Fair value: a call to arms

The battle for sensible fair value auditing isn’t over yet. But to win it, CFOs need to convince the PCAOB that deriving fair value requires a little more intuition, and a little less math.

Eight years on from the introduction of FAS 157, the section of accounting code governing fair value reporting now known as Topic 820, there’s been a belief amongst CFOs that tougher audits are here to stay. But they're wrong.

Not many CFOs are aware of it, but in late October board members from the Financial Accounting Standards Board (FASB) and representatives from the American Institute of CPAs (AICPA) came out of a critical meeting on fair value in agreement that something was wrong. The importance of this meeting cannot be stressed enough: FASB, the group responsible for writing fair value rules, and the AICPA, the body comprised of accountants responsible for auditing GPs’ fair value estimates, reached a consensus that Topic 820 isn’t working as intended in the private funds universe – where assets are harder to price and inherently contain an element of subjectivity. All this despite the Financial Accounting Foundation, the oversight body responsible for reviewing FASB’s standards, saying earlier this year that Topic 820 hasn’t resulted in any “unintended consequences.”

Private fund CFOs reading those words will tell you through gritted teeth that Topic 820 has been a headache. Investments used to be simply held at cost, but the arrival of FAS 157 in 2006 required CFOs to make educated guesses about a portfolio’s exit price at the time of measurement. For the most part, they could rely on dealmakers’ business acumen and seasoned intuition of the portfolio to calculate a reasonable estimate. But that didn’t last very long. Following their own increased oversight in recent years, auditors began standardizing their approach to audits, leaving small industries like private equity and venture capital subjected to audit approaches better suited for large public companies. As reported on pfm, the result has been private fund CFOs running option pricing models and other needless exercises to justify their marks.

The hopeful few in our industry expect this to change. They correctly point out that no one wins when GPs are audited in a way that doesn’t sync with how market participants determine fair value. Some in this crowd are even optimistic about the AICPA recently forming a taskforce to create bespoke guidelines for the private equity industry. But the cynical majority has a strong counterpoint to their optimism: auditors already recognize the problem (the October meeting is proof of that) but will continue pushing for more quantitative means of estimating fair value until the Public Company Accounting Oversight Board (PCAOB), their oversight body, recognizes the problem too.

Happily, the PCAOB completed a consultation on fair value auditing earlier this month that garnered responses from the National Venture Capital Association and other trade bodies willing to point out the unintended consequences in Topic 820 others have ignored. But for the PCAOB to take smaller industries like private equity and venture capital outside of their immediate purview seriously, it will require constant engagement on the part of CFOs and other industry representatives to make the case that all the mathematical models in the world can’t always compete with an experienced GP’s professional judgment.