Most Level 2 investment balances rest on a price somebody else produced: a pricing service feed, a custodian statement, or a broker quote. The client's number is only as good as that source, and the auditor cannot accept a custodian statement as proof of value without knowing how the price was built. This post covers what to evaluate about a pricing source, how to compare several, what stale prices look like, and what the file needs to show. For Level 3 measurements, where inputs are unobservable, see ASC 820 Level 3 valuation audit procedures; the hierarchy itself is in ASC 820 fair value measurement.
What do the standards say about third-party prices?
PCAOB AS 2501 Appendix A is the most detailed text. It requires the auditor, when using pricing information from a third party, either to develop an expectation or to evaluate pricing information used by the company, to perform procedures to determine whether the information provides sufficient appropriate evidence (.A2). It addresses two sources: pricing services (organizations that routinely provide uniform pricing to subscribers) and brokers or dealers (.A3). The AICPA's AU-C 540 does not repeat this appendix, but its requirements to test methods, significant assumptions and data (.22 to .24) and to obtain evidence that data is relevant and reliable apply to the same price when it is the data behind an estimate.
How reliable is a pricing service?
Under AS 2501.A4, the reliability of a service's prices depends on:
- the service's experience and expertise with the type of instrument, including whether it routinely prices it;
- whether its methodology conforms with the applicable framework; and
- whether management can directly or indirectly control or significantly influence the service. The note ties this to related-party procedures.
If the auditor tests a service at an interim date, the auditor evaluates whether the service changed its valuation process for the type of instrument and, if so, the effect at period end.
Relevance (.A5) depends on whether fair values come from quoted prices in active markets for identical instruments; when from transactions in similar instruments, how those are identified and judged comparable; and when there are no recent transactions or the price is a broker quote, how the fair value was built and whether the inputs reflect market participant assumptions.
Two further requirements follow. When prices rest on transactions in similar instruments, the auditor performs additional procedures on the service's process, and for a group priced by one process, the work can be done by group if the instruments are similar (.A6). When no recent transactions exist for the instrument or similar ones, the auditor evaluates the valuation method and the reasonableness of observable and unobservable inputs (.A7).
When can multiple pricing services reduce the work?
Paragraph .A8 says less information about each service's methods and inputs is needed when all four conditions hold: there are recent trades of the instrument or substantially similar ones; the type is routinely priced by several services; prices are reasonably consistent across services given the instruments and market conditions; and prices are generally based on observable inputs. If the conditions are not met, the auditor evaluates the valuation method and inputs for a representative price.
How are broker quotes evaluated?
Paragraph .A9 lists the factors: whether the broker has a relationship with the company that lets management influence it; whether the broker is a market maker in the same type of instrument; whether the quote reflects market conditions at the statement date; whether it is binding; and whether it carries restrictions, limitations or disclaimers. The note says quotes are generally more relevant and reliable when timely, binding, unrestricted, and from unaffiliated market makers in the same instrument type; if the quote falls short, the auditor obtains pricing information from another source.
Worked example
A company holds a $1,000,000 face-value corporate bond classified as Level 2. At year-end it recorded the price from its pricing service, 98.25, or $982,500. The auditor gets a second service price and a broker quote:
| Source | Price | Value of $1,000,000 face | Difference from recorded |
|---|---|---|---|
| Service A (recorded) | 98.25 | $982,500 | |
| Service B | 98.40 | $984,000 | +$1,500 |
| Broker quote, indicative, dated 3 days before year-end | 97.10 | $971,000 | $(11,500) |
The two services are 0.15 points apart, $1,500 on this position, which is consistent. The broker quote is 1.15 points below the recorded price, $11,500. The auditor does not average the three. The questions are: is the broker a market maker in this bond? Is the quote binding or indicative? Does it carry a disclaimer? Does it reflect the year-end date, or three days earlier, when conditions may have differed? If the quote is indicative, non-binding and dated before the statement date, it carries less weight under .A9 and the corroborating pair of services supports the recorded value. If a market maker's binding quote at the statement date were 97.10, the auditor would have to understand why the services disagree, for example a stale input or a model assumption.
Scale matters. If the portfolio holds 40 similar bonds and the recorded prices run 1.15 points high on all of them, the exposure is 40 x $11,500 = $460,000 at $1,000,000 face each, not $11,500. Extend the comparison to a sample across the portfolio.
What do stale prices look like?
- A price identical to the prior period or flat for weeks on an instrument that normally moves.
- Prices equal to cost or par on instruments that have traded elsewhere at a discount.
- A price date earlier than the statement date, or a price from the next business day used for a weekend statement date without explanation.
- A service flagging an instrument as "matrix priced" or "evaluated" where the company's records say "quoted."
- Large differences between sources for instruments from the same issuer or structure.
- Custodian prices defaulting to last known when the pricing feed fails.
Procedures
- Identify the population and classification. Agree holdings to custodian confirmations or statements and agree each instrument's level in the hierarchy to the company's documentation.
- Understand the source. For each pricing service, obtain its methodology description and evidence of its experience with the instrument type. Document the related-party assessment.
- Obtain independent prices for a sample, ideally from a second service the company does not use, and compare to recorded prices with a tolerance set in advance.
- Investigate differences beyond the tolerance. Ask the service or the company's valuation group how the price was built and whether inputs were observed at the statement date.
- Test the classification of instruments with thin trading, since a Level 2 label with no observable inputs is a disclosure error.
- Check price dates and stale indicators by running the whole price file for repeats and gaps.
- Read broker quote terms, including disclaimers.
- Test controls over price loads, overrides and exceptions. Overrides of a service price by management need documented support. Price files the company extracts for you need accuracy and completeness procedures before you rely on them.
- Evaluate disclosure of valuation techniques and inputs for Level 2.
Documentation
Record the sources, the sample, prices compared, the tolerance, differences and their resolution, the evaluation of each broker quote against the .A9 factors, and the conclusion on sufficiency of the evidence. Include the pricing service methodology document and the price date for each instrument.
Sources
- PCAOB, AS 2501, Auditing Accounting Estimates, Including Fair Value Measurements, Appendix A paragraphs .A2 to .A9: https://pcaobus.org/oversight/standards/auditing-standards/details/AS2501
- AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures, paragraphs .22 to .24: https://www.aicpa-cima.com/resources/landing/aicpa-professional-standards
- FASB, Accounting Standards Update 2018-13, Fair Value Measurement (Topic 820), Disclosure Framework (paragraph 820-10-50-2(bbb), valuation technique and input disclosure for Level 2 and Level 3): https://storage.fasb.org/ASU%202018-13.pdf
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