Regulators Increase Scrutiny on PEGs and Public Companies

Regulators from the Public Company Accounting Oversight Board (PCAOB) to the Securities and Exchange Commission (SEC) Enforcement Division are turning up the heat on valuations used for financial reporting of private equity groups (PEGs) and publicly traded companies. This increased focus emphasizes the importance to use qualified independent valuation specialists to ensure compliance with existing and changing requirements, along with peace-of-mind for management and investors.

PEGs are increasingly facing disciplinary sanctions from the SEC Enforcement Division. In a speech given in December 2012 by Bruce Karpati, Chief, SEC Enforcement Division’s Asset Management Unit, several examples were offered of actions taken against hedge funds and PEGs. A significant majority of these actions involved valuation and valuation processes among other breaches of fiduciary duty. After several years of going largely unregulated, it is clear that PEGs are now in the cross-hairs of regulatory agencies. Larger PEGs are already migrating toward using experienced valuation consultants to provide third-party valuations of their underlying assets. Smaller firms who submit their own valuations for acceptance or rejection by their auditors should be aware that more intense scrutiny by regulators may put their hard-earned reputations among investors at risk.

Most financial analysts and investment professionals will tell you that valuation is more of an art than a science and that almost all valuations are subject to a great deal of variability based on the assumptions used to estimate value. But since the Financial Accounting Standards Board (FASB) set accounting rules in place that strengthened the requirements and standards for fair value accounting in 2001, the rule-setting organization has only increased the emphasis of fair value in accounting standards for both financial assets and non-financial assets. In ASC 820 (formerly SFAS 157), also known as Fair Value Measurement, the FASB set out its requirements for the process of estimating fair value, where that standard is required throughout the auditing standards.

For the first time in decades, major changes for audit reports for public companies have been proposed by the PCAOB in its Release No. 2013-05 dated August 13, 2013. This proposal would expand reports on audits of financial statements requiring auditors to describe “critical audit matters” that the auditors found to be more challenging in issuing their opinions. For example, matters that required more judgments and estimates in areas such as fair value measurements would need to be highlighted in the auditors’ opinions. It shouldn’t come as a surprise that the PCAOB has put forward this proposal, given that its reports on the inspection of auditors, from the Big Four to the smallest firms with public company clients, have been heavily weighted towards perceived audit weaknesses around matters of judgment such as fair value. In fact, as much as 50% or more of the comments in the PCAOB’s inspection reports have focused on fair value matters.

PEGs and public companies are paying the price in terms of higher audit fees when inexperienced valuation providers are hired to assist with fair value estimates. These higher fees come in the form of increased challenges by auditors and their valuation specialists as well as back-and-forth rounds of expensive conference calls. This can all be avoided if the internal finance teams resolve to use experienced valuation providers with intimate knowledge of fair value requirements.

Many valuation advisors today claim that they are competent in valuation matters when in fact, they do not understand fair value rules that are required by the FASB, the PCAOB, and the SEC. Avoid costly mistakes, and select a valuation advisor with several years of experience with and intimate knowledge of fair value requirements as prescribed by the standard setters and regulators.

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Bryan Fleming

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