Accurate asset valuation is a cornerstone of trustworthy financial reporting. Valuation missteps can carry significant legal, reputational and financial consequences. A recent study of securities action lawsuits underscores these consequences. Here’s an overview of the study’s findings, including the types of assets prone to valuation errors, and some guidance for complying with today’s accounting rules.
Recent class action filing trends
Litigation support service provider Cornerstone Research has studied the sources of securities class action filings for the last 30 years. From 2010 to 2023, revenue recognition was the top alleged violation of U.S. Generally Accepted Accounting Principles (GAAP). But its latest report, “Accounting Class Action Filings and Settlements — 2024 Review and Analysis,” reveals that asset valuation and impairment issues were the main accounting allegations last year. This shift reflects a broader awareness of the impact and subjectivity of asset valuations.
The report also found that the median pre-disclosure market capitalization of defendants in accounting case filings declined for the fourth consecutive year. This suggests that accounting-related class actions are increasingly targeting smaller companies. While most securities class actions target public companies, private entities may also face legal or financial consequences from private investors, lenders and regulators.
Why asset valuation matters
While all asset classes may be subject to valuation risks, certain types have historically proven more complex and error-prone, including:
- Inventory,
- Receivables and loans,
- Property, plant and equipment (PPE) and other long-lived assets,
- Investments, such as marketable securities and private equity holdings, and
- Goodwill and intangible assets.
Errors — whether intentional or due to poor judgment — can mislead stakeholders, obscure underlying risks and invite regulatory scrutiny. In the context of public companies, such inaccuracies can lead to restatements, share price volatility and securities class actions. For private businesses, they may result in investor distrust, loan covenant breaches and trouble securing capital.
Fair Value Hierarchy
Under GAAP, assets are generally reported at the lower of cost or market (net realizable value). However, the accounting rules increasingly emphasize “fair value” reporting. This approach requires updated estimates based on market participant assumptions, not internal or arbitrary benchmarks.
Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures, defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly market transaction, as opposed to a fire sale or other unusual circumstance.” Fair value measurements are separated into the following three-tier hierarchy depending on the judgment used:
- Level 1: Quoted prices in active markets for identical assets,
- Level 2: Observable inputs for similar assets, including older prices from inactive markets and quoted prices of comparable assets, and
- Level 3: Nonpublic information and management’s estimates.
When second and third-tier inputs are used to value assets, estimates require detailed documentation, assumption testing and disclosure. Inputs without adequate disclosures or support can raise red flags. Valuation professionals or other specialists may be brought in to help validate assumptions, perform discounted cash flow analyses and benchmark fair values against industry data. Their expertise is particularly valuable when judgment plays a significant role, such as allocating purchase price in a merger and valuing intangible assets.
A disciplined approach
To comply with GAAP and avoid costly consequences, companies must have robust valuation processes in place. This begins with establishing clearly documented policies for valuing each type of asset that define:
- How is fair value determined?
- How often should valuations be updated?
- What methods are used to identify potential impairment triggers, such as changes in market conditions, significant operating cash flow reductions, the loss of key customers, and legal or regulatory changes?
Applying these policies consistently across business units and reporting periods enhances audit readiness and financial credibility.
Strong internal controls are also essential. Management must document and review the assumptions underlying asset valuations, such as discount rates, growth projections and cash flow forecasts. This documentation may be evaluated during audit fieldwork and used to craft transparent financial statement disclosures. It can also be critical evidence in litigation or enforcement actions.
Get it right
The recent uptick in claims alleging inaccurate asset valuations among public companies is a reminder that valuation errors aren’t just technical accounting issues. In an environment where stakeholders expect timely, transparent and accurate reporting, business leaders should work with their CPAs to proactively assess areas where existing asset-valuation practices may fall short. In doing so, they can protect the integrity of their financial reporting and minimize the risk of costly stakeholder litigation and other adverse consequences.
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