By Leighton McKnight, Contributor
The following is part II of a paper on International Standards on Auditing (ISA) and the audit of fair value measurements and disclosures (ISA 545). Part 1 dealt with the general outline and application of ISA together with details on the various standards. This article focuses primarily on the auditing of fair value measurements and related disclosures.
THE CONCEPT of fair value is one of the most topical issues in the accounting profession and relates to financial reporting frameworks. Fair value can be defined as, "the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction."
Here in Jamaica, this issue is very critical in the preparation of financial statements under International Accounting Standards (IAS) and even under Jamaican Generally Accepted Accounting Principles (GAAP). Jamaican GAAP, under JSSAP 3.29, requires disclosure on the fair values of financial instruments carried on a balance sheet, while IAS requires assets and liabilities to be carried at fair value in specified circumstances and mandate greater disclosure. The auditing of fair value measurements and disclosures is becoming increasingly important for local practitioners and also for persons preparing financial statements. Auditors are expected to carry out their work with due care, which is a prerequisite in making well-informed decisions (including those relating to fair values) in the execution of audits. In this regard, ISA provides guidance for carrying out high quality audits. The auditing of fair values poses significant challenges for auditors, as it is very important that auditors obtain sufficient audit evidence that fair value measurements and disclosures are in accordance with the relevant entity's financial reporting framework. ISA 545, 'Auditing Fair Value Measurements and Disclosures' developed by IFAC, seeks to address the increasing number of complex accounting pronouncements contained in the measurement and disclosure provisions based on fair value.
A full understanding of this ISA by all local practitioners is very important as it addresses audit considerations relating to the valuation, measurement, presentation and disclosure for material assets, liabilities, and specific components of equity presented or disclosed at fair value in financial statements. Specifically, this ISA provides information on the following:
- Understanding the entity's process for determining fair value measurements
and disclosures and relevant control procedures;
- Assessing the appropriateness of fair value measurements and disclosures;
- Using the work of an expert;
- Testing the entity's fair value measurements and disclosures;
- Evaluating the results of audit procedures;
- Management's process for determining fair value and management representations;
and
- Communication with those charged with governance.
The purpose of ISA 545 is to establish standards and provide guidance on auditing fair value measurements and disclosures contained in financial statements. While this ISA provides guidance on auditing fair value measurements and disclosures, it does not address specific types of assets or liabilities, transactions, or industry-specific practices. These specifics are to be addressed by the auditor's professional judgement along with guidance from this and other ISA. In addition, when examining an entity's financial statements, the auditor must have a full understanding of the financial reporting framework under which the statements are prepared. As the requirements for fair value accounting varies from one financial reporting framework to another, ISA 545 is not written for any specific framework. In accordance with ISA 500, the auditor must obtain appropriate evidence to support his conclusions on fair value measurements and disclosures. Other relevant ISA such as ISA 540 Audit of Accounting Estimates must be applied in this process.
UNDERSTANDING THE PROCESS FOR DETERMINING FAIR VALUE
This section of the standard points out that the auditor should obtain an understanding of the entity's process for determining fair value measurements and disclosures and the relevant control procedures necessary to develop an effective audit. The standard emphasises the fact that management is responsible for the preparation of the financial statements, including establishing an accounting and financial reporting process for determining reliable fair value measurements. It also provides guidance on issues that the auditor should consider in assessing the reliability of the system used to provide fair values, noting that some systems may be simple while others may be very complex.
EVALUATING FAIR VALUE
The auditor should evaluate whether the fair value measurements and disclosures in the financial statements are in accordance with the entity's financial reporting framework.
This section of the standard stipulates that the auditor should have a clear understanding of the requirements of the relevant financial reporting framework and knowledge of the business and industry to assess whether the accounting and disclosures relating to fair values are appropriate. In the case of Jamaica, full knowledge of Jamaican SSAP 3.29 is required and for financial periods commencing on or after July 1, 2002, the same applies to IAS.
The auditor should obtain evidence about management's intent to carry out specific courses of action, and consider its ability to do so, where relevant to the fair value measurements and disclosures under the entity's financial reporting framework.
In providing guidance in this section, suggestions are given as to how the auditor should obtain evidence about management's intent to carry out specific courses of action, and to consider its ability to do so, where relevant to the fair value measurements and disclosures. For example, under IAS 39, the matter of whether a financial instrument can be classified under "held to maturity" and not "fair valued" can be quite problematic and the standard provide good guidance on auditing in these circumstances. Issues recommended for the auditor include:
- 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,
such as budgets and minutes.
- 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.
- Consider management's ability to pursue a specific course of action if
ability is relevant to the use, or exemption from the use, of fair value measurement
under the entity's financial reporting framework.
It should be noted that regulatory bodies such as the Financial Services Commission (FSC) and the Bank of Jamaica (BoJ) have fully endorsed the adoption of International Standards on Auditing (ISA) and that the ICAJ's Audit Practice Committee has been holding discussions with the FSC in formulating specific auditing report formats for those sectors falling within the purview of that organisation. Additionally, as a result of the change over to ISA, the scope paragraph of audit reports should no longer refer to Jamaican Standards on Auditing but to International Standards on Auditing in accordance with ISA 700. Revised audit report formats have been devised and have been posted on the Web site for the benefit of the general membership. It should also be noted that since January 1, 2003, all ISA and related guidance on auditing have been available via the IFAC Web site and can be downloaded free of cost.
Leighton McKnight is the chairman of ICAJ's Audit Practice Committee
