Mutual Fund Directors’ Forum · · 2017-02-02Mutual Fund Directors’ Forum ... Forward...

Mutual Fund Directors’ Forum

ACCOUNTING AND FINANCIAL REPORTING ISSUES ASSOCIATED WITH VALUATION

Deloitte & Touche LLP

1Copyright © 2008 Deloitte Development LLC. All rights reserved.

Agenda

Valuation Challenges & Issues in the Current

Environment

Fair Value Guidance

Best Practices From Fund Oversight

Appendix A – FAS 157 Disclosure Examples

Appendix B – Valuation Case Studies

Valuation Challenges & Issues in the Current Environment

2


Current Environment Affecting Valuation

Impact of Credit Crunch

Money Market Fund Challenges

Failing Auctions for Auction Rate Securities

Bond Insurer Difficulties

Increased Use of Derivatives

Investment Bank Failures


Valuation Challenges

Active vs. Inactive Market

Valuation of Derivatives

Changes in the Valuation Process

– Enhanced Documentation of Pricing Procedures

– Increased Use of Internal Modeling

– Authoritative Guidance

Counterparty Exposure

3rd Party Pricing Vendors


Valuation Trends

Deloitte‟s 2008 Fair Value Survey

– Gap between policies and procedures of large and small asset

managers continues to narrow

– FAS 157 has increased the transparency of the valuation process

– Pricing challenges continue to increase

– Development of models to supplement 3rd party information

– Valuation is an increased area of focus by regulators (SEC and PCAOB)

– Most participants have made changes to their fair value policies and

procedures

– Asset managers are committing more resources to the fair value

process

– Creation of a separate Fair Value Committee by boards

– Involvement of the board‟s Fair Value Committee in fair value

discussions on a “real time” basis

Fair Value Guidance

6


Fair Value Guidance

Fair Value

SEC

PCAOB

FASB

Center for Audit Quality, AICPA

Fair Value guidance comes from many places


Defining Fair Value

What is Fair Value?


Flurry of Recent Fair Value Guidance

SFAS 157 “Fair Value Measurements”– Issued September

2006

Center for Audit Quality White Paper – Fair Value in Illiquid

Markets – October 2007

PCAOB Staff Audit Practice Alert – December 2007

SEC Guidance

SEC/FASB Joint Press Release “Clarifications on Fair Value

Accounting” – September 2008

FASB FSP 157-3 “Determining Fair Value of a Financial

Asset When the Market for That Asset Is Not Active” –

October 2008


FAS 157 Definition of Fair Value

Fair value is the price that would be received to sell an asset

or paid to transfer a liability in an orderly transaction between

market participants at the measurement date.”

Exit price: Not necessarily the price paid for an asset (for example),

which is an entry price

Market participants: Buyers and sellers that are independent,

knowledgeable, able, and willing.

Skepticism of a risk averse buyer.

Fair value should reflect how market participants would value the asset,

even if market participants would use the asset differently than the

owner‟s intended use.


What is FAS 157?

Aimed at improving the consistency, comparability and

transparency of fair value measurements:

– Establishing a single authoritative definition of fair value (“exit price”)

– Establishing a framework for measuring fair value

– Expanding fair value financial statement disclosure requirements

No new fair value measurement requirements, simply

codified the meaning of fair value under GAAP


Fair Value Hierarchy

Inputs are directly or indirectly observable inputs (e.g. prices for similar instruments)

Evaluated price based on a model

Inputs are observable (spreads, ratings, credit analysis, industry and company performance)

Forward Currency Contracts, Senior Debt, Municipal Bonds

Level 2 Inputs

Inputs are unobservable and reflect the entity‟s own assumptions about assumptions that market participants would use, including assumptions about risk.

Internally developed assumptions

Private Equity Investments, Subordinated Debt, Structure Products, Long Dated Currency SWAPs, Halted Securities

Level 3 Inputs

Fair value based on quoted prices (unadjusted) in active markets for identical assets or liabilities

Exchange Traded Securities, U.S. Treasury Securities, G7 Government Securities

Broker Quote in an Active Market

Exchange Traded Derivatives

Level 1 Inputs


Challenges of FAS 157

Implementation Ongoing Administration

• Determining overall measure levels when many different types of inputs are used (i.e. 1, 2 and 3)

• Defining „active‟ market in relation to level 1

• MD&A discussion (SEC „Dear CFO Letter‟)

• Systems limitations

• Roll Forward disclosure of Level 3 Securities

• Understanding valuation methods and inputs used by pricing vendors and brokers

• Impact of single source securities and stale prices

• Monitoring thousands of security types

• Completeness of disclosure

• Ensuring communication among different support groups


Center for Audit Quality

Center For Audit Quality

– Fair Value White Paper Issued October 9, 2007

Discuss issues associated with the measurement of fair value under

existing generally accepted accounting principles (GAAP) in the context

of illiquid (or less liquid) market conditions that currently exist in many

segments of the credit markets


Public Company Accounting Oversight Board

What is PCAOB Staff Audit Practice Alert No. 2?

– Auditing Fair Value Measurements

– Interaction with FAS 157

– Using the work of a specialist

– Use of a pricing service

The Alert States“…if the price is not based on quoted prices from an active market or observable inputs (such as prices for similar assets), the auditor should obtain an understanding of the model and evaluate whether the assumptions are reasonable.”

Use of pricing service and broker quotes present various challenges


Securities & Exchange Commission Guidance

Investment Company Act of 1940

Additional SEC Guidance

– 1969, ASR 113 (Restricted Securities)

– 1970, ASR 118 (General Valuation Guidelines)

– 1999, No Action Letter (Emergency or Unusual Situations)

– 2001, No Action Letter (Foreign Securities)

– 2002, Lori Richards (Best Practices Speech)

Recent Guidance

– July 22, 2008, Dear CCO Compliance Alert

– SEC Speeches, Sweep Exams

– September 30, 2008 SEC/FASB Clarifications on Fair Value

Accounting


SEC / FASB Joint Press Release

SEC / FASB React To Credit Crisis

– Can management‟s internal assumptions (e.g., expected cash flows)

be used to measure fair value when relevant market does not exist?

– How should the use of “market” quotes (e.g., broker quotes or

information from a pricing service) be considered when assessing

the mix of information available to measure fair value?

– Are transactions that are determined to be disorderly representative

of fair value? When is a distressed (disorderly) sale indicative of fair

value?

– Can transactions in an inactive market affect fair value

measurements?

– What factors should be considered in determining whether an

investment is other-than-temporarily impaired?


FASB Staff Position 157-3

Proposed FSP on FAS 157 Released

– Same Themes from the Joint Press Release

– FAS 157-3, “Determining the Fair Value of a Financial Asset When

the Market for that Asset Is Not Active

How management‟s Internal assumptions are considered when

observable data does not exist

Observable market data in an inactive market

How market quotes should be used in determining fair value


Step 1

Establish roles and responsibilities over the valuation function

Step 2:Determine, assess and enhance the

appropriateness of the valuation policies and procedures and gain approval

Step 3:Determine the appropriate sources

(pricing services, brokers, management,etc.) for valuations

Step 4:Assess the controls over the valuation

function

Step 5:Establish level and frequency of oversight

and monitor activities

Step 6:Perform oversight and monitoring activities

Step 7:Revise elements of valuation function

as warranted

Oversight of Valuation Function


Is the source capable of providing a price today?

Identify another external source &

restart process

Use internal source & move to “Internal Source“ diagram

Is it an exchange-traded security?

Validate price

Gain understanding of how price was

determined:-Active market?-Liquid market?

- Observable inputs?

Compare to other sources

Consider issuer and security specific

data

Consider general market data

Yes

No

Yes

No

Are results satisfactory

?

Yes

No

Perform back-testing

Evaluate results

Identify additional sources and restart

process

Use internal source & move to “Internal Source” diagram)External

Source

Evaluate source‟s methodology

Compare to internal model

Consider need to revise policies &

procedures

Consider revising policies &

procedures

Use price

Valuation Procedures (External Source)


Obtain appropriate assistance to move

to “Yes” above

Does methodology conform to policies

& procedures?

Yes

No

Internal

Source

Are assumptions valid and

appropriate?

Yes

No

Perform back-testing

Request and obtain revised fair value estimate. Move to

“Yes” above

Are results satisfactory

?

Yes

No

Continue to use internal process as

necessary


procedures

Revise fair value methodologyIs the source

capable of providing a fair value estimate?

Use price


procedures

Valuation Procedures (Internal Source)

Appendices

23


Appendix A

FAS 157 Mutual Fund Disclosure Examples

– See Accompanying Handout


Appendix B

Valuation Case Studies


Case Study – Scenario 1

Vulture Bid/Vulture Transaction

– Fund holds Mortgage Backed Securities (MBS) valued at 100

– On Day 1, the fund learns that a hedge fund has expressed interest

at 60

– On Day 2, the fund learns that the hedge fund (HF) purchased similar

MBS from another fund at 70



Large Complex/Small Complex

– Large firm and small firm hold the same bonds

– Regular pricing service is unable to price

Prior day‟s price = 102

– Large firm able to use business contacts to obtain two broker quotes

(97 and 92)

– Small firm unable to obtain broker quotes and doesn‟t know what

large firm has obtained



Information from Competitor Fund

– Fund fair values defaulted bond at 89

– Very little information about the bond available

– Fund learns that a competitor is fair valuing the same bond at 84



Discovery of Possible Fraud

– Noon Tuesday, company‟s offices raided by the FBI

Before raid, the company‟s stock was trading at 100

Following raid, the stock plummets

Trading of the stock was halted at 2 p.m. – last trade at 80

– 10 a.m. Wednesday, CFO indicted for financial fraud

– Noon Wednesday, stock trades at 65



Insured Bonds

– Municipality issues two series of bonds, one insured and one

uninsured

– Fund owns both issues

– Due to general market concerns about bond insurers, insured bonds

trade at lower price than uninsured



Use of Vendor Prices

– For past ten days, bonds priced by vendor at 82

– On Wednesday, fund learns about significant capital infusion into

issuer of bond by an independent third party

– On Thursday, vendor price still at 82

– On Friday, fund sells half its position at 95; vendor provides price of

88



Use of Broker Quotes

– Only consistent pricing source is a broker

– On Monday, broker provides price of 90

– No price provided on Tuesday

– On Wednesday, broker provides price of 90; second broker provides

price of 80

– On Thursday, broker provides price of 85; second broker does not

provide a price



Valuation Committee Availability

– Fund has a three person valuation committee; “GC” acts as their

adviser

– On Tuesday, significant credit event occurs affecting a fund holding

– Pricing service does not provide price

– Only one member of committee is available, along with “GC”



Foreign Trading Limits

– Fund owns illiquid “free shares” of foreign company

– Company announces positive earning surprise before market opens

Local shares open 10% higher and halt trading due to a local trading limit

– Fund unable to sell free shares

– Fund prices holdings 10 hours after local market closes



Foreign Holiday

– Fund owns stock trading on London Stock Exchange (LSE)

– On April 21, fire destroys company‟s main plants

– LSE closed for holiday, US markets open

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