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Risks associated with using fair value estimates in accounting while conducting the audit engagement in accordance with IFRS 13 and ISA 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures

04-Feb-2024

In the early stages of accounting, it originated from customary rules with the primary goal of presenting financial statements to users without complicating accounting operations. This approach was widely accepted by professional accountants and became a settled practice. Due to the evolving nature of accounting thinking over successive periods and the quest for effective methods of measurement to accurately depict the economic realities of entities in monetary terms, various measurement approaches have emerged. In this exploration, accounting thinking identified the historical cost approach as one of the pivotal inputs in the processes of measurement, recognition, and disclosure.

In the 1960s, the concept of fair value emerged as a response to the debate surrounding the accounting treatment of inflation. It evolved to address the question of how changes in prices should be incorporated into accounting practices. The criticism of the historical cost approach, particularly its inability to provide relevant and objective information reflecting the true position of entities, especially amid significant price fluctuations, played a significant role in leading accountants and accounting bodies to adopt other approaches.

It is worth noting that, to date, there is no unanimous agreement from a theoretical standpoint among professional accountants, professional bodies, and researchers regarding the concept or definition of fair value, or a standardized method to estimate it. This lack of consensus is attributed to the numerous factors influencing the fair value of financial instruments, especially when employing valuation techniques in the absence of an active market. Furthermore, these factors have implications for the characteristics of the required accounting information in decision-making or economic decisions.

As a concept, the International Accounting Standards Board (IASB) defines fair value (IFRS, SOCPA  translation, 2023) as:-

It is a measurement that involves assessing values according to prevailing market conditions rather than entity-specific considerations. Some assets and liabilities have observable market transactions and readily available market information, while others may lack such observable transactions and market data. However, the objective of fair value measurement remains consistent in both scenarios. It seeks to determine an estimate of the price at which a transaction, such as normal business transactions, could be conducted under normal circumstances for selling an asset or transferring a liability between market participants on the measurement date. This assessment is made with regard to current market conditions, repreenting the exit price on the measurement date from the perspective of a market participant holding the asset or assuming the liability.

The preceding definition underscores that fair value represents the consideration at which an asset could be exchanged or a liability settled in an arm's length transaction between willing parties operating on a business basis under balanced or normal conditions, or between two independent parties.

The earlier definition also specified that fair value is the amount for which an asset could be acquired or liability undertaken or settled in a business transaction between willing parties, excluding forced selling or liquidation scenarios.

In summary, fair value is predicated on the following elements:

• 1-The presence of an active market wherein harmonious elements are traded, and prices are publicly disclosed for all participants (observable market, transactions, and information);
• 2-Unrelated and informed parties;
• 3-Normal conditions;
• 4-Estimation of the appropriate monetary value using various methods, depending on the market's activity, whether it is active or inactive;
• 5-When there is no active market, fair value is determined by relying on the best information accessible under the given conditions. This involves employing evaluation techniques, including technical approaches, and incorporating the latest market transactions conducted on a commercial basis between willing and informed parties.
  
  

IFRS 13, fair value measurement, outlines appropriate valuation techniques that entities must adhere to, taking into account the prevailing circumstances and the availability of sufficient data for fair value measurement. The guidance emphasizes optimizing the use of observable inputs when they are available, and the reliance on unobservable inputs is minimized, particularly in favorable conditions where robust data is accessible.

The valuation techniques of fair value shall be consistently applied. Nevertheless, altering the valuation technique or its application might be warranted if it leads to an equivalent or improved measurement of the fair value under the given circumstances. This may be applicable, for instance, in the following scenarios:-

• 1-Emergence of new markets;
• 2-Availability of new information;
• 3-Information that was previously utilized but not available now;
• 4-Improvement in the valuation techniques;
• 5-Changes in the market conditions.

In such instances, auditors need to be cognizant of the accounting implications stemming from the alterations in the valuation technique or its application. This adjustment should be treated as a change in the accounting estimate in accordance with IAS 8. However, it's important to note that disclosures specified in IAS 8 regarding changes in accounting estimates may not apply to changes resulting from modifications in the valuation technique or its application.

IFRS 13 aims to improve the consistency and comparability of fair value measurement as well as the associated disclosures by establishing a hierarchy for fair value. The hierarchy classifies the inputs utilized in valuation techniques into three levels. It assigns the highest priority to quoted prices (unadjusted) in active markets for identical assets and liabilities, while allocating the lowest priority to unobservable inputs.

An active market refers to a market where transactions involving assets and liabilities occur regularly and with a significant volume of activity. This level of activity ensures a continual flow of information, offering insights into the ongoing prices.

These levels include the following:

• 1-The first level of inputs: The first level of fair value inputs comprises quoted prices in active markets for identical assets and liabilities, provided that the entity has access to that market on the measurement date.

  The quoted price in an active market serves as a benchmark, providing more reliable evidence for fair value measurement. In such cases, the price is utilized to measure fair value without requiring adjustments, with only a few exceptions.
  2-The second level of inputs: The inputs at the second level differ from those at the first level and can be observed concerning the asset or liability, either directly or indirectly.
  3-The third level of inputs: The third level of inputs involves measuring fair value based on unobservable inputs. In this case, the entity utilizes the information at its disposal and, considering the nature of the asset or liability in question, develops a value that it deems to be fair.

Fair Value Measurement: 

The objective of fair value measurement is to estimate the prices that would be applicable for selling an asset or transferring a liability between market participants as of the fair value measurement date, considering the prevailing market conditions.

Below are some guidelines included in IFRS 13 for measuring fair value:

• 1-The entity is required to take into account the attributes of the assets or liabilities it aims to evaluate for fair value. This involves considering the factors that market participants would contemplate in the pricing of assets or liabilities on the measurement date. Such considerations may include the condition and location of the asset or liability, along with any other factors pertinent to the disposal or utilization of the asset;  
• 2-During the fair value measurement process, the assumption is that the valuation is carried out in a routine and customary manner, reflecting the natural market conditions prevailing on the valuation date;
• 3- The fair value measurement process assumes that the assessment is conducted through the principal market of the asset or an analogous market;
• 4-When measuring the present value of non-financial assets, careful consideration should be given to both the maximum and best use of the asset; 
• 5-Equity methods are taken into account when determining the present value of both financial and non-financial assets; the transfer of a financial instrument occurs between participants on the measurement date without settlement or any delay in the settlement process. 

Fair Value Measurement Techniques: 

• 1-Market approach: Relies on market prices and other relevant information from active markets for identical or similar assets or liabilities.
• 2-Cost approach: The cost associated with acquiring the service provided by the asset, often referred to as the current replacement cost;
• 3-Income approach: Relies on discounting the future cash flows and anticipated expenses associated with the asset. This includes:

• Present value method;
• Options pricing method;
• Annual Profits Surplus Method.

IFRS 13 requires making the following disclosures:

• 1-Assets and liabilities that are frequently measured at fair value;
• 2-Disclosures about the impact of measuring based on unobservable inputs (level 3)
• 3-And their effect on gains and losses.

Concerning the responsibilities of professional auditors in auditing estimates: as defined by ISA 540, accounting estimates, refer to monetary amounts whose measurement is susceptible to uncertainty.

Various forms of accounting estimates exist, encompassing, but not restricted to, the following:-

1. Accounting estimates related to assets, such as:

1. Accounting estimates made to account for an actual decrease, such as impairment provisions
2. Accounting estimates made to account for certain reductions, such as the provisions for bad debts.
3. Accounting estimates made to account for potential decreases, as seen in provisions for expected credit losses.
   1. 
       Accounting estimates linked to both existing and potential liabilities, including:

1. Accounting estimates formulated to accommodate existing liabilities, exemplified by provisions for contingent taxes;
2. Accounting estimates designed to address potential liabilities, such as the provisions for legal proceedings.

In light of the foregoing, accounting estimates represent an amount deducted from current period revenues to provision for anticipated expenses or obligations related to potential losses. Examples of such estimates include:
Actual impairment in the value of assets (impairment provision);
Actual unspecified losses (bad debts provisions);
Actual or potential expenses (provision for end-of-service compensation);
uncertain and potential burdens (price decrease provision);

ISA 540 establishes standards and offers guidance for auditing accounting estimates presented in financial statements.

Auditors are required to obtain sufficient and suitable evidence about accounting estimates. Management holds the responsibility for formulating accounting estimates within the financial statements, a task often carried out amidst uncertainties regarding the outcomes of events, demanding diligent efforts. Therefore, the likelihood of material misstatements is elevated when dealing with accounting estimates.

Moreover, intricate accounting estimates, particularly in this context, demand a heightened level of expertise and specialized efforts in the market to accurately calculate fair value. Uncertainty or the absence of objective information may render it challenging to arrive at reasonable estimates. Consequently, auditors must employ appropriate audit procedures to gather adequate and relevant evidence, ensuring that the accounting estimate aligns with the circumstances and that items in the financial statements are appropriately adjusted according to accounting principles.

The steps that auditors take to scrutinize the procedures established by the management encompass, for instance:

I: The auditor, in evaluating the information and assumptions relied upon by the management to prepare the information, performs the following:

• 1-Verifies the accuracy and completeness of the information, assessing its appropriateness for formulating the estimates;
• 2- Gathers corroborative evidence from external sources, such as obtaining industry data, particularly when the estimate for impaired or slow-moving inventory relies on expected sales;
• 3-Verifies the accuracy of the information analysis, ensuring, for instance, that the analysis of debt maturities is conducted accurately.
• 4-Verifies the foundation upon which the management relies, which may include government and industry statistics, interest rates, employment figures, inflation rates, and other relevant factors.
• 5-Verifies the alignment between the assumptions utilized and those applied to other pertinent estimates;
• 6-Pays special attention to assumptions pertinent to accounting estimates that are sensitive to changes;
• 7-Leverages external experts, if deemed necessary;
• 8-Ensures the ongoing appropriateness of accounting estimates for both the current and future financial periods.

II:  Verifies that the calculation process adheres to the specified assumptions.

III: Verifies the precision of estimates from prior periods against the actual outcomes; this provides evidence regarding the accuracy of the management's overall estimates. It also aids in identifying whether adjustments are needed for prior assumptions and estimates.

IV: Verifies the procedures established by the management to monitor the preparation of estimates.

References:
1-The International Financial Reporting Standards (IFRS) - translated by SOCPA
2-The International Auditing and Assurance Standards  - translated by SOCPA
3-The International Valuation Standards - Saudi Authority for Accredited Valuers, 2022
4-An Eye on Solutions to Financial Reporting Standards Questions - Dr. Hossam El Din et al., 2022. Daralkhalij for Publishing and Distribution.