For Fair-Value Measurements, Third-Party Pricing Alone Won't Do

Regulators are dropping a hammer on fair-value measurements that rely too readily on third-party pricing, forcing management and auditors to take a closer look at what's behind the numbers.

The Securities and Exchange Commission and the Public Company Accounting Oversight Board turned up the volume on their warnings to management and auditors on how to properly account for and audit fair value measurements that rely on broker quotes or outside pricing or valuation service providers. In a recent speech, Jason Plourde, a professional accounting fellow at the SEC, said preparers are skirting accounting and disclosure requirements, their duty to maintain adequate books and records, and their duty to maintain internal control over financial reporting when they simply lift a price out of a broker quote or a valuation report and transfer it to their books.

The SEC and PCAOB are especially paying attention to fair-value measurements that are based in whole or in part on assumptions and estimates that may not be visible to investors, which often occurs when a given financial instrument is not frequently traded in an open market. When a pricing service or a broker gives a company a price based on such assumptions and estimates, it's up to management to vet those judgments and take ownership of them, Plourde said. “If the pricing service only provides a price for a given CUSIP [an identification number for a given security] with no information about the models or assumptions used to price it, management may not have enough information to assess the appropriateness of that price,” he said.

Mark Shannon, an associate chief accountant at the SEC, told the audience at a recent accounting conference that if a fair-value measurement appears to have a significant impact on financial statements or management discussion and analysis, the staff will comment on it. According to analysis by Audit Analytics, fair-value measurement has ranked as the top issue explored by the SEC comment process in every year since 2006, except in 2010 when it fell behind executive compensation.

Preparers that use a pricing service should be prepared for a litany of questions from the SEC. “We might question whether or not the registrant uses a pricing service,” said Shannon. “If the answer is yes, how do you evaluate the appropriateness of the models used by pricing services? How do you evaluate the accuracy and completeness of the data? And is it observable? Depending on the response, we may ask how the registrant assures it is complying with GAAP and how it assesses internal control over financial reporting with respect to those points.”

The PCAOB has flagged fair-value measurement and the use of pricing services so frequently in audit inspections that it formed a task force in 2011 to explore the audit challenges and determine whether more guidance might be in order. PCAOB member Jay Hanson said during the same accounting conference that auditors probably do indeed need more guidance in this area. “As a board member, we spend a lot of time dealing with findings in inspections,” he said. After seeing enough concerns raised over this particular issue, “I posed the question: Does anybody get this right? The answer is yes, there are some teams that get it right. So that tells me at least it's possible.”

Cindy Ma, managing director and co-head of portfolio valuation at investment banking firm Houlihan Lokey, says it used to be common practice to rely on broker quotes or pricing services to establish fair values, but that was before trading thinned out for complicated instruments and before market volatility became the norm. Now that management needs its own independent understanding of assumptions and estimates underlying pricing, a broker quote may not be a fully reliable source, she says. As an example, if a company wants to rely on a counterparty price for a derivate instrument in a hedge transaction, that price may be based on assumptions or business interests the counterparty won't want to share.

FAIR-VALUE CONSIDERATIONS

Below is an excerpt from SEC Professional Accounting Fellow Jason Plourde's speech before the 2011 AICPA National Conference on current SEC and PCAOB developments:

Compliance with GAAP

In markets where securities are not actively traded, pricing services may make assumptions about inputs that market participants would use to price securities, including assumptions about what securities are similar for the purposes of using observable inputs to price securities that are not as actively traded. Management may need to perform different procedures and controls when considering the information obtained from pricing services regarding the fair value of financial instruments, than the types of controls it performs when considering information obtained from other specialists, such as those that provide information about the fair value of intangible assets in business combinations or about pension liabilities. For example, management may be more involved in the initial determination of assumptions used by an actuary to value its pension liability than in determining the assumptions that are used to value a financial instrument. Further, there may be more information routinely provided by other specialists such as actuaries regarding their methodology. Existing financial statement disclosure requirements in these areas may require management to reveal more detailed disclosures about assumptions and inputs than it would in the fair value context. For example, the discount rate and the expected long-term rates of return on plan assets for a pension liability are required to be disclosed.

In determining compliance with GAAP, if management includes information from a third party pricing service to inform developing its estimate, it may need to consider the extent of its understanding of the pricing service's valuation techniques, assumptions and other inputs depending on, for example, the significance and complexity of its securities positions and the other procedures and controls it performs. For example, management may need to consider how the pricing service developed the assumptions and models used to assure that its fair value estimate is consistent with a market participant view and appropriately classified within the fair value hierarchy. If the pricing service only provides a price for a given CUSIP with no information about the models or assumptions used to price it, management may not have enough information to assess the appropriateness of that price to determine whether it is in conformity with GAAP. This point may be more important when the assumptions used could be within a wide range of estimates used by market participants. Further, caveats or disclaimers that the pricing service includes with its pricing information may affect the procedures management performs to evaluate that information.

Source: SEC.

John Keyser, a partner with McGladrey & Pullen and a member of the PCAOB's Pricing Sources Task Force, said task force dialogue has revealed that corporate investors can challenge pricing established by various pricing sources, and pricing sometimes changes as a result. “So that raises some eyebrows,” he says. “That raises a concern about the validity of those prices, so you need significant rigor on the part of management and auditors” to dig further into what underpins those prices and determine whether they can be relied on to form a GAAP-compliant fair-value measurement.

Based on the PCAOB's emphasis of late, companies can expect auditors to ask a lot more questions about management's fair value measurement process when it relies on prices from third-party sources, says Mike Santay, a partner with Grant Thornton who also serves on the task force. “How did you get comfortable with the pricing source and its credibility?” he said. “What methods were used? How did the company assure itself it has the proper controls and processes in place? There's an acknowledgment that pricing sources don't have perfect information.”

Pricing from third-party sources won't be perfect if it is based on few or no transactions, if it reflects a distressed sale, or if it is an instrument sold by only by a single broker, says David Larsen, managing director at valuation firm Duff & Phelps. “It's a delicate pendulum,” he says. “You don't want to put too much emphasis on limited trading data, but you don't want to ignore trading data. Based on the emphasis from the SEC and the PCAOB, best practice now is to take market information or a broker quote and augment it with a model.”

To satisfy the SEC that management has done more than blindly rely on a third-party price, Plourde said management should ask itself some basic questions: “Do we have sufficient information about the values provided by pricing services to know that we're complying with GAAP?” he asked. “Have we adequately considered the judgments that have been made by third parties in order to be comfortable with our responsibility for the reasonableness of such judgments? Do we have a sufficient understanding of the sources of information and the processes used to develop it to identify risks to reliable financial reporting? Have we identified, documented, and tested controls to adequately address the risks to reliable financial reporting?”

They are good questions for auditors to ask as well, Plourde added. “The answers to these questions may help to inform the auditor's assessment of the presence and severity of control deficiencies,” he said.