Accounting Horizons

Vol. 20, No. 3

September 2006
pp. 287303

Auditing Fair Value Measurements:

A Synthesis of Relevant Research
Roger D. Martin, Jay S. Rich, and T. Jeffrey Wilks
SYNOPSIS: To contribute to the PCAOB project on auditing fair value measurements
(FVMs), we synthesize relevant academic literature to offer insights, conclusions, and
future research directions for auditors, standard-setters, and academics focusing on
auditing FVMs. We structure our synthesis along two dimensions: (1) an emphasis on
the auditors need to understand how FVMs are prepared, and (2) the audit steps and
procedures necessary to verify and attest to FVMs, including an awareness of the
potential biases inherent in auditing FVMs. Drawing primarily from the judgment and
decision-making literature, we highlight a number of potential biases and limitations in
the preparation and audit of FVMs. Additionally, we note that the specialized valuation
knowledge necessary to effectively audit FVMs will be difficult for auditors to gain and
maintain.

INTRODUCTION

T
o facilitate the development of auditing standards and to inform standard-setters of
insights from academic research, the Auditing Section of the American Accounting
Association (AAA) has decided to develop a series of literature syntheses for the
Public Company Accounting Oversight Board (PCAOB).1 This paper synthesizes and dis-
cusses implications of academic research that should be relevant to auditors, standard-
setters, and academics who increasingly deal with the complexities of auditing fair value
measurements (hereafter FVMs) (Carmichael and Holstrum 2005).2
The recent Financial Accounting Standards Board (FASB) exposure draft, Fair Value
Measurements, underscores a desire for wider acceptance and consistent application of

1
The views expressed in this paper are those of the authors and do not reflect an official position of the AAA
or the Auditing Section. In addition, while discussions with the PCAOB staff helped us identify the issues that
are most relevant to setting auditing standards, the author team was not selected or managed by the PCAOB,
and the resulting paper expresses our views, which may or may not correspond with the views held by the
PCAOB and its staff.
2
Auditing fair values has been identified as a priority topic by the Standing Advisory Group of the PCAOB in
each of the last two years (see discussion of these priorities at the following two PCAOB links: http: / /
www.pcaobus.org / Standards / Standing Advisory Group / Meetings / 2004 / 06-21 / Agenda%20item%206.pdf,
http: / / www.pcaobus.org / Standards / Standing Advisory Group / Meetings / 2005 / 10-05-06 / Carmichael
Statement.pdf).

Roger D. Martin is an Assistant Professor at the University of Virginia, Jay S. Rich is an

Associate Professor at Illinois State University, and T. Jeffrey Wilks is an Associate Pro-
fessor at Brigham Young University.
We thank the reviewers, Bob Lipe, Linda McDaniel, and Ed Trott for their helpful comments and suggestions.
Submitted: September 2005
Accepted: May 2006
Corresponding author: Roger D. Martin
Email: rdm3h@virginia.edu

287
288 Martin, Rich, and Wilks

FVMs within financial statements (FASB 2004b). The exposure draft, along with the current
audit guidance in Statement on Auditing Standards (SAS) No. 101, Auditing Fair Value
Measurements and Disclosures (AU Sec. 328, AICPA 2003a), also highlights a willingness
to allow and to audit the more subjective inputs and assumptions necessary to measure fair
values. As more assets and liabilities are measured at fair value, auditors and auditing
standard-setters must understand not only the valuation models and the management proc-
esses that determine model inputs, but also managements potential biases and likely errors
when applying models, identifying market inputs, and making assumptions. Auditors and
standard-setters also need to understand the likely sources of auditor biases and errors when
auditing FVMs recognized in the financial statements.3
We structure our synthesis of prior research along two dimensions: (1) an emphasis on
the auditors need to understand how FVMs are prepared, including an awareness of the
potential pitfalls and biases inherent in preparing FVMs, and (2) the audit steps and pro-
cedures necessary to verify and attest to FVMs, including an awareness of the potential
biases inherent in auditing FVMs. We focus first on the generation of FVMs because we
believe that auditors cannot exercise due care in the audit of FVMs without a thorough
understanding of the underlying valuation techniques and inputs used in assessing FVMs.
Although a substantial academic and business discipline is dedicated to valuation and ap-
praisals, auditors have historically learned very little of this discipline.4 We focus second
on research related to verification and attestation procedures for FVMs, even though very
little research directly examines the auditing of FVMs. This dearth of research is quite
surprising, given the three-decade trend toward recognition of FVMs (Barlev and Haddad
2004) and the considerable research on the impact of FVMs on capital market variables
(see AAA FASC [2005] for a brief review). We suggest potential research topics related to
auditing FVMs throughout the paper.
A considerable body of research jointly examines the relevance and reliability of fair
value estimates (e.g., AAA FASC 1998, 2000, 2005) and generally concludes that FVMs
based on inputs from actively traded markets are more reliably associated with share prices
than FVMs derived from thinly traded markets or entity specific inputs (AAA FASC 2005).
Although this research is informative to financial reporting standard-setters (cf., Holthausen
and Watts 2001), it does not directly address the issues faced by auditors, who tend to be
more concerned with the verifiability of FVMs than with their relevance or association with
share price (Carmichael 2004; Maines and Wahlen 2005). As a result, we focus our attention
on the formal and practical guidance in auditing standards, as well as academic research
in psychology and economics that potentially relates to the auditing of FVMs.5

3
As listed in a PCAOB briefing paper, Fair value measurements are required for a variety of assets and liabilities
on the balance sheet, such as investments in securities, derivative financial instruments, goodwill and other
intangibles, impaired long-lived assets, certain financial instruments with aspects of liabilities and equity, asset
retirement obligations, pension and postretirement obligations, guarantees, and also in the consolidation of
variable-interest entities. Therefore, auditors have a significant responsibility to effectively audit the fair value
measurements found in current financial statements (PCAOB 2004). See also Barth (2006).
4
The American Society of Appraisers (http: / / www.appraisers.org) describes a number of appraisal disciplines
that would be relevant to auditors work, including business valuation, machinery and technical specialties, and
appraisal review and management.
5
Given our objective to inform readers about the auditing of FVMs, our focus is purposefully in contrast to the
examination of whether FVMs are sufficiently relevant and reliable to warrant inclusion in financial statements
(e.g., Barth 2006; Maines and Wahlen 2005; AAA FASC 1998, 2000, 2005). Our focus on how audits are
conducted and how such conduct might be improved with regard to FVMs is also consistent with Kinneys
(2005) distinction between research in auditing versus research about auditing (e.g., studies of how auditor
affiliation with FVMs affect market responses).

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Auditing Fair Value Measurements: A Synthesis of Relevant Research 289

The research topics discussed in the paper are not uniquely applicable to auditing
FVMs; for example, many of the same challenges are faced by auditors when auditing other
accounting estimates (e.g., asset impairment, allowance for doubtful accounts, loan loss
reserves, estimated depreciable lives, etc.). However, the FASBs desire for wider accep-
tance and application of FVMs will lead to a higher proportion of audit effort directed
toward FVM auditing issues. Further, auditors anecdotally report concerns over the com-
plexity of new FVM demands (e.g., Copeland 2005, 37). So while the challenges faced by
auditors in auditing estimates of the future are not unique to FVMs (Barth 2006), the relative
importance and complexity of that audit effort is expected to increase. We believe that this
increase in the frequency and complexity of FVM applications will challenge auditors. As
a result, we identify topics reflected in current audit guidance that we believe should be
considered by standard-setters, practitioners, and researchers as FVMs become more widely
accepted.
Our synthesis of prior research suggests a number of important issues related to audi-
tors understanding of how FVMs are prepared. FVMs frequently incorporate forward-
looking information reflected in market place exchanges as well as judgments about the
applicability of those market inputs to company-specific conditions (e.g., amount and timing
of cash flows). Future events and conditions cannot be predicted with certainty, so an
element of judgment is always involved. Because most auditors have little training in val-
uation, specialists are often required to audit FVMs. Importantly, the structures of audit
teams may inhibit the utilization of knowledge of such specialists in todays audit firms.
Researchers and policy makers within firms need to grapple with the possibility that existing
audit team structure and incentives may not be compatible with audits that require more
and more specialized valuation knowledge (Vera-Munoz et al. 2006).
In addition to the lack of specialized knowledge among auditors regarding the prepa-
ration of FVMs, a number of errors and biases likely affect preparers valuation judgments,
and auditors should be aware of those. For example, auditors should be aware that in the
process of estimating FVMs, preparers may derive too much confidence from the amount
of information used to estimate those measures (Slovic 1982; Davies et al. 1994; Paese and
Sniezek 1991). As a result, preparers may fail to consider other likely scenarios, relevant
information, or valuation possibilities. Prior research also documents considerable incon-
sistency and error when individuals make predictions (e.g., Dawes 1971). Even after using
statistical or mechanical means of analyzing data to facilitate predictions, the motivated
reasoning literature suggests that decision makers may unknowingly bias their estimates in
preferred directions (e.g., Kunda 1990; Wilks 2002; Kadous et al. 2003).
Our research synthesis also suggests a number of important issues related to the auditing
of FVMs. Prominent among these concerns is auditors reliance on internal controls over
the FVM estimation process. Barlev and Haddad (2004) argue that internal controls
over the FVM estimation process must be different from controls over typical exchange
transactions. Auditors must ensure that controls over FVMs are appropriate, especially in
relation to the separation of duties (Barlev and Haddad 2004).
While preparers are likely to fall prey to biases and other motivated reasoning effects
as noted above, auditors must also be wary of their own biases when auditing FVMs. For
example, auditors must be careful not to simply search for evidence that corroborates man-
agements assertions, even though current audit guidance specifies that very approach (e.g.,
AU Sec. 332.35, AICPA 2000). Finding such evidence is far too easy if this is all the
auditor is pursuing. Instead, auditors must also consider evidence that could potentially
disconfirm managements assertions. Although no prior research directly examines this issue

Accounting Horizons, September 2006

290 Martin, Rich, and Wilks

in relation to auditing FVMs, prior research has examined the issue generally and suggests
a number of useful steps in avoiding the confirmation bias and other motivated reasoning
effects in audit settings (e.g., Koonce 1992; Kennedy 1995; Anderson and Koonce 1998).
Finally, auditors must be able to identify key assumptions and inputs in the FVM
process. The lack of existing guidance on what would constitute a significant assumption
suggests that auditing standard-setters will likely need to specify principles to identify such
assumptions. Identifying key assumptions and testing their reasonableness is a major con-
cern among auditors of FVMs.
In the next section of the paper, we briefly review the FASB exposure draft on FVMs
and SAS No. 101 (AU Sec. 328, AICPA 2003a). In doing so, we describe the auditors
primary responsibilities, which we reference throughout our synthesis of the academic lit-
erature. In the subsequent two sections we synthesize prior research along the dimensions
of preparing and auditing FVMs, as described above. Finally, we conclude with a summary
and discussion of implications for auditing standard-setters, practitioners, researchers, and
auditing educators.

FAIR VALUE REPORTING AND AUDITING STANDARDS

FASB Exposure Draft, Fair Value Measurements
The FASB exposure draft on FVMs was issued in June 2004. After an examination of
comment letters, the FASB revised the exposure draft and currently anticipates its final
issuance in 2006. A working draft of the proposed standard (FASB 2005) includes the
following four significant components, which vary slightly from the summary outlined in
the Financial Accounting Standards Committees commentary on the original exposure draft
(AAA FASC 2005):
1. Fair value is defined as the price that would be received for an asset or paid to
transfer a liability in a current transaction between able, willing, knowledgeable,
and independent marketplace participants in the reference market for the asset or
liability.
2. Three valuation techniques are specified for estimating fair values: the market ap-
proach, income approach, or cost approach. Regardless of approach, the use of
market inputs should be maximized while the use of entity inputs should be
minimized.
3. A hierarchy of inputs is established to use in determining fair value estimates. The
working draft identifies five levels of inputs:
Level 1 inputs are market inputs that reflect quoted prices for identical assets or
liabilities in active markets.
Level 2 inputs are market inputs that reflect quoted prices for identical assets or
liabilities in markets that are not active, or quoted prices for similar assets
or liabilities in all markets, adjusted for differences.
Level 3 inputs are market inputs other than quoted prices, such as interest rates,
yield curves, volatilities, and default rates.
Level 4 inputs are market inputs not directly observable for the asset or liability,
but that are corroborated by other market data through correlation or other
means.
Level 5 inputs are entity inputs.
Subsequently, the FASB decided to combine Levels 24 thereby establishing a
three-level hierarchy for both measurement and disclosure purposes.

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Auditing Fair Value Measurements: A Synthesis of Relevant Research 291

4. Disclosures are required to enable users to evaluate the extent to which fair value
is used to remeasure assets and liabilities recognized in the financial statements
and to evaluate the inputs used to develop those estimates.
The proposed standard does not require any new FVMs, but does provide procedural
guidance for measuring fair value and would apply to assets and liabilities measured at fair
value under other authoritative accounting pronouncements. As a result, auditors must be
prepared to examine whether a clients existing FVMs and disclosures conform to the
requirements of this new standard.

SAS No. 101, Auditing Fair Value Measurements and Disclosures

SAS No. 101 (AU Sec. 328, AICPA 2003a) provides a general audit approach for
FVMs and related disclosures. The standard does not provide guidance for auditing specific
assets, liabilities, or equity items reported at fair value, but it does provide a framework
that applies to all audits of FVMs.6 This standard begins with the clarification that company
management is responsible for making the FVMs and related disclosures included in fi-
nancial statements. Specifically, management must establish accounting and reporting proc-
esses for determining FVMs, select appropriate valuation methods, identify and adequately
support any significant assumptions used, prepare the valuations, and ensure that the pre-
sentation and related disclosures are in accordance with GAAP (AU Sec. 328.04, AICPA
2003a).
Many FVMs result from approximations, rather than exact measures, and involve nu-
merous estimates, classifications, judgments, and allocations (PCAOB 2004, 1). The audit
of these measurements is intended to enhance their reliability by reducing measurer and
measurement bias (Carmichael 2004). Direct verification of accounting measures by audi-
tors (e.g., substantiation of the fair value of a share of stock on the balance sheet date)
tends to minimize both measurer and measurement bias. Many FVMs, however, rely on
valuation techniques (e.g., the value of employee stock options) that incorporate inputs and
outcomes that cannot be directly verified, so the auditor is faced with exercising due care,
including the use of professional skepticism, to ensure that bias does not materially affect
FVMs based on valuation techniques (Carmichael 2004).
Consider employee stock option (ESO) fair value estimates as an example.7 ESO fair
value estimates derive directly from estimated model inputs, so auditors must consider how
these estimated inputsindividually and collectivelymight be subject to uncertainty in
estimation, misapplication, or bias. Research suggests management opportunistically uses
allowable discretion to bias ESO fair values downward (Aboody et al. 2006; Balsam et al.
2003; Bartov et al. 2004), but recent results also indicate discretion might actually improve
predictive accuracy by allowing managers to convey private information in their estimates
(Hodder et al. 2006). Hodder et al. (2006) also point out that all four model inputs (expected

6
Examples of guidance that apply to specific assets and liabilities include SAS No. 92 (AU Sec 332, AICPA
2000), Auditing Derivative Instruments, Hedging Activities, and Investments in Securities, and Auditing Fair
Value Measurements and Disclosures: A Toolkit for Auditors (AICPA 2003b), which relates to FVMs required
by SFAS No. 141 (FASB 2001a), Business Combinations, SFAS No. 142 (FASB 2001b), Goodwill and Other
Intangible Assets, and SFAS No. 144 (FASB 2001c), Accounting for the Impairment or Disposal of Long-Lived
Assets.
7
Note that SFAS No. 123R indicates that the measure of option value specified in the standard is a modified (as
opposed to pure) FVM because it ignores some contractual clauses that would not be ignored in a market price
(e.g., restrictions stemming from forfeiture of the option if vesting conditions are not satisfied) (FASB 2004a,
B70). We drop the modified adjective for ease of exposition.

Accounting Horizons, September 2006

292 Martin, Rich, and Wilks

term of the option, expected volatility of the price of the underlying share, expected divi-
dends on the underlying share, and the risk-free interest rate for the expected term of the
option) are used systematically to affect ESO fair value estimates (cf., Balsam et al. 2003;
Aboody et al. 2006; Johnston-Wilson 2003). Given these findings, the auditor must evaluate
managements inputs relative to historical experience and industry standards, but must also
use client-specific knowledge to consider the propriety of fluctuations from those bench-
marks. This requires valuation and client-specific expertise and judgment from the auditor,
as well as professional skepticism in evaluating managements choices (e.g., Hunton et al.
2006).
To help auditors exercise due care in the audit of FVMs and related disclosures, SAS
No. 101 (AU Sec. 328, AICPA 2003a) outlines a number of requirements. We believe these
requirements establish two general challenges to auditors: (1) to obtain a sufficient under-
standing of the entitys processes and relevant controls for determining FVMs to develop
an effective audit approach (AU Sec. 328.09), and (2) to evaluate whether the entitys
methods of measurement and significant assumptions are appropriate and are likely to
provide a reasonable basis for the FVMs and related disclosures in the entitys financial
statements (AU Secs. 328.18 and 328.28). As discussed earlier, these challenges are not
unique to FVM applications, but we believe the need to understand and evaluate clients
FVM applications will increase in importance and complexity as FVMs become more
common. In the next section of the paper, we discuss and synthesize a broad range of
research with implications for auditing FVMs. In doing so, we relate that research back to
the audit challenges established in SAS No. 101 (AU Sec. 328, AICPA 2003a).

UNDERSTANDING HOW FAIR VALUE MEASUREMENTS ARE PREPARED

Knowledge of the Estimation Process
SAS No. 101 (AU Sec. 328, AICPA 2003a) mandates that auditors sufficiently under-
stand the process and relevant controls for determining how FVMs are derived to develop
an effective audit approach (AU Sec. 328.09). The standard also refers to the need to
understand how a particular FVM should be derived in order to determine whether the
clients approach is appropriate (AU Sec. 328.18). Auditors develop knowledge of client
estimation processes and related controls via a combination of audit team members tech-
nical knowledge and assistance from valuation assurance specialists utilized by an audit
team.8
Audit team members technical knowledge related to valuation models is likely to be
difficult to gain and maintain. Accounting education programs might demonstrate to stu-
dents why this specialized knowledge is important, but formal education on valuation tech-
niques demands exposure to accounting, finance, and economic modeling that is not cur-
rently likely to be incorporated in the traditional 150-hour accounting education program.
Audit practitioners can receive training on technical valuation topics through continuing
education and firm training programs, but complex and innovative financial instruments are
constantly being developed that demand application of new valuation models and assump-
tions. This continuous evolution hinders the identification of state-of-the-art techniques
to use in training and to apply to subsequent audit applications.

8
The use of specialists is discussed in the PCAOBs Standing Advisory Group briefing on fair value auditing
(PCAOB 2004, 10) and in a more recent Standing Advisory Group briefing on the use of specialists (PCAOB
2006).

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Auditing Fair Value Measurements: A Synthesis of Relevant Research 293

The need to look beyond the auditors for specialized valuation expertise is similar to
the need for computer assurance specialists utilized today by audit teams. Assurance spe-
cialists in the areas of computer systems and valuation models have the advantage of being
more narrowly focused on specific applications and are thus able to leverage knowledge
and experience across a broader range of clients. Valuation specialists also supply benefits
to other audit team members by providing education and insights into technical applications
of valuation models in specific audit contexts. When relying on specialists, auditors must
effectively manage the specialists work to assure high-quality evidence is accumulated and
employed in the audit.
Given the movement toward more specialization on audit teams to respond to the
demands of the fair value standards, a number of important questions could be examined
in future research. For example, how does the current structure of audit teams, where audit
team members have responsibility for one or two clients and are rewarded only for their
efforts on those clients, affect firm utilization of specialist knowledge? Will auditors ask
for the help of specialists when specialists time is typically billed to the engagement at
significantly higher rates? Will auditors who deeply understand FAS No. 123R valuation
(FASB 2004a), as an example, hesitate to help another audit team because they are not
rewarded for such efforts? How might the incentive and reward structure of audit teams
need to change as the number of necessary specialists (e.g., fair value, forensic, and com-
puter controls specialists) increases in the future?9 Will smaller audit firms without national
or professional practice offices or specialists be able to staff audits with extensive FVM
applications? The impact of specialists on audit team structure and incentives is an area
full of unanswered questions.

Biases and Errors in the Estimation Process

In the previous section, we argue that a thorough understanding of the fair value esti-
mation process is a necessary first step in the auditing of FVMs. Additionally, auditors
must be aware that individuals are cognitive misers who use simplifying decision strat-
egies or heuristics (e.g., Simon 1955, 1956). A primary finding in this literature is that
these simplifying decision strategies lead to cognitive biases and limitations in judgment.
These biases and limitations can be intentional or unintentional, and auditors efforts should
focus on the aspects of clients estimation processes most susceptible to these problems. In
the remainder of this section, we review research that should help auditors identify the
riskiest aspects of their clients fair value estimation processes.

Statistical or Intuitive Judgment

Many estimates of future events and conditions are used in assessing fair value. For
example, when valuing mortgage-servicing rights, management must estimate prepayment
speeds. This estimate is made by considering a wide range of available information such
as predictions of future interest rates and portfolio-specific characteristics. Extensive bodies

9
We note that the last four questions are not unique to incentive and utilization issues related to FVMs. For
example, audit firms have recently been forced to examine how they utilize expertise related to auditing infor-
mation technology controls. The increased frequency and complexity of FVMs across engagements, however,
will demand that audit firms also evaluate utilization issues for this additional type of specialty. Nonetheless,
these questions are indicative of a larger questionhow and how well do audit firms create and share knowledge
among employees, and how does the current audit team structure promote or inhibit knowledge sharing (e.g.,
Vera-Munoz et al. 2006).

Accounting Horizons, September 2006

294 Martin, Rich, and Wilks

of psychology research investigate how and how well individuals integrate available in-
formation (or cues) into a judgment about some unknown event (e.g., Kleinmuntz 1990;
Hammond et al. 1975; Dawes 1971). Studies appear in a wide variety of fields including
clinical assessment (e.g., Meehl 1954), medicine (Blois 1980), and law (Hastie et al. 1983),
and a number of conclusions are clearly substantiated.
First, individuals have very little insight into how they weight or combine information
to form judgments (e.g., Brehmer 1980). This result holds even when the individual is
considered an expert in the subject matter. This lack of insight suggests that auditors should
be wary of managements description of how judgments about model inputs are reached.
For example, managements claim that economic projections were heavily weighted (or
ignored) in developing estimates of prepayment speeds may not be supported by the actual
data. Instead, analysis of a series of judgments must be undertaken to determine how
important the specific information is in any particular clients judgments.
Second, individuals are inconsistent in their weighting and/or combining of information
to form judgments. At one level, this means there is random error in their judgments (e.g.,
Dawes 1971). For example, when estimating the value of employee stock options, man-
agements assumptions about expected stock price volatility should be based on historical
experience, adjusted for publicly available information that may indicate ways in which the
future is reasonably expected to differ from the past (FASB 1995, para. 251). Management
is likely to consider currently available information such as implied volatilities reflected in
observed option prices and forward-looking projections of changes in future volatility,
but random error may be introduced into managements estimate of volatility because
the weights assigned to various factors are different from period to period. In addition, the
variance of the errors may be correlated with task characteristics such as complexity and
nonlinearity (e.g., Dawes 1971). That is, when the relations between model inputs
and outcomes are relatively complex, as in fair value estimates, the variance of these in-
consistencies increases.
Third, judgment processes are relatively simple along two dimensions:
decision makers usually rely on few pieces of information despite their beliefs that
more pieces are used (see lack of insight above and subsequent discussion in the
overconfidence section); and
decision makers generally combine the pieces of information as if they use simple
additive rules.
For example, while management may believe they are considering many variables in reach-
ing an estimate of future stock price volatility, the actual judgments are likely to be best
explained by a small number of information items in an additive model.
Individuals, organizations, and society in general often rely on human judgment because
of a belief that other methods cannot capture the complexity of human processes. Research,
on the other hand, suggests that whatever advantage individuals may have over simple
statistical models is not due to our ability to process large amounts of data or combine data
in complex ways. Further, research suggests that individuals are not very good at learning
complex, nonlinear relations within information (e.g., Hammond and Summers 1972). Con-
sequently, auditors should recognize that simple, additive models (e.g., linear regression)
using relatively little information often outperform experts, even in the presence of an
abundance of information (e.g., Dawes 1971). Future research is needed to better understand
how and how well management forms estimates used in the FVM process. With this un-
derstanding, more formalized statistical analysis can aid in the development of FVMs.
Auditors may ultimately be well positioned to develop statistical models for estimates used

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Auditing Fair Value Measurements: A Synthesis of Relevant Research 295

in many FVMs. For example, auditors access to data from a wide range of organizations
could be formally captured and mined to form data-driven FVM models. These models
would facilitate the auditing of FVMs by allowing individual audit teams to benefit from
the collective experience gained from other engagements within the audit firm.

Overconfidence and Information Quantity

In the preparation of FVMs, management may fall prey to overconfidence that occurs
because of information quantity. A number of studies suggest that additional information
often fails to improve prediction accuracy (e.g., Slovic 1982; Paese and Sniezek 1991;
Davies et al. 1994).10 Further, these studies suggest that despite the failure of additional
information to improve accuracy, individuals confidence increases with the amount of in-
formation they are allowed to use (see Russo and Schoemaker 2002).
This research suggests that when estimating FVMs, a setting in which tremendous
quantities of information are often available, preparers must guard against being overcon-
fident. For example, when estimating the fair value of employee stock options, having a lot
of information and alternative measures related to historical stock price volatility may make
preparers overconfident in their estimate of future stock price volatility, which may prevent
a preparer from considering additional factors that suggest alternative predictions of future
volatility. An auditor who is aware of this potential overconfidence would review alternative
sources to corroborate or refute a clients estimate of future stock price volatility.
Interestingly, prior research examining the relationship between information and con-
fidence has required individuals to assimilate information only in their heads. An estimation
process that allows software to assimilate information may avoid overconfidence, even with
large amounts of information clearly being used by the software. Given that many of the
inputs for FVMs are likely derived through some mechanical or statistical process, the
concern with overconfidence noted in prior research may be mitigated in data-intensive
FVM settings. Future research could address this issue by documenting the frequency of
and settings in which mental calculations instead of statistical or mechanical calculations
are used to generate inputs.

Confirmation Bias
Another potential concern when estimating FVMs is the tendency to search for infor-
mation that supports, as opposed to refutes, a previously held belief or preference. In many
situations this tendency results in unwarranted confidence in this previously held belief or
preference (e.g., Klayman and Ha 1987; Nickerson 1998). For example, if management
believes that future net cash flows are high for an asset being valued with an income
approach, then they may actively seek out evidence in support of this proposition such as
internal sales forecasts. Although such evidence is likely to increase managements con-
fidence that future cash flows will be high, management might have found equally plausible
evidence suggesting a decrease in future sales if they had looked for disconfirming evidence.
Although the confirmation bias has been studied in both tax (Cloyd and Spilker 1999)
and audit settings (McMillan and White 1993), it has not been studied in relation to val-
uations. Future research could offer perspective on this issue by documenting the processes
whereby supporting data are gathered to arrive at FVM model inputs. Distinguishing be-
tween sources that are internal to a company and those external to a company would be
an important first step. Such research should also document the decision process or controls

10
Note that this is consistent with the finding that individuals use relatively few pieces of information as discussed
in the previous section.

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296 Martin, Rich, and Wilks

and procedures that direct the search for information used to support the selection of inputs
to FVM estimation models. Some approaches may simply be a mental exercise meant to
quantify the otherwise ill-defined input, while other approaches may entail rigorous statis-
tical analysis and modeling that considers not only the reliability of utilized data, but also
whether all available or relevant data is being used.

Motivated Reasoning
The confirmation bias is just one facet of a broader literature known as motivated
reasoning (e.g., Pyszczynski and Greenberg 1987; Kunda 1990; Ditto and Lopez 1992;
Brownstein 2003), a literature that has spawned a number of recent studies in auditing (e.g.,
Boiney et al. 1997; Wilks 2002; Kadous et al. 2003). Motivated reasoning is the process
whereby a previously held belief or desire affects four mental reasoning steps: (1) hypoth-
esis formation, (2) the search for relevant information (this being the point in motivated
reasoning related to the confirmation bias), (3) the interpretation or evaluation of that in-
formation once found, and (4) the weighting of information in order to arrive at a final
judgment. Prior research illustrates that an individuals motives can affect his/her
final judgment at any of these four reasoning points.11
For an example of step 3, consider a preparer with a preference or previously held
belief about what a model input or final FVM should be. Such a preparer may (consciously
or unconsciously) be more critical of information that is inconsistent with this belief or
preference (cf., Ditto and Lopez 1992). Or, as an example of step 4, consider a preparer
who is aware of three or four different input values and simply lowers the weight given to
potential inputs that are inconsistent with his/her preferred value (e.g., Boiny et al. 1997).
An auditor aware of this potential weighting bias will want to consider the control process
in place that ensures an objective weighting of all potential inputs, devoid of interference
from the decision maker. An auditor will also want to make efforts to discover all potential
input values that might have been considered for a valuation model and why particular
values were ignored or given less weight.

Reiteration Effects
Many of these problems could be mitigated over time if people learned from their
previous mistakes and recognized their limitations. Unfortunately, research suggests that
people are quite poor at learning from their mistakes; instead, they fall prey to a phenom-
enon known as the reiteration effect (e.g., Hasher et al. 1977). The reiteration effect
describes individuals tendency to infer confidence in the truth of an assertion from the
frequency of occurrence. Although not studied in accounting settings, findings suggest that
mere repetition of processes used to produce FVMs will increase confidence in the appro-
priateness of these processes. For example, if management consistently estimates future
stock price volatility using the same process, confidence in the process will likely increase
through repetitioneven though alternative processes may be superior. Interestingly, this
increase in confidence appears to happen automatically (e.g., Hasher and Chromiak 1977).
In summary, a number of potential biases and limitations can creep into the process of
estimating FVMs as we have outlined above. Not only must audit teams have the requisite

11
A number of academic studies document the effects of motivated reasoning in appraisal and valuation judgments
reported in U.K. financial statements. Dietrich et al. (2001) find evidence suggesting that U.K. managers un-
dervalue the FVMs of real assets in order to report higher earnings when those assets are later sold. Similarly,
Aboody et al. (1999) find evidence suggesting that when U.K. managers with higher debt-to-equity ratios (and
thus with a greater motivation to revalue assets higher) revalue their assets higher, the market does not respond
as strongly as it does for upward revaluations made by managers without high debt-to-equity ratios.

Accounting Horizons, September 2006

Auditing Fair Value Measurements: A Synthesis of Relevant Research 297

expertise to understand the FVM process, but they must also be aware of the errors and
biases that occur within the FVM process. With this understanding of how FVMs are
prepared, an auditor can turn his/her attention to the steps necessary to audit FVMs.

AUDITING OF FAIR VALUE MEASUREMENTS

As our attention shifts to the auditing of FVMs, we once again find very little academic
research directly examining the subject. As a result, we select three issues we believe pose
the greatest difficulties for auditors in auditing FVMs: internal controls over FVMs, iden-
tifying and evaluating FVMs that are likely to be higher risk, and potential auditor biases
due to motivated reasoning and overconfidence. These areas can also benefit the most from
future research.

Internal Controls over FVMs

A key component of the audit process is the evaluation of and reliance on the design
and implementation of clients internal control systems. Internal controls related to FVMs,
as well as most other estimates included in financial statements, are likely more difficult to
audit effectively than traditional transactions-based controls. The pace of revisions to FVM
methods and applications presents challenges for control systems to keep up with new
estimation procedures. Consequently, while more traditional applications of controls are
relatively stable from year to year, controls related to FVMs will likely require considerable
audit work each year to understand and evaluate.
A second factor associated with the difficulty of auditing controls over FVMs is that
they typically rely on different mechanisms than more traditional control systems (Barlev
and Haddad 2004). Controls over accounting information based on historical costs utilize
business transactions and associated documentation and processes to establish and maintain
control. In contrast, when assets are measured at lower of cost or market or at fair value,
such measurements rely on assumptions and projections of the future, and establishing
controls for assumptions is more difficult.12 Controls over FVMs are also likely to be
developed on an application by application basis (as opposed to more uniform control
systems applied to traditional transaction processes), and this uniqueness requires more
audit work to understand and test. For example, management needs to establish and main-
tain control over the estimation of future stock price volatility to value employee stock
options. The specific information and control processes needed to support this estimate will
be very specialized. With the increasing complexity and frequency of FVM applications,
we expect higher demand for valuation assurance specialists to identify key controls nec-
essary to provide comfort to the audit team about control effectiveness over these FVM
estimation processes.

Identifying and Evaluating Higher Risk FVMs

Auditors need to identify assumptions that are significant to FVMs; significant as-
sumptions are described as those that materially affect FVMs and may be characterized by
sensitivity to variation, uncertainty in amount or nature, or susceptibility to misapplication
or bias (AU Sec. 328.33, AICPA 2003a). Management is to identify and provide represen-
tations about assumptions used in determining FVMs (AU Sec. 333, AICPA 1997, App.
B), but the auditor must still exercise judgment when testing managements significant
assumptions, FVM models, and underlying data (AU Sec. 328.26).

12
See, for example, Bentson and Hartgraves (2002) for a discussion of Enron abuses related to projections and
estimates.

Accounting Horizons, September 2006

298 Martin, Rich, and Wilks

For example, when auditing fair value estimates of employee stock options, auditors
must consider how managements estimates of expected option term, expected share price
volatility, expected dividends, and risk-free interest rates over the option term are subject
to uncertainty in estimation, misapplication, or bias, both individually and collectively.
Unfortunately, research finds that even experts often attend to and weight information dif-
ferently when forming estimates of future events and conditions (Brehmer 1980). This
suggests that auditors are likely to benefit from producing independent estimates of these
inputs rather than merely assessing the reasonableness of managements estimates. Specif-
ically, if the auditors independent estimates are not significantly different from manage-
ments estimates, then the auditor gains additional assurance that managements inputs are
appropriate. If, however, the auditors independent estimates are significantly different from
managements estimates, then auditor skepticism is heightened. In fact, as mentioned pre-
viously, in the long run audit firms may be well positioned to produce independent estimates
as specialists acquire expertise in evaluating FVMs and firms acquire data on how similar
FVMs are made across clients.
In the short run, however, we believe auditors will rely on their own expertise and
valuation specialists to gain assurance. Auditor expertise in FVMs and the limitations and
risks of relying on that expertise were discussed earlier. We found no research related
directly to how auditors utilize FVM assurance specialists on audit engagements, but ex-
isting research related to computer assurance specialists might provide insight to challenges
related to FVMs. For example, in an experimental setting, financial auditors appropriately
compensated for their lack of specialized computer information systems knowledge when
making risk assessments in a complex accounting information system environment (Brazel
and Agoglia 2004). Hunton et al. (2004), however, find that financial auditors might not
recognize the need to consult with computer assurance specialists when auditing an enter-
prise resource planning (ERP) system (compared to a non-ERP system) and might be
overconfident in their ability to assess ERP system risks.
In FVM settings, the challenge for auditors will be to recognize the need for valuation
assurance specialists and then how to utilize input from specialists. Future research could
examine how well financial statement auditors recognize the need for valuation assurance
specialists when evaluating changes in assumptions or valuation models made by manage-
ment. While auditors might recognize how to employ specialists inputs (similar to the
computer assurance specialist results in Brazel and Agoglia [2004]), they might or might
not recognize when such specialized assistance is needed.
Motivated Reasoning
As explained in an earlier section of the paper, motivated reasoning occurs when a
previously held belief or preference affects how an individual reasons through a decision,
primarily through information search (confirmation bias), evaluation, and weighting
(Pyszczynski and Greenberg 1987; Kunda 1990). The notion that individuals are less critical
of evidence they view as favorable applies just as much to auditing FVMs as to preparing
FVMs (see earlier discussion). Prior academic research documents a number of instances
in which motivated reasoning affects auditors judgments, however none of this research
directly examines judgments that occur when auditing FVMs. Still, this literature provides
a basis to suggest the issues and concerns auditors likely face when auditing FVMs.
One concern auditors face is actually embodied within the auditing standards them-
selves, as written in SAS No. 92 (AU Sec. 332, AICPA 2000):
The auditor should obtain evidence supporting managements assertions about the fair value of de-
rivatives and securities measured or disclosed at fair value. (AU Sec. 332.35) (emphasis added)

Accounting Horizons, September 2006

Auditing Fair Value Measurements: A Synthesis of Relevant Research 299

If auditors were to follow this instruction literally, they could easily fall prey to the con-
firmation bias because they would search only for evidence to support the assertion but
none that might disconfirm the assertion. Prior audit research recognizes this concern with
confirmation bias and motivated reasoning in general, and has suggested a number of cor-
rective approaches.
For example, Koonce (1992) examines how auditors are affected by the requirement to
document arguments that support managements explanations (much like is suggested by
SAS No. 92 [AU Sec. 332, AICPA 2000]). Her results suggest that requiring auditors to
document arguments or evidence to counter managements explanation will make auditors
less likely to accept managements assertions outright. In the context of auditing FVMs,
Koonces (1992) findings suggest that auditors should be careful to consider both supporting
and disconfirming arguments for the inputs and assumptions used by management in the
valuation process. In particular, when auditors are examining the reasonableness of man-
agements assumptions, they should be careful not to search for only confirming evidence,
but to also consider evidence that might support a different assumption. This will help
prevent auditors from prematurely accepting managements explanations. Future research
could suggest interventions that might make auditors more aware of this tendency in par-
ticularly technical applications such as FVMs.

Overconfidence
Overconfidence should also be considered in relation to the auditing of FVMs. As
discussed earlier in the paper, individuals tend to become more confident in their judgments
as more information is utilized in the decision, regardless of whether accuracy actually
improves (Slovic 1982; Paese and Sniezek 1991; Davies et al. 1994). When auditing FVMs,
auditors will often encounter extensive data and evidence that can be used to support or
refute managements assertions.13 They must guard against the tendency to be overconfident
when so much information does not really improve accuracy.
Overconfidence that results from too much information is not the only concern for
auditors. Hunton et al. (2004) suggest that financial auditors may be overconfident in their
ability to assess the risks associated with an ERP system relative to IT specialist auditors.
Applying this finding to the context of auditing FVMs suggests that auditors may sometimes
over-rely on their own expertise instead of using a specialist. Such overconfidence would
clearly inhibit audit effectiveness. Interestingly, Taylor (2000) indicates that non-banking
auditors were appropriately less confident in their risk assessments regarding banking-
specific accounts than were banking auditors. The differences between the results of Hunton
et al. (2004) and Taylor (2000) have not yet been resolved, so the importance of overcon-
fidence for auditors and policy makers is still open to debate.

CONCLUSIONS AND IMPLICATIONS

As discussed previously, much of the difficulty in auditing fair value measurements is
that such measures frequently incorporate estimates of future events and conditions (e.g.,
amount and timing of cash flows, discount rates, etc.), so an element of judgment is always
involved. Although no research specifically addresses the audit of FVMs, psychology re-
search addresses two questions of obvious importance to such estimates. First, whether
individuals are capable of making appropriate predictions and, second, whether such pre-
dictions can be improved.

13
Even the sheer complexity of some FVM estimates or appraisal reports may make auditors overconfident because
of an awe factor, something not previously examined in this body of literature.

Accounting Horizons, September 2006

300 Martin, Rich, and Wilks

Auditors would prefer answers to the first question because their task is to verify the
appropriateness of managements FVM. However, assessing the appropriateness of any
particular FVM is very difficult. Even after the future events and conditions occur, un-
expected outcomes could be due to inappropriate judgments being made when estimating
FVMs or due to low probability events occurring by chance. Nonetheless, a great deal of
psychological research investigates human judgment after the outcomes are known. We
attempt to draw from this vast literature to highlight prominent decision strategies that are
likely to create biases and limitations in the preparation of FVMs. We believe that when
armed with knowledge of how management may intentionally or unintentionally introduce
error into their FVMs, auditors will be better able to take steps to adjust for this error. In
the short run, professional skepticism appears to be the auditors best means of combating
these problems. For example, disconfirming managements estimates by explicitly consid-
ering the appropriateness of other models or input values used in reaching the FVM helps
mitigate confirmation bias. Further, auditors can attempt to gain additional assurance by
obtaining evidence from sources outside of the traditional accounting information system
(Bell et al. 2005).
However, auditors must also take steps to obtain necessary knowledge of FVMs to
effectively reach appropriate levels of assurance over managements estimates. We note that
the requisite knowledge to audit FVMs is likely difficult to gain and maintain and is largely
lacking from current auditor education and training. Educators can contribute by evaluating
whether and how to incorporate valuation issues into university accounting curricula. But
even with an increased understanding of basic valuation issues by auditors, the specialized
knowledge necessary to effectively evaluate managements FVMs may require use of FVM
specialists and/or a restructuring of audit teams. Additionally, auditors are likely well po-
sitioned to collect and analyze fair value information from their clients to develop data-
driven models for making and evaluating FVMs. These more formal, statistical models have
the potential to mitigate or eliminate many common forecasting errors.
In conclusion, the trend toward more consistent recognition of fair values poses a
challenge to audit standard-setters and practitioners; however, it also poses a great oppor-
tunity for audit researchers. Research is needed that investigates how and how well FVM
experts make their judgments. As this understanding is gained, decision aids such as sta-
tistical models can be developed to improve FVMs. Additionally, the sheer quantity of
FVM data obtained by audit firms in the course of the audit presents opportunities for data
mining to create alternative methods for gaining assurance as to the appropriateness of the
FVMs.

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