The following auditing standard is not the current version and does not reflect any amendments effective on or after December 31, 2016. The current version of the auditing standards can be found  here.

AU Section 328

Auditing Fair Value Measurements and Disclosures

• (.01 - .08) Introduction
• (.09 - .14) Understanding the Entity's Process for Determining Fair Value Measurements and Disclosures and the Relevant Controls, and Assessing Risk
• (.15 - .19) Evaluating Conformity of Fair Value Measurements and Disclosures With GAAP
• (.20 - .22) Engaging a Specialist
• (.23 - .42) Testing the Entity's Fair Value Measurements and Disclosures
• (.43 - .46) Disclosures About Fair Values
• (.47) Evaluating the Results of Audit Procedures
• (.48 - .49) Management Representations
• (.50) Communication With Audit Committees
• (.51) Effective Date

Source: SAS No. 101.

Effective for audits of financial statements for periods beginning on or after June 15, 2003, unless otherwise indicated.

Introduction

.01

The purpose of this section is to establish standards and provide guidance on auditing fair value measurements and disclosures contained in financial statements. In particular, this section addresses audit considerations relating to the measurement and disclosure of assets, liabilities, and specific components of equity presented or disclosed at fair value in financial statements. Fair value measurements of assets, liabilities, and components of equity may arise from both the initial recording of transactions and later changes in value. Changes in fair value measurements that occur over time may be treated in different ways under generally accepted accounting principles (GAAP). For example, GAAP may require that some fair value changes be reflected in net income and that other fair value changes be reflected in other comprehensive income and equity.

.02

While this section provides guidance on auditing fair value measurements and disclosures, evidence obtained from other audit procedures also may provide evidence relevant to the measurement and disclosure of fair values. For example, inspection procedures to verify existence of an asset measured at fair value also may provide relevant evidence about its valuation, such as the physical condition of the asset.

.03

The auditor should obtain sufficient appropriate audit evidence to provide reasonable assurance that fair value measurements and disclosures are in conformity with GAAP. GAAP requires that certain items be measured at fair value. Financial Accounting Standards Board (FASB) Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, defines the fair value of an asset (liability) as “the amount at which that asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” ^fn 1 Although GAAP may not prescribe the method for measuring the fair value of an item, it expresses a preference for the use of observable market prices to make that determination. In the absence of observable market prices, GAAP requires fair value to be based on the best information available in the circumstances.

.04

Management is responsible for making the fair value measurements and disclosures included in the financial statements. As part of fulfilling its responsibility, management needs to establish an accounting and financial reporting process for determining the fair value measurements and disclosures, select appropriate valuation methods, identify and adequately support any significant assumptions used, prepare the valuation, and ensure that the presentation and disclosure of the fair value measurements are in accordance with GAAP.

.05

Fair value measurements for which observable market prices are not available are inherently imprecise. That is because, among other things, those fair value measurements may be based on assumptions about future conditions, transactions, or events whose outcome is uncertain and will therefore be subject to change over time. The auditor’s consideration of such assumptions is based on information available to the auditor at the time of the audit. The auditor is not responsible for predicting future conditions, transactions, or events that, had they been known at the time of the audit, may have had a significant effect on management’s actions or management’s assumptions underlying the fair value measurements and disclosures. ^fn 2

.06

Assumptions used in fair value measurements are similar in nature to those required when developing other accounting estimates. However, if observable market prices are not available, GAAP requires that valuation methods incorporate assumptions that marketplace participants would use in their estimates of fair value whenever that information is available without undue cost and effort. If information about market assumptions is not available, an entity may use its own assumptions as long as there are no contrary data indicating that marketplace participants would use different assumptions. These concepts generally are not relevant for accounting estimates made under measurement bases other than fair value. Section 342, Auditing Accounting Estimates, provides guidance on auditing accounting estimates in general. This section addresses considerations similar to those in section 342 as well as others in the specific context of fair value measurements and disclosures in accordance with GAAP.

.07

GAAP requires or permits a variety of fair value measurements and disclosures in financial statements. GAAP also varies in the level of guidance that it provides on measuring fair values and disclosures. While this section provides guidance on auditing fair value measurements and disclosures, it does not address specific types of assets, liabilities, components of equity, transactions, or industry-specific practices. ^fn 3

.08

The measurement of fair value may be relatively simple for certain assets or liabilities, for example, investments that are bought and sold in active markets that provide readily available and reliable information on the prices at which actual exchanges occur. For those items, the existence of published price quotations in an active market is the best evidence of fair value. The measurement of fair value for other assets or liabilities may be more complex. A specific asset may not have an observable market price or may possess such characteristics that it becomes necessary for management to estimate its fair value based on the best information available in the circumstances (for example, a complex derivative financial instrument). The estimation of fair value may be achieved through the use of a valuation method (for example, a model premised on discounting of estimated future cash flows).

Understanding the Entity's Process for Determining Fair Value Measurements and Disclosures and the Relevant Controls, and Assessing Risk

.09

The auditor should obtain an understanding of the entity’s process for determining fair value measurements and disclosures and of the relevant controls sufficient to develop an effective audit approach.

.10

Management is responsible for establishing an accounting and financial reporting process for determining fair value measurements. In some cases, the measurement of fair value and therefore the process set up by management to determine fair value may be simple and reliable. For example, management may be able to refer to published price quotations in an active market to determine fair value for marketable securities held by the entity. Some fair value measurements, however, are inherently more complex than others and involve uncertainty about the occurrence of future events or their outcome, and therefore assumptions that may involve the use of judgment need to be made as part of the measurement process.

.11

Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement, requires the auditor to obtain an understanding of each of the five components of internal control sufficient to plan the audit. In the specific context of this section, the auditor obtains such an understanding related to the determination of the entity’s fair value measurements and disclosures in order to plan the nature, timing, and extent of the audit procedures.

.12

When obtaining an understanding of the entity’s process for determining fair value measurements and disclosures, the auditor considers, for example:

• Controls over the process used to determine fair value measurements, including, for example, controls over data and the segregation of duties between those committing the entity to the underlying transactions and those responsible for undertaking the valuations.
• The expertise and experience of those persons determining the fair value measurements.
• The role that information technology has in the process.
• The types of accounts or transactions requiring fair value measurements or disclosures (for example, whether the accounts arise from the recording of routine and recurring transactions or whether they arise from nonroutine or unusual transactions).
• The extent to which the entity’s process relies on a service organization to provide fair value measurements or the data that supports the measurement. When an entity uses a service organization, the auditor considers the requirements of section 324, Service Organizations, as amended.
• The extent to which the entity engages or employs specialists in determining fair value measurements and disclosures.
• The significant management assumptions used in determining fair value.
• The documentation supporting management’s assumptions.
• The process used to develop and apply management assumptions, including whether management used available market information to develop the assumptions.
• The process used to monitor changes in management’s assumptions.
• The integrity of change controls and security procedures for valuation models and relevant information systems, including approval processes.
• The controls over the consistency, timeliness, and reliability of the data used in valuation models.

.13

The auditor uses his or her understanding of the entity’s process, including its complexity, and of the controls when assessing the risk of material misstatement. Based on that risk assessment, the auditor determines the nature, timing, and extent of the audit procedures. The risk of material misstatement may increase as the accounting and financial reporting requirements for fair value measurements become more complex.

.14

Paragraph A5, second note of Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements, discusses the inherent limitations of internal control. As fair value determinations often involve subjective judgments by management, this may affect the nature of controls that are capable of being implemented, including the possibility of management override of controls. The auditor considers the inherent limitations of internal control in such circumstances in assessing control risk.

Evaluating Conformity of Fair Value Measurements and Disclosures With GAAP

.15

The auditor should evaluate whether the fair value measurements and disclosures in the financial statements are in conformity with GAAP. The auditor’s understanding of the requirements of GAAP and knowledge of the business and industry, together with the results of other audit procedures, are used to evaluate the accounting for assets or liabilities requiring fair value measurements, and the disclosures about the basis for the fair value measurements and significant uncertainties related thereto.

.16

The evaluation of the entity’s fair value measurements and of the audit evidence depends, in part, on the auditor’s knowledge of the nature of the business. This is particularly true where the asset or liability or the valuation method is highly complex. For example, derivative financial instruments may be highly complex, with a risk that differing assumptions used in determining fair values will result in different conclusions. The measurement of the fair value of some items, for example “in process research and development” or intangible assets acquired in a business combination, may involve special considerations that are affected by the nature of the entity and its operations. Also, the auditor’s knowledge of the business, together with the results of other audit procedures, may help identify assets for which management should assess the need to recognize an impairment loss under applicable GAAP.

.17

The auditor should evaluate management’s intent to carry out specific courses of action where intent is relevant to the use of fair value measurements, the related requirements involving presentation and disclosures, and how changes in fair values are reported in financial statements. The auditor also should evaluate management’s ability to carry out those courses of action. Management often documents plans and intentions relevant to specific assets or liabilities and GAAP may require it to do so. While the extent of evidence to be obtained about management’s intent and ability is a matter of professional judgment, the auditor’s procedures ordinarily include inquiries of management, with appropriate corroboration of responses, for example, by:

• Considering management’s past history of carrying out its stated intentions with respect to assets or liabilities.
• Reviewing written plans and other documentation, including, where applicable, budgets, minutes, and other such items.
• Considering management’s stated reasons for choosing a particular course of action.
• Considering management’s ability to carry out a particular course of action given the entity’s economic circumstances, including the implications of its contractual commitments.

.18

When there are no observable market prices and the entity estimates fair value using a valuation method, the auditor should evaluate whether the entity’s method of measurement is appropriate in the circumstances. That evaluation requires the use of professional judgment. It also involves obtaining an understanding of management’s rationale for selecting a particular method by discussing with management its reasons for selecting the valuation method. The auditor considers whether:

1. Management has sufficiently evaluated and appropriately applied the criteria, if any, provided by GAAP to support the selected method.
2. The valuation method is appropriate in the circumstances given the nature of the item being valued.
3. The valuation method is appropriate in relation to the business, industry, and environment in which the entity operates.

Management may have determined that different valuation methods result in a range of significantly different fair value measurements. In such cases, the auditor evaluates how the entity has investigated the reasons for these differences in establishing its fair value measurements.

.19

The auditor should evaluate whether the entity’s method for determining fair value measurements is applied consistently and if so, whether the consistency is appropriate considering possible changes in the environment or circumstances affecting the entity, or changes in accounting principles. If management has changed the method for determining fair value, the auditor considers whether management can adequately demonstrate that the method to which it has changed provides a more appropriate basis of measurement or whether the change is supported by a change in the GAAP requirements or a change in circumstances. ^fn 4 For example, the introduction of an active market for an equity security may indicate that the use of the discounted cash flows method to estimate the fair value of the security is no longer appropriate.

Engaging a Specialist

.20

The auditor should consider whether to engage a specialist and use the work of that specialist as evidential matter in performing substantive tests to evaluate material financial statement assertions. The auditor may have the necessary skill and knowledge to plan and perform audit procedures related to fair values or may decide to use the work of a specialist. If the use of such a specialist is planned, the auditor should consider the guidance in section 336, Using the Work of a Specialist.

.21

When planning to use the work of a specialist in auditing fair value measurements, the auditor considers whether the specialist’s understanding of the definition of fair value and the method that the specialist will use to determine fair value are consistent with those of management and with GAAP. For example, the method used by a specialist for estimating the fair value of real estate or a complex derivative may not be consistent with the measurement principles specified in GAAP. Accordingly, the auditor considers such matters, often through discussions with the specialist or by reading the report of the specialist.

.22

Section 336 provides that, while the reasonableness of assumptions and the appropriateness of the methods used and their application are the responsibility of the specialist, the auditor obtains an understanding of the assumptions and methods used. However, if the auditor believes the findings are unreasonable, he or she applies additional procedures as required in section 336.

Testing the Entity's Fair Value Measurements and Disclosures

.23

Based on the auditor’s assessment of the risk of material misstatement, the auditor should test the entity’s fair value measurements and disclosures. Because of the wide range of possible fair value measurements, from relatively simple to complex, and the varying levels of risk of material misstatement associated with the process for determining fair values, the auditor’s planned audit procedures can vary significantly in nature, timing, and extent. For example, substantive tests of the fair value measurements may involve (a) testing management’s significant assumptions, the valuation model, and the underlying data (see paragraphs .26 through .39), (b) developing independent fair value estimates for corroborative purposes (see paragraph .40), or (c) reviewing subsequent events and transactions (see paragraphs .41 and .42).

.24

Some fair value measurements are inherently more complex than others. This complexity arises either because of the nature of the item being measured at fair value or because of the valuation method used to determine fair value. For example, in the absence of quoted prices in an active market, an estimate of a security’s fair value may be based on valuation methods such as the discounted cash flow method or the transactions method. Complex fair value measurements normally are characterized by greater uncertainty regarding the reliability of the measurement process. This greater uncertainty may be a result of:

• The length of the forecast period
• The number of significant and complex assumptions associated with the process
• A higher degree of subjectivity associated with the assumptions and factors used in the process
• A higher degree of uncertainty associated with the future occurrence or outcome of events underlying the assumptions used
• Lack of objective data when highly subjective factors are used

.25

The auditor uses both the understanding of management’s process for determining fair value measurements and his or her assessment of the risk of material misstatement to determine the nature, timing, and extent of the audit procedures. The following are examples of considerations in the development of audit procedures:

• The fair value measurement (for example, a valuation by an independent appraiser) may be made at a date that does not coincide with the date at which the entity is required to measure and report that information in its financial statements. In such cases, the auditor obtains evidence that management has taken into account the effect of events, transactions, and changes in circumstances occurring between the date of the fair value measurement and the reporting date.
• Collateral often is assigned for certain types of investments in debt instruments that either are required to be measured at fair value or are evaluated for possible impairment. If the collateral is an important factor in measuring the fair value of the investment or evaluating its carrying amount, the auditor obtains sufficient appropriate audit evidence regarding the existence, value, rights, and access to or transferability of such collateral, including consideration of whether all appropriate liens have been filed, and considers whether appropriate disclosures about the collateral have been made.
• In some situations, additional procedures, such as the inspection of an asset by the auditor, may be necessary to obtain sufficient appropriate audit evidence about the appropriateness of a fair value measurement. For example, inspection of the asset may be necessary to obtain information about the current physical condition of the asset relevant to its fair value, or inspection of a security may reveal a restriction on its marketability that may affect its value.

Testing Management’s Significant Assumptions, the Valuation Model, and the Underlying Data

.26

The auditor’s understanding of the reliability of the process used by management to determine fair value is an important element in support of the resulting amounts and therefore affects the nature, timing, and extent of audit procedures. When testing the entity’s fair value measurements and disclosures, the auditor evaluates whether:

1. Management’s assumptions are reasonable and reflect, or are not inconsistent with, market information (see paragraph .06).
2. The fair value measurement was determined using an appropriate model, if applicable.
3. Management used relevant information that was reasonably available at the time.

.27

Estimation methods and assumptions, and the auditor’s consideration and comparison of fair value measurements determined in prior periods, if any, to results obtained in the current period, may provide evidence of the reliability of management’s processes. However, the auditor also considers whether variances from the prior-period fair value measurements result from changes in market or economic circumstances.

.28

Where applicable, the auditor should evaluate whether the significant assumptions used by management in measuring fair value, taken individually and as a whole, provide a reasonable basis for the fair value measurements and disclosures in the entity’s financial statements.

.29

Assumptions are integral components of more complex valuation methods, for example, valuation methods that employ a combination of estimates of expected future cash flows together with estimates of the values of assets or liabilities in the future, discounted to the present. Auditors pay particular attention to the significant assumptions underlying a valuation method and evaluate whether such assumptions are reasonable and reflect, or are not inconsistent with, market information (see paragraph .06).

.30

Specific assumptions will vary with the characteristics of the item being valued and the valuation approach used (for example, cost, market, or income). For example, where the discounted cash flows method (a method under the income approach) is used, there will be assumptions about the level of cash flows, the period of time used in the analysis, and the discount rate.

.31

Assumptions ordinarily are supported by differing types of evidence from internal and external sources that provide objective support for the assumptions used. The auditor evaluates the source and reliability of evidence supporting management’s assumptions, including consideration of the assumptions in light of historical and market information.

.32

Audit procedures dealing with management’s assumptions are performed in the context of the audit of the entity’s financial statements. The objective of the audit procedures is therefore not intended to obtain sufficient appropriate audit evidence to provide an opinion on the assumptions themselves. Rather, the auditor performs procedures to evaluate whether the assumptions provide a reasonable basis for measuring fair values in the context of an audit of the financial statements taken as a whole.

.33

Identifying those assumptions that appear to be significant to the fair value measurement requires the exercise of judgment by management. The auditor focuses attention on the significant assumptions that management has identified. Generally, significant assumptions cover matters that materially affect the fair value measurement and may include those that are:

1. Sensitive to variation or uncertainty in amount or nature. For example, assumptions about short-term interest rates may be less susceptible to significant variation compared to assumptions about long-term interest rates.
2. Susceptible to misapplication or bias.

.34

The auditor considers the sensitivity of the valuation to changes in significant assumptions, including market conditions that may affect the value. Where applicable, the auditor encourages management to use techniques such as sensitivity analysis to help identify particularly sensitive assumptions. If management has not identified particularly sensitive assumptions, the auditor considers whether to employ techniques to identify those assumptions.

.35

The evaluation of whether the assumptions provide a reasonable basis for the fair value measurements relates to the whole set of assumptions as well as to each assumption individually. Assumptions are frequently interdependent and therefore need to be internally consistent. A particular assumption that may appear reasonable when taken in isolation may not be reasonable when used in conjunction with other assumptions. The auditor considers whether management has identified the significant assumptions and factors influencing the measurement of fair value.

.36

To be reasonable, the assumptions on which the fair value measurements are based (for example, the discount rate used in calculating the present value of future cash flows), ^fn 5 individually and taken as a whole, need to be realistic and consistent with:

1. The general economic environment, the economic environment of the specific industry, and the entity’s economic circumstances;
2. Existing market information;
3. The plans of the entity, including what management expects will be the outcome of specific objectives and strategies;
4. Assumptions made in prior periods, if appropriate;
5. Past experience of, or previous conditions experienced by, the entity to the extent currently applicable;
6. Other matters relating to the financial statements, for example, assumptions used by management in accounting estimates for financial statement accounts other than those relating to fair value measurements and disclosures; and
7. The risk associated with cash flows, if applicable, including the potential variability in the amount and timing of the cash flows and the related effect on the discount rate.

Where assumptions are reflective of management’s intent and ability to carry out specific courses of action, the auditor considers whether they are consistent with the entity’s plans and past experience.

.37

If management relies on historical financial information in the development of assumptions, the auditor considers the extent to which such reliance is justified. However, historical information might not be representative of future conditions or events, for example, if management intends to engage in new activities or circumstances change.

.38

For items valued by the entity using a valuation model, the auditor does not function as an appraiser and is not expected to substitute his or her judgment for that of the entity’s management. Rather, the auditor reviews the model and evaluates whether the assumptions used are reasonable and the model is appropriate considering the entity’s circumstances. For example, it may be inappropriate to use discounted cash flows for valuing an equity investment in a start-up enterprise if there are no current revenues on which to base the forecast of future earnings or cash flows.

.39

The auditor should test the data used to develop the fair value measurements and disclosures and evaluate whether the fair value measurements have been properly determined from such data and management’s assumptions. Specifically, the auditor evaluates whether the data on which the fair value measurements are based, including the data used in the work of a specialist, is accurate, complete, and relevant; and whether fair value measurements have been properly determined using such data and management’s assumptions. The auditor’s tests also may include, for example, procedures such as verifying the source of the data, mathematical recomputation of inputs, and reviewing of information for internal consistency, including whether such information is consistent with management’s intent and ability to carry out specific courses of action discussed in paragraph .17.

Developing Independent Fair Value Estimates for Corroborative Purposes

.40

The auditor may make an independent estimate of fair value (for example, by using an auditor-developed model) to corroborate the entity’s fair value measurement. ^fn 6 When developing an independent estimate using management’s assumptions, the auditor evaluates those assumptions as discussed in paragraphs .28 to .37. Instead of using management’s assumptions, the auditor may develop his or her own assumptions to make a comparison with management’s fair value measurements. In that situation, the auditor nevertheless understands management’s assumptions. The auditor uses that understanding to ensure that his or her independent estimate takes into consideration all significant variables and to evaluate any significant difference from management’s estimate. The auditor also should test the data used to develop the fair value measurements and disclosures as discussed in paragraph .39.

Reviewing Subsequent Events and Transactions

.41

Events and transactions that occur after the balance-sheet date but before the date of the auditor's report (for example, a sale of an investment shortly after the balance-sheet date), may provide audit evidence regarding management’s fair value measurements as of the balance-sheet date. ^fn 7 In such circumstances, the audit procedures described in paragraphs .26 through .40 may be minimized or unnecessary because the subsequent event or transaction can be used to substantiate the fair value measurement.

.42

Some subsequent events or transactions may reflect changes in circumstances occurring after the balance-sheet date and thus do not constitute appropriate evidence of the fair value measurement at the balance-sheet date (for example, the prices of actively traded marketable securities that change after the balance-sheet date). When using a subsequent event or transaction to substantiate a fair value measurement, the auditor considers only those events or transactions that reflect circumstances existing at the balance-sheet date.

Disclosures About Fair Values

.43

The auditor should evaluate whether the disclosures about fair values made by the entity are in conformity with GAAP. ^fn 8 Disclosure of fair value information is an important aspect of financial statements. Often, fair value disclosure is required because of the relevance to users in the evaluation of an entity’s performance and financial position. In addition to the fair value information required under GAAP, some entities disclose voluntary additional fair value information in the notes to the financial statements.

.44

When auditing fair value measurements and related disclosures included in the notes to the financial statements, whether required by GAAP or disclosed voluntarily, the auditor ordinarily performs essentially the same types of audit procedures as those employed in auditing a fair value measurement recognized in the financial statements. The auditor obtains sufficient appropriate audit evidence that the valuation principles are appropriate under GAAP and are being consistently applied, and that the method of estimation and significant assumptions used are adequately disclosed in accordance with GAAP.

.45

The auditor evaluates whether the entity has made adequate disclosures about fair value information. If an item contains a high degree of measurement uncertainty, the auditor assesses whether the disclosures are sufficient to inform users of such uncertainty. ^fn 9

.46

When disclosure of fair value information under GAAP is omitted because it is not practicable to determine fair value with sufficient reliability, the auditor evaluates the adequacy of disclosures required in these circumstances. If the entity has not appropriately disclosed fair value information required by GAAP, the auditor evaluates whether the financial statements are materially misstated.

Evaluating the Results of Audit Procedures

.47

The auditor should evaluate the sufficiency and competence of the audit evidence obtained from auditing fair value measurements and disclosures as well as the consistency of that evidence with other audit evidence obtained and evaluated during the audit. The auditor’s evaluation of whether the fair value measurements and disclosures in the financial statements are in conformity with GAAP is performed in the context of the financial statements taken as a whole (see paragraphs 12 through 18 and 24 through 27 of Auditing Standard No. 14, Evaluating Audit Results).

Management Representations

.48

Section 333, Management Representations, requires that the independent auditor obtain written representations from management as a part of an audit of financial statements performed in accordance with generally accepted auditing standards and provides guidance concerning the representations to be obtained. The auditor ordinarily should obtain written representations from management regarding the reasonableness of significant assumptions, including whether they appropriately reflect management’s intent and ability to carry out specific courses of action on behalf of the entity where relevant to the use of fair value measurements or disclosures.

.49

Depending on the nature, materiality, and complexity of fair values, management representations about fair value measurements and disclosures contained in the financial statements also may include representations about:

• The appropriateness of the measurement methods, including related assumptions, used by management in determining fair value and the consistency in application of the methods.
• The completeness and adequacy of disclosures related to fair values.
• Whether subsequent events require adjustment to the fair value measurements and disclosures included in the financial statements.

Communication With Audit Committees

.50

Paragraphs 12-13 of Auditing Standard No. 16, Communications with Audit Committees, require the auditor to communicate to the audit committee matters related to critical accounting estimates, which may include fair value measurements.

Effective Date

.51

This section is effective for audits of financial statements for periods beginning on or after June 15, 2003. Earlier application of the provisions of this section is permitted.