Essay on "Auditing Fair Value the Explanatory"

Essay 11 pages (3048 words) Sources: 0

[EXCERPT] . . . .

As discussed in the audit planning meeting, analysts expect Roman Holiday's growth to slow; its revenue growth in recent years came from acquisitions of franchise rights and existing restaurants, not from real growth in the franchise. These recent, significant economic developments are such that they require specific attention.

Another factor to consider in assessing risk is the complexity of the transaction, which criteria apply to Roman Holiday's reacquisition transactions. Some additional criteria for consideration include whether the risk involves significant transactions with related parties; understanding the degree of subjectivity in the measurement of financial information related to the risk, especially those measurements involving a wide range of measurement uncertainty; and whether the risk involves significant transactions that are outside the normal course of business for the entity, or that otherwise appear to be unusual. All these conditions are present in Roman Holiday's franchise reacquisitions.

With respect to the reacquired franchise rights valuation of $127 million, this is a significant risk given that it is more than twenty five percent of Roman Holiday's total assets. As to likelihood of misstatement, the risk is at least moderate, if not higher. The auditor should assign this level of risk because of the pressure Roman Holiday is under to meet earnings forecasts. Management is aware of the issues surrounding so much of their growth having come from acquisition of franchise rights and existing restaurants; knowing that analysts will be closely scrutinizing their balance sheet creates pressure, which is another one of the three elements of the fraud triangle.

As for impairment testing, there are similar risks of misstatement for the same reasons; that is, two of the three elements that must be present for fraud to occur are indeed present. The amount of fair value in excess of book value is less significant, only $1.5 million, but the cash flow projections cover a period of fourteen years, so the impact of misstatement of income is potentially significant. The same fraud triangle element is present, pressure, and the risk must be assessed as high.

The Roman Holiday auditor has to consider an overall materiality level, and a materiality level that should be used for the audit of reacquired franchise rights. One factor in determining materiality issues is the degree of audit risk. Audit risk is defined as "the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated." Given the issue of Roman Holiday's valuation approach for reacquired franchise rights, there is some degree of audit risk involved.

Audit risk and materiality need to be considered together in designing the nature, timing, and extent of audit procedures and in evaluating the results of those procedures. For these reasons the audit senior is completing certain of the year-end procedures in the audit of Roman Holiday's intangible assets, in particular the reacquired franchise rights.

When establishing the overall audit strategy for Roman Holiday, the auditor should determine a materiality level for the financial statements as a whole for purposes of determining the nature, timing, and extent of risk assessment procedures; identifying and assessing the risks of material misstatement; and determining the nature, timing and extent of further audit procedures.

Materiality is still a matter of professional judgment and is influenced by the auditor's perception of the needs of users of financial statements. Judgments about matters that are material to users of the financial statements are based on a consideration of the common financial information needs of users a group. All users of information contained in Roman Holiday's financial statements benefit from the auditor's exacting determination of materiality.

Based on Roman Holiday's financial statements, the overall materiality level is high because of the risk of material misstatements affecting both income and asset valuation for Holiday Roman. As discussed previously, the financial statements indicate a high degree of audit risk. Because the risks of material misstatement are fairly significant with respect to the reacquired franchise rights, and the needs of users advocate for it as well, the materiality level is high as well.

Substantive tests are the procedures by which auditors gather evidential matter to form the basis of an opinion on the fairness of the financial statements. Because substantive tests should be related to the assessed level of control risk, Roman Holiday will require increased testing Performing substantive testing for intangible assets typically involves examining legal documents to support the intangible assets.

Roman Holiday substantive testing will vary because reacquired franchise rights are indefinite-lived; in any case the inherent risk is high and substantive analytical procedures are not likely to provide sufficient, appropriate evidence for significant transactions involving intangible assets. The future revenue producing capacity of the reacquired franchise rights will require a higher level of scrutiny.

Four assertions are normally considered for test of details of intangible assets: Existence and completeness, valuation, rights and obligations, and classification.

In addition, the nature, timing, and extent of resources require consideration of the following issues to allocate professional staff by rank and expertise. There is a requirement for professional staff to be deployed for specific audit areas, such as the use of appropriately experienced team members for high-risk areas, or involvement of experts. Setting of audit time budgets for the individual components of the audits must be considered, as must the timing of work to be performed, such as year-end procedures. The assignment of work to audit team members with sufficient competence to perform such work is critical. Such expertise may be available internally, or if not, reliance on external experts may be necessary for the level of complexity of specific tasks. The perceived capabilities of team members would also influence the extent of direction and supervision of audit work required. Management, direction, and supervision of resources, including team meetings, partner and manager reviews, and whether an engagement quality review is required are all factors that are influenced by the assessment of risk associated with the audit of reacquired franchise rights.

Audit procedures are designed based on the assessment of management's process for determining fair value measures and on the risk of material misstatement; these are all significant concerns in the Roman Holiday audit. There are several examples of the types of auditing procedures necessary in order to evaluate management's assertions in estimating the fair value of the reacquired franchise rights. 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 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.

After reviewing both SFAS 142 and SFAS 144 to determine which standard is applicable to Roman Holiday's circumstances, the auditor must conclude that 142 applies. Roman Holiday did not follow the methodologies suggested in SAS 142 for fair value measurement of an indefinite-lived intangible asset. SAS 142 states that in estimating the fair value of a reporting unit, a valuation technique based on multiples of earnings or revenue or a similar performance measure may be used if that technique is consistent with the objective of measuring fair value.

Because Roman Holiday's treatment deviates from the suggested guidelines, I would issue a qualified opinion with an explanatory paragraph.

With respect to valuation specialists, they could play a role in determining fair value measurements and disclosures for Roman Holiday's franchise reacquisitions. SAS 101 provides guidance for fair value estimates. They differ from other accounting estimates in that fair value must be used when marketing prices are not available, and management must estimate fair value using an "appropriate" approach and assumptions that reflect those that individuals in the marketplace would make. SAS provides guidance on understanding management's process for developing fair value estimates, and evaluating whether the measurement conforms to GAAP. The auditor evaluates significant assumptions and considers the appropriateness of the valuation model, and tests the underlying data. The auditor does this even when management uses a valuation specialist… READ MORE

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