You are part of the audit team that is auditing Happy Chicken, Inc., a company that franchises Happy Chicken family restaurants. During the current year, management of Happy Chicken purchased for $2 million one of its franchised locations, a store that was having financial difficulties. In performing its analysis for impairment of assets at year-end, management of Happy Chicken determined that the carrying value of the asset may not be recoverable. As a result, management developed an estimate of the fair value of the location using a discounted cash flow model. The estimated fair value of the location was determined to be $1.5 million, which resulted in an impairment loss of about $500,000. The undiscounted future cash flows are equal to $1.7 million.
a. State why the audit of fair values is often difficult.
b. Describe how you might approach the audit of the impairment loss in this situation.
c. If you decide to use the work of a valuation specialist to audit the estimate of fair value, describe your responsibilities with respect to using the specialist’s work.
d. List two significant assumptions that you would expect to underlie Happy Chicken management’s estimate of the fair value of its recently purchased franchise location.
e. For the significant assumptions that you identified in (d), describe the types of evidence that you would expect to examine in order to support those assumptions.