Outsourcing Fair Value Measurements
When using pricing services, companies often don’t know what inputs, models and judgments are used. These concerns are even more pronounced in volatile markets and when valuing instruments such as thinly-traded bonds, asset-backed securities and other structured products.
Historically investors relied on market makers and their related back office pricing services to provide indications of value for various securities, including debt and equity securities. In 2008, as markets became less liquid, the SEC Division of Corporation Finance sent a “Dear CFO” letter to certain public companies identifying a number of disclosure issues they may wish to consider in preparing Management's Discussion and Analysis. This letter included the following request:
- If you disclose that you use brokers or pricing services to assist you in determining fair values, consider explaining the extent to which, and how, the information is obtained and used in developing the fair value measurements in the consolidated financial statements. The nature and form of this information may vary depending on the facts and circumstances, but may include the following:
- The nature and amount of assets you valued using broker quotes or prices you obtained from pricing services, along with the classification in the fair value hierarchy;
- The number of quotes or prices you generally obtained per instrument, and if you obtained multiple quotes or prices, how you determined the ultimate value you used in your financial statements;
- Whether, and if so, how and why, you adjusted quotes or prices you obtained from brokers and pricing services;
- The extent to which the brokers or pricing services are gathering observable market information as opposed to using unobservable inputs and/or proprietary models in making valuation judgments and determinations;
- Whether the broker quotes are binding or non-binding; and
- The procedures you performed to validate the prices you obtained to ensure the fair value determination is consistent with SFAS 157 (now known as FASB ASC 820), Fair Value Measurements, and to ensure that you properly classified your assets and liabilities in the fair value hierarchy.
Because of the impact of the financial crisis and less transaction data the Financial Accounting Standards Board modified SFAS 157 (ASC 820) to provide guidance for situations where access to pricing data was limited or not available in 2009. FASB ASC 820 paragraph 820-10-35-54 L states: If there has been a significant decrease in the volume or level of activity for the asset or liability, a reporting entity shall evaluate whether the quoted prices provided by third parties are developed using current information that reflects orderly transactions or a valuation technique that reflects market participant assumptions (including assumptions about risk).
While market conditions have improved, in early 2011 the Public Company Accounting Oversight Board’s (PCAOB) Standing Advisory Committee formed a taskforce to focus on the extent to which auditors were evaluating management’s reliance on pricing services to determine fair value. On December 5, 2011, at the AICPA National Conference on Current SEC and PCAOB Developments, Jason K. Plourde, Professional Accounting Fellow, of the SEC Office of the Chief Accountant made the following key points with respect to pricing services:
Does management have sufficient information about the values provided by pricing services to know that we’re complying with GAAP?
Has management adequately considered the judgments that have been made by pricing services in order to be comfortable with management’s responsibility for the reasonableness of such judgments?
Does management have a sufficient understanding of pricing services sources of information and the processes used to develop it to identify risks to reliable financial reporting?
Has management identified, documented, and tested controls to adequately address the risks to reliable financial reporting?
It is clear that both the SEC and the audit community will be applying greater scrutiny to the use of pricing services to estimate Fair Value. At a minimum, management must understand the nature of inputs and calculation methodology of their pricing services. Such understanding could be obtained through extensive due diligence and ongoing monitoring. However, because of the need for management to validate and document that their pricing services are using appropriate inputs and models, it may prove more cost-effective for management to establish their own models for securities that trade infrequently or not at all.
Management can enhance their internal control processes through the use of an independent valuation expert such as Kroll. Kroll provides technical skills and sound advice that can assist management validation of pricing service practices and inputs for more liquid securities. Further, Kroll Alternative Asset Advisory team can enhance a company's internal control system by contributing an independent assessment of the reasonableness of management's estimate of value and can also assist in the design and review of management’s valuation procedures. In addition to providing market-based guidance on valuing complex and illiquid securities, the Portfolio Valuation team can help ensure that management’s fair value procedures are compliant with standards set by GAAP, and that are expected by the SEC and auditors.
Click here for complete remarks by Jason K. Plourde, Professional Accounting Fellow, Office of the Chief Accountant, U.S. Securities and Exchange Commission.