Valuation of Financial Instruments from the perspective of valuation specialists

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By Marie Gardner CA, Head of Research at ICAS

10 January 2020

Marie Gardner CA, looks at a research report prepared for ICAS, the IAASB and the IAAER which considers the environmental and situational factors that influence the judgements and decisions of valuation specialists in a reporting and audit context.

The valuation of financial instruments has been an area of focus immediately after, and since, the 2007-8 financial crisis, particularly in the context of level 3 valuations¹. Specifically, there seems to have been a lack of confidence in level 3 valuations which undermined confidence generally in financial reporting, especially in the financial services industry.

Although the International Accounting Standards Board (IASB) concluded that IFRS 13 Fair Value Measurement is working² as intended , the International Valuation Standards Council (IVSC) formed the Financial Instruments Board (the ‘FI Board’) in December 2018. The FI Board set out to ‘significantly modify and enhance the existing Financial Instrument standard IVS 500’, and to ‘complete an Agenda Consultation designed to set direction for the FI Board and to obtain feedback from stakeholders on how to modify and enhance the existing IVS 500’.

This research report positions itself against this background. ICAS joined forces back in 2016 with the International Association of Accounting Education and Research (IAAER) and the International Audit and Assurance Standard Board (IAASB), to commission qualitative research on the valuation of financial instruments. Previous research had been done from the perspective of auditors, but this research focuses on the perspective of the valuation specialist.

Through a survey completed by 62 specialists across North America, Europe and Asia Pacific, followed by 21 semi-structured interviews to gain deeper insights into the issues identified, this study examines the process that specialists use when preparing fair value measurements (FVMs) for management, and evaluating the reasonableness of management’s FVMs for auditors. It examines the factors that influence the specialist’s analyses, whether the purpose of the specialist’s task (preparation of FVM for management or evaluation of FVM for auditors) influences the process they use, and the auditability of FVMs.

Key results

Results from participants feedback suggest no distinct differences across geographical regions. They are analysed along the following identified four phases in the production of FVMs, encompassing both the specialists’ preparation and evaluation roles.  It is important to stress that these findings are taken from the perspective of specialists, and represent their views. Findings include the following:

Project acquisition and Planning

• Specialists face tight deadlines and fee pressures from both types of clients (auditors and management), who are perceived to focus more on the cost rather than the quality of the valuation service;
• These pressures have negative implications for audit and financial reporting quality as they have been suggested to reduce judgement performance.

Scoping, Valuation approach and Methodology

• Project budget, management’s valuation knowledge, availability of model and market data, and auditor preference all influence the specialist decision making process;
• For evaluation engagements (performed for auditors), whether to develop an independent measurement or to evaluate management ‘s process is highly dependent on the availability of information on how the estimate was prepared and the technical competence of the preparing specialist;
• Auditors have significant influence over the scoping and decisions when specialists prepare and evaluate FVMs as they seek auditor acceptance of the valuation approach and final measurement, and prefer to minimize tensions with auditors;
• While FVMs comply with applicable accounting standards, they are not an approximation of the market value of the underlying financial instrument, and are therefore perceived as an ‘artificial ‘concept. A value range would often be deemed more appropriate.

Estimate preparation and Relationship management

• Valuation is a judgement-intensive process which could result in significantly different estimates for the same underlying financial instrument from two different specialists;
• Specialists often encounter clients who do not understand the complexity of the financial instruments they hold or of the valuation task;
• Increased regulatory oversight can lead to an excessive emphasis on documentation and development of an audit trail, sometimes to the detriment of a high quality FVM.

Negotiations and Final estimates

• Specialists rarely share their valuation models with clients due to their proprietary nature;
• Measurement disagreements are often negotiated directly with clients but specialists in an evaluation role feel frustrated when audit teams advocate for clients’ positions.

Policy recommendations

A number of implications are flagged in the report for regulators and other stakeholders which include the following:

• Given the potential for specialists to anchor on clients’ value when re-performing management’s process, auditors and regulators should consider the relative advantages and disadvantages of adopting the independent estimate approach as best practice when evaluating clients’ FVMs;
• Standard-setters should consider strengthening auditor awareness of the effects of budget and timeline pressures, and scope constraints, and encourage a more collaborative team-based approach between auditors and specialists;
• Regulators should consider incorporating an evaluation of management’s competence related to FVMs as a component of the auditors’ risk assessment process.
• Standard-setters should consider enhancing corporate governance by promoting understanding of the subjectivity inherent in FVMs among the board and audit committees.

Further recommendations inferred from the above could be suggested such as not only management competence but also an evaluation of specialists’ competence to be included as a component of the auditors’ risk assessment, and for the promotion of understanding of FVM subjectivity to account users and other stakeholders.

Rebuilding confidence in the valuation of financial instruments is therefore a clear goal to underpin the reliability of financial statements, and ICAS hopes this new research will be useful in highlighting some behavioural aspects relating to financial instrument valuation.

ICAS would like to thank the researchers, Dereck Barr-Pulliam (then of University of Wisconsin-Madison, now of University of Louisville), Jennifer R. Joe (University of Delaware), Stephani A. Mason (DePaul University), and Kerri-Ann Sanderson (Bentley University) for their work in completing this project.

We are also grateful for the financial support of the Scottish Accountancy Trust for Education and Research (SATER), now known as the ICAS Foundation (charity registered in Scotland SCO34836), without which this research would not have been possible.

View the full report here

^{[1] Level 3 valuations use inputs which are unobservable for the asset or liability.  They are used to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. [IFRS 13:86-87]}

^{[2] https://www.ifrs.org/projects/2018/pir-of-ifrs-13-fair-value-measurement/}