Audit wars

Bob (not his real name), an East Coast-based general partner of a middle-market buyout firm who unsurprisingly declined to speak on the record for this article, has had some problems with his auditor lately. He blames this on fair value.

Despite having known and worked with his auditor for more than a decade, the professional relationship between the two has grown strained over the past two years over the issue of how Bob values his portfolio of private companies. In particular, the auditor now takes issue with Bob's practice of holding his investments at cost until a third-party validates a rise in value, such as through a next round of financing or IPO.

?I had a very contentious discussion with the guy,? says Bob of his conservative and widely practiced method of holding at cost. ?He says it's never been GAAP. I told him that was a ridiculous argument because everybody I know does it this way.?

Increasingly, the way ?everybody does it? in the private equity community is not receiving the blessing of the auditor community. At the root of this dichotomy is fair value, or rather the pressure being exerted on private equity funds to be more aggressive and proactive in adopting fair value accounting methods. Thanks to increased scrutiny of private company accounting practices, auditors are less willing to risk their own practices by giving an opinion on private equity portfolios where they cannot discern a reasonable effort to determine fair value.

Limited partners, as well, are coming under pressure from their own boards and overseers to certify that private equity portfolios are reported as being worth today what they would fetch if sold today.

General partners, however, largely wince when told to determine, on a quarterly basis, an exit value for their private companies. Many are now making a good-faith effort to adopt practices and guidelines that estimate fair value. Some complain that such practices still produce wildly arbitrary valuations and go as far as to ignore auditor advice.

Does cost equal fair value?
A partner at a prominent financial services and valuation firm admits that many of his firm's private equity clients will have a hard time fully embracing a true fair value system. The current value of private companies may vary widely based on the specific niche they are in and on totally unpredictable factors, such as how much a potential acquirer might want to pay for it. He notes that ?VC companies have the biggest challenge. If a company doesn't have any revenue, it's a guess. It's a bet.?

Increasingly, the powers that be within the accounting world are demanding that educated guesses take precedence over ?let's just hold it at cost.? Sometime later this summer, the Financial Accounting Standards Board is expected to release a final version of its new statement regarding the definition and determination of fair value. An exposure draft of the statement makes clear that even in the absence of a quoted price or comparable values of similar assets, accountants must still go to great lengths to document an effort to arrive at fair value. A current draft reads: ?If quoted prices for identical or similar assets or liabilities in active markets are not available, or if differences between similar assets or liabilities are not objectively determinable, fair value shall be estimated using multiple valuation techniques consistent with the market approach, income approach, and cost approach whenever the information necessary to apply those techniques is available without undue cost and effort.?

?In some cases, market inputs might not be available without undue cost and effort, requiring the use of significant entity inputs derived from an entity's own internal estimates and assumptions.?

This new fair-value definition is expected to put a finer point on the issue above and beyond the pressure that has already been created as a result of PEIGG, the Private Equity Industry Guidelines Group, a volunteer group that has created a North American version of valuation standards.

These trends make it seem like the long era of hold-at-cost is coming to an end. ?For years, the GPs somehow got the auditors comfortable and to accept that cost or another round of financing is representative of fair value,? says the accounting firm partner. ?But now there's more pressure on GPs to do more robust valuation and documentation.?

A New York-based auditor with many private equity clients says he is open to hearing arguments from GPs that a company should be held at cost, so long as those arguments demonstrate that cost is, in fact, fair value. ?There needs to be a note at the bottom of the piece of paper stating that, coincidentally, cost and fair value are the same,? the auditor says.

However, he adds, ?If someone says, ?I know I can sell this for more than I'm carrying it at,? then you're sort of in a quandary. That isn't what fair value is.?

The truth is, many GPs don't hold their investments at cost because that's the fair value. They hold at cost because they see no reliable method for determining what the investment might be worth in the event of an orderly sale, save for actually entering into an orderly sale. The only available policies available to these GPs involve what they see as guesswork and, significantly, the hiring of expensive valuation experts each quarter, who may produce valuations that vary significantly with each reporting period.

Bob, the East Coast GP, complains that his auditor now pushes him toward fair value without recognizing that this forces the GP to assign arbitrary values. ?Here's a discussion I had with my auditor last year,? relates Bob. ?He said, ?Would you sell this for 10?? No. ?Then it's undervalued, and as a result of that I think it should be written up.? Okay, what number are you comfortable with? And he said, ?Well, you're the expert.??

Bob points out a potential problem with a private equity firm suddenly adopting an aggressive fair value approach – if it writes up an asset from cost to what it supposedly would be worth today if sold, ?that increase in value didn't just happen in one day, it happened over the course of five years. Do I have to go back and restate valuations? for prior reporting periods?

Proponents of fair value in private equity, including PEIGG, the Institutional Limited Partners Association and most of the private equity trade groups around the world, all acknowledge that assigning a value to a certain type of private investment is heavily reliant on the professional judgment of the GP, but they argue that simply ignoring the global standard of fair value will eventually draw unwanted attention from regulators as well as potentially sour some limited partners on the asset class.

For his part, Bob is taking a stand. After disagreeing with his auditor last year on whether or not to write up the values of certain portfolio items, Bob's firm issued its annual report without an opinion from an auditor. This year, his audit is again being delayed over the same contentious issue.

?What drives me nuts is that accountants by their natures tend to be conservative,? says Bob. ?You very rarely argue to write up a position. It's just strange to me that an auditor would be arguing to write up an asset. It's completely upside down.?

Fair value 101
Below are excerpts from ?Auditing Fair Value Measurements and Disclosures,? a ?toolkit? for auditors issued by the American Institute of Certified Public Accountants.

[Financial Accounting Standards Board] Statement No. 141, defines the fair value of an asset (liability) as ?the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.? Although GAAP may not prescribe the method for measuring the fair value of an item, it expresses a preference for the use of observable market prices to make that determination. In the absence of observable market prices, GAAP requires fair value to be based on the best information available in the circumstances?

[Statement on Auditing Standards] No. 101 states that management is responsible for making the fair value measurements and disclosures included in the financial statements. In connection with that responsibility, management needs to establish an accounting and financial reporting process for determining the fair value measurements and disclosures, select appropriate valuation methods, identify and adequately support any significant assumptions used, prepare the valuation, and ensure that the presentation and disclosure of the fair value measurements are in accordance with GAAP?

The auditor should evaluate whether management's fair value measurements and disclosures, and the allocation of the acquisition cost relating to the business combination are in conformity with FASB Statement No. 141 and any other applicable GAAP.