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Regulators Push for More Transparency on Independent Valuation Services

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By: Tammy Whitehouse | March 18, 2014

Companies may eventually find some relief for the disconnect between valuation and audit that has become a source of tension in the financial reporting supply chain.

A fragmented valuation industry is starting to take notice of regulatory displeasure with how a lack of standards and inconsistent approach by some valuation firms is feeding into financial reporting and is taking early steps to address it.

“The valuation profession certainly has heard the concerns,” says Mark Hanson, a shareholder with regional accounting firm Schenck and a member of the executive advisory board for the National Association of Certified Valuators and Analysts. NACVA is one of several professional organizations in the United States that writes standards and provides credentials to valuation specialists. “You have working groups out there developing white papers and best practices. Everyone is trying to come up with a solution.”

The valuation industry was never geared toward addressing the growing demand for fair value in financial reporting, says Anthony Aaron, a principal with EY and a trustee for the Appraisal Foundation. Independent valuation services traditionally were used for purposes such as taxes, litigation, bankruptcy, or mergers and acquisitions, and valuation methods have been focused on particular types of assets, such as real estate, intangibles, fixed assets, and others. Each of the various professional groups writes its own standards, none of which are compulsory, except for those followed by licensed real estate appraisers.

Less focus had been placed, traditionally, on valuing financial instruments, even as accounting standards and regulators in recent years have demanded more rigor on valuing various types of increasingly complex instruments. “Today you have a bunch of different professional organizations and professional firms that provide accounting, valuation, and other services, and you have a regulator that says the environment is too fragmented,” says Aaron.

Indeed, the Securities and Exchange Commission recently has raised its voice on the issue, asking the varied organizations to jointly come up with a way to better meet the needs of the financial reporting community. SEC Chief Accountant Paul Beswick reminded the valuation profession in December that its work is increasingly relied upon even by banking regulators that are concerned about valuations that factor into regulatory capital requirements. While he senses a general willingness within the profession to raise the bar, “it is too early to declare victory,” he said. “The next step is still needed to make firm commitments to assess the valuation profession.”

Companies trying to prepare financial reports that include a hefty amount of fair-value accounting have been caught in a growing divide between valuation professionals and auditors. Valuation professionals use different methods, follow different standards, and seek to protect their processes and evidence as proprietary. “There are so many different things that govern how a valuation has to be done,” says Rick Martin, vice president at Pluris Valuation Advisors. “But it doesn't really tell you how to fair value something in terms of a detailed methodology. So each firm is free to develop its own approach to valuation within certain constraints.”

Auditors, under the watchful eye of the Public Company Accounting Oversight Board and the SEC, are demanding more transparency in the valuation process so they can give it greater credence.

“One of the major issues we see—and it's improving but it has a ways to go—is transparency. Some valuation specialists view their work as a black box, and the only thing they show is their output.”

—John Keyser,National Director of Assurance,McGladrey 

“One of the major issues we see—and it's improving but it has a ways to go—is transparency,” says John Keyser, national director of assurance for audit firm McGladrey. “Some valuation specialists view their work as a black box, and the only thing they show is their output.” The PCAOB and SEC have made clear in recent years they expect both auditors and management to demonstrate a deeper understanding of the inputs to a valuation, not just blind faith in a valuation report.

John Glynn, a partner and valuation services leader for PwC, says the valuation profession has made progress in recent months answering the SEC's call for action. In addition to early collaboration on the part of U.S. groups, the International Accounting Standards Board and the International Valuation Standards Council have formed an agreement to cooperate on fair-value standards. He's hopeful the collective efforts will lead to comprehensive technical standards as well as professional standards governing valuation. “Without comprehensive standards governing the valuation profession at the front end, the auditor has to deal with difficult issues at the back end,” he says. “That's the difficult dynamic right now.” Glynn notes Beswick's first call for action came two years earlier than his latest remarks on the matter. “At what point does the regulator say more?” he asks.

VALUATION Q&A

Below PwC provides some answers to frequently asked questions regarding valuations.

Q: Valuations are performed for a variety of purposes, not just to meet financial reporting requirements. Should the same global standard setter issue valuation standards for these other purposes as well? 

A: Perhaps. Given the nuances specific to each type of valuation performed, the purpose of standards that are issued needs to be well-defined. We do not believe that one set of valuation standards can satisfy all purposes (e.g., financial reporting, compliance, advisory, regulatory etc.) in most instances. However, having the same standard setter for all purposes could enhance consistency where consistency is appropriate. It would enable that one standard setter to determine when separate guidance may need to be issued for different valuation purposes and when a single standard may have broader applicability.

Q: How should a global standard setter decide which topics to issue standards on? 

A: One of the key outcomes of thorough due process is determining where to focus the standard setter's effort. The agenda-setting process is critical to issuing relevant standards that target high priority, hot topic areas where there is a lack of consistency and quality. Such a process should include substantive research and constituent feedback that supports the need for a standard and explores the potential solutions.

A global standard setter should ultimately strive to progress relevant thinking on valuation methods and techniques, not just codify existing practice.

A systematic approach to standard setting, supported by formal research capability, will not only help to ensure that standard setting projects are appropriately defined but that the global standard setter will generate innovative thinking.

Q: How could consistent use of global valuation standards be enforced? 

A: There are several different ways that use of global valuation standards could be enforced, though each country or regulator will need to decide for itself how to enforce consistent application.

National professional organizations with a robust professional infrastructure can issue performance standards that require use of global valuation standards by their members. Regulators could also require their use by any valuation professional providing service to companies or individuals subject to that regulator's jurisdiction.

Professional organizations also can facilitate a formal peer review process to ensure that valuation firms are consistently and appropriately applying the global valuation standards.

Finally, key stakeholders can indirectly enforce application by mandating the use of global valuation standards whenever a company performs, or hires someone to perform, a valuation.

Source: PwC.

EY's Aaron wonders whether the profession should galvanize and form a self-regulatory organization. “The regulators have appealed for some degree of unification or defragmentation,” he says. In his view, some leaders in the valuation profession are more open to the discussions than others. “Some say we should work together, and others are more fiercely independent,” he says. “Unfortunately, we don't have consensus right now.”

Robert Barnett, senior vice president for Valuation Research Corp., says the financial reporting supply chain could benefit from more unified approaches to valuing complex instruments, especially those at “level 3” in the fair-value measurement hierarchy where values are based on little or no observable market activity. “The goal is that as we see different kinds of instruments with a lot of bells and whistles, whether valued or audited by any firm, there should be a similar approach,” he says. “We need some measure of consistency so we can get to some level of consensus.”

Leslie Seidman, former chairman of the Financial Accounting Standards Board now executive director of the Center for Excellence in Financial Reporting at Pace University, says the root of the problem is education, not just for valuation specialists but for auditors as well. “There's no question there's a significant intersection between accounting and valuation, but valuation is not used only for financial reporting purposes,” she says. “One of the most common concerns I heard expressed was that there isn't enough emphasis on the education of accountants in valuation, so start there in training those who are responsible for financial reporting in the United States.”

In the meantime, auditors and valuation experts alike say the best way for companies to manage the gap is to assure auditors and valuation specialists are talking to one another and agreeing on methods, inputs, and conclusions. “Often there's give and take as to what the valuation specialist thinks and what methodologies they're thinking of using,” says Mark Scoles, partner at Grant Thornton. “You can bounce that stuff off of auditors. Auditors aren't going to tell them what to do early in the process, but if they have an issue they will let it be known. If there isn't communication, it can break down badly in the 11th hour.”