The Financial Accounting Standard Board’s Accounting Standards Codification Topic 820, Fair Value Measurement, (ASC 820) provides a framework for measuring or estimating the fair value of certain assets and liabilities. It provides a hierarchy with three levels that are differentiated by the inputs used to derive estimates. Level 1 valuations are based on quoted prices in active markets for identical assets or liabilities. Level 2 valuations are based on directly or indirectly observable market data for similar or comparable assets or liabilities. Orderly transactions between market participants may not be observable at the valuation date; therefore, Level 3 valuations are based on management’s judgments and assumptions about unobservable inputs. While standard setters and most users believe an appropriately developed Level 3 valuation provides valuable information and is better than the alternative (e.g., possibly irrelevant historical value), some critics of Level 3 valuations refer to such valuations as being marked to “make believe.”1 There are a number of valuation models that are commonly used for Level 3 measurement: stock option pricing models (e.g., the Black Scholes model), discounted cash flows method, discounted dividend method, and others. Even though some inputs into these models could qualify for Level 1 or Level 2 treatment, the overall model and the related asset or liability being estimated would be considered a Level 3 model/valuation if any of the significant inputs are unobservable because the level of the asset or liability is determined based on the lowest level input. In the next section you will find a dialogue between an audit manager and an audit senior discussing the fair value method and assumptions used by audit client Morris Mining Corporation to form a fair value estimate. Morris Mining, Corp., with a fiscal year-end of December 31, owns and operates mining facilities in the U.S. and Canada and distributes various extracted ores and minerals to customers throughout the world. In January 2019, Morris Mining acquired another mining company called King Co. The acquisition is expected to be synergistic, as the location and nature of King’s operations fit well with Morris Mining’s longterm strategy. The combined firm controls greater market share in key ores and minerals and some redundant overhead costs can be streamlined to improve overall profitability. According to valuation analyses conducted by Morris Mining and its advisors in preparation of the acquisition, the purchase price will exceed the value of identifiable net assets. As a result Morris Mining will record goodwill and the identifiable assets and liabilities of King Co. will be recorded on the books of Morris Mining at fair value. One of the assets that will require fair value measurement is a patent that King Co. was granted two years ago. King Co. engineers developed and patented the design for a new mining machine that significantly improves mining efficiency. The patent obtained by King Co. gives the company the right to exclude others from commercial exploitation of the invention for a period of 20 years. King Co. developed some prototypes of the new mining machine, the “Extract-o-Matic 1000,” and then entered into an agreement with a manufacturing firm called Build-IT, Inc. The agreement gives Build-IT the exclusive rights to manufacture and sell the Extracto-Matic 1000 machines for a period of 12 years. In exchange, King Co. receives a yearly royalty payment in the amount of 10 percent of the revenue from sales of the Extract-o-Matic 1000. After acquiring King Co., Morris Mining is now the legal patent holder and as such is entitled to receive the royalty payments. Sales of the Extract-o-Matic have gone well, as the machines allow mines to significantly reduce the amount of waste during the mineral extraction process. In fact, Morris Mining purchased one of the machines before the acquisition, and it is performing as promised.

REQUIRED 

[1] What is the definition of fair value according to ASC 820? Do you believe the discounted cash flow method is capable of computing an estimate that would be considered a reasonably reliable fair value for the patent held by Morris Mining? Why or why not? 

[2] Should Gabriela and Rob be concerned about the fair value estimate Morris Mining has computed? Why? What incentive does the company likely have in terms of valuing the patent (over or understatement)? Explain your answer. 

[3] Research auditing standards and describe the typical procedures that an auditor would perform in auditing a fair value estimate such as the value of Morris Mining’s patent. Is the patent a Level 1, Level 2, or Level 3 fair value asset? Why? 

[4] Examine the 10-year discounted cash flow analysis provided by the client in Appendix A and also available electronically at www.pearsonhighered.com/beasley and verify that the model is producing a mathematically sound fair value estimate based on the inputs used by Morris Mining. Assuming planning or performance materiality for Morris Mining is $10 million, answer the following questions: 

[a] How sensitive is the fair value estimate to changes in the discount rate? How much would the discount rate estimate have to change for it to have a material impact on the financial statements? 

[b] How sensitive is the fair value estimate to changes in the estimated growth rates? How much would the estimated growth percentages have to change to have a material impact on the fair value estimate? Do rate changes in early years or later years have a larger impact? Why? [5] Now, assuming planning or performance materiality at Morris Mining is $600,000, answer the following questions.  

[a] How sensitive is the fair value estimate to changes in the discount rate? How much would the discount rate estimate have to change for it to have a material impact on the financial statements? 

[b] How sensitive is the fair value estimate to changes in the estimated growth rates? How much would the estimated growth percentages have to change to have a material impact on the fair value estimate? Do rate changes in early years or later years have a larger impact? Why? [6] What are the most significant audit risks associated with the fair value estimate of the patent? Assuming performance materiality of $600,000, what additional steps can the auditor take to improve the sufficiency and appropriateness of the evidence gathered to support the fair value estimate for the patent? 

It is recommended that you read the Professional Judgment Introduction found at the beginning of this book prior to responding to the following question. 

[7] A great deal of judgment often is required when estimating fair values, and sometimes a "reasonable range" for the possible estimate value is very large relative to materiality. Considering the sensitivity highlighted in question 4, what implications do the estimate's sensitivity to small changes in input values, and the related judgments and potential biases, have when it comes to auditing fair value estimates?