. But other situations may also trigger impairment testing. Examples include:
· A significant decline in the market value of the asset or company,
· Adverse changes in the business or legal environment,
· Increases in interest rates,
· Evidence of obsolescence or physical damage, and
· Poor performance or cash flow losses associated with the asset.
The difference between an impaired asset’s carrying value and its fair value is recorded as an impairment loss. The loss is reported in three places on the company’s financial statements. First, it lowers the asset’s carrying value on the balance sheet. Second, it’s recognized as an expense (usually in operating income) on the income statement. Third, it’s added back to net income in the operating activities section on the statement of cash flows. (This is because impairment is a noncash item that doesn’t directly affect cash flow.)
Under GAAP, impairment is a permanent reduction in value that can’t be recovered through use or sale. So, impairment losses can’t be reversed in subsequent reporting periods.
Impairment testing helps ensure that assets aren’t overstated on the balance sheet. It signals to investors and stakeholders that certain assets no longer hold their previously expected economic value.
Are you audit-ready?
In today’s uncertain markets, fair value estimates face increased scrutiny. Expect your auditor to ask detailed questions about the assumptions and inputs that support your estimates. Be ready to provide thorough documentation to justify management’s conclusions. Taking a proactive approach can help prevent misunderstandings, reduce audit adjustments and strengthen confidence in your financial reporting. For additional guidance on fair value measurement or impairment testing, reach out to Hood & Strong.
