In this video, we walk through 5 AUD practice questions teaching about measurement and disclosure of the fair value of investments. These questions are from AUD content area 3 on the AICPA CPA exam blueprints: Performing Further Procedures and Obtaining Evidence
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Measurement and Disclosure of the Fair Value of Investments
When performing an audit of financial statements, auditors are expected to evaluate management’s measurement and disclosure of investment securities reported at fair value. Fair value estimation introduces complexity due to its reliance on judgment, market data, classification, and supporting internal controls. This overview outlines the key considerations auditors must address, supported by practical examples.
Evaluation of Management’s Valuation Techniques and Assumptions
Auditors must obtain an understanding of how management determines fair value, including the models used and the reasonableness of inputs and assumptions. The auditor’s responsibility is to evaluate whether these estimates are consistent with GAAP and supported by sufficient appropriate evidence.
For example, if a company uses a discounted cash flow model to value a privately held bond, the auditor should evaluate whether the projected cash flows and discount rate reflect observable market data or require further corroboration.
Assessment of Internal Controls over Valuation
Internal controls play a significant role in the reliability of fair value measurements. One key consideration is whether the entity maintains proper segregation of duties. Specifically, individuals responsible for authorizing investment transactions should not also perform or oversee the valuation of those investments.
For instance, if the same employee both initiates and values securities purchases, the risk of biased or inaccurate valuations increases. Auditors must assess these controls and adjust the nature, timing, and extent of audit procedures accordingly.
Evaluation of Audit Evidence and Source Reliability
The reliability of fair value estimates depends significantly on the source of the evidence. Observable inputs, such as quoted prices in active markets (Level 1 inputs), provide the most reliable evidence. In contrast, unobservable inputs (Level 3), including internally developed estimates or broker quotes, require more auditor scrutiny.
For example, a quoted market price for publicly traded stock is considered high-quality evidence. However, if management relies on a broker quote—particularly from the broker that originally sold the investment—the auditor must consider the potential for bias and whether additional corroborating evidence is necessary.
Review of Investment Classification and Financial Statement Impact
Investment classification determines the measurement method (fair value vs. amortized cost) and affects how unrealized gains and losses are reported. Auditors must verify that classifications are consistent with management’s stated intent and ability, and that disclosures clearly reflect the valuation approach.
For example, trading securities are measured at fair value with gains and losses reported in earnings. Available-for-sale (AFS) securities are also measured at fair value, but unrealized gains and losses are recognized in other comprehensive income. Held-to-maturity (HTM) securities are recorded at amortized cost. Misclassification can result in misstatements in both the balance sheet and income statement.
Confirmation of Existence and Rights Before Valuation Assessment
Before assessing the valuation of investment securities, auditors must first confirm their existence and the entity’s ownership rights. Independent confirmations from custodians or brokers provide strong evidence for both the existence and rights and obligations assertions.
For example, if a broker confirms that municipal bonds are held in the client’s name as of year-end, this supports the assertion that the investment exists and is owned by the client. Without such evidence, the validity of any fair value estimate is undermined.
Conclusion
Auditing the fair value of investment securities requires more than simply verifying market prices. It involves assessing management’s valuation process, evaluating internal controls, determining the reliability of audit evidence, confirming proper classification, and validating existence and ownership. Auditors must ensure that all measurements and disclosures are supported by sufficient appropriate evidence and are consistent with applicable accounting standards.
