Mark O. Smith, CPA, JD
When you hear the word measurement, what comes to mind? For most of us, measurement implies an exact science. However, there are situations, especially in the financial sector and broader business community, where measurement is not so easily defined or performed. One of those situations is fair value measurement.
What makes fair value measurement such a challenge is that, unlike real property and other tangible assets (which can be objectively measured and valued), there’s tremendous subjectivity and diversity within the available and applicable valuation resources, guidance and methodologies. This diversity often manifests itself in inconsistent application and documentation which, in turn, can result in valuation deficiencies.1
The reaction to these valuation deficiencies can be seen in heightened regulatory scrutiny and diminished investor confidence.
As regulators and investors continue to push for greater transparency in financial markets, both domestically and internationally, financial statement disclosures that rely on professional judgment generally — and fair value measurement specifically — will continue to receive scrutiny.
Valuation professionals who avoid certain deficiencies will produce more supportable, consistent and well-documented valuations. As a result, clients and auditors will have a clear understanding of how the valuations were determined, thus increasing overall trust in the valuation professional.
Here are three common deficiencies that should be avoided:
1. Insufficient documentation for professional judgment.
Assumptions used to determine the fair value of a product or service are often not well supported by the valuation professional. Inputs based on professional judgment that are qualitative in nature are present in every valuation engagement. However, if they’re not properly documented, the users of the valuation report (e.g. client, auditors) are left to guess what the valuation professional was thinking. Well-documented qualitative inputs provide a clear path from the thought process to the results disclosed in the valuation report.
2. Insufficient documentation of fair value conclusion. I
t’s common for valuation professionals to use multiple methods when determining fair value. In situations where multiple methods are used, it’s important to thoroughly document how each method contributed to the final conclusion of value. However, what’s not appropriate is to simply take an average of the results without providing a rationale for doing so. How the results of each method are weighted and integrated into the final conclusion of value relies heavily on the professional judgment of the valuation professional. Therefore, adequate documentation of the work is crucial to support the conclusion of value properly.
3. Lack of professional skepticism when reviewing management’s prospective financial information (PFI).
A company’s PFI might be prepared routinely by one or more members of management or, in larger companies, an internal functional group often called “financial planning and analysis” (subsequently referenced as ‘management’). Valuation professionals must understand and document how the PFI was developed by management. It’s important to be aware of the purpose for which the PFI was prepared and understand whether the PFI was developed using market participant assumptions. Part of the valuation professional’s responsibility is to evaluate the PFI provided by management for reasonableness in general, as well as in specific areas.
Factors and common procedures to consider when preparing an assessment of a company’s PFI may include, but are not limited to:
- Comparison of prior forecasts to actual results.
- Comparison of PFI to industry expectations.
- Checking PFI against other internally prepared financial information for consistency.
- Comparison of entity PFI to historical trends.
- Understanding who prepares the PFI and how often is it prepared.
- Performing mathematical and logic check.
Fair value measurement deficiencies present challenges not only for valuation professionals, but also for their clients, investors and regulators, as well as others who are placing their trust in a company’s financial statement. With more consistency and transparency in the valuation process, and a dedicated focus on the qualifications and oversight of valuation professionals, fair value measurements can effectively meet the needs and expectations of the global marketplace and those who contribute to its ongoing evolution.
1 The term ‘deficiencies’ is used broadly here to define errors or omissions in a valuation professional’s report or supporting work documents; however, readers should understand that this also is a technical term used in the audit profession as well, where it has a different meaning.