In April, the Securities and Exchange Commission released proposed Rule 2a-5 under the Investment Company Act of 1940, which addresses valuation practices and the relative role of the board of directors for registered investment companies and business development companies. The comment period for this proposed rule ran through July 21, and from all accounts, there was much interest in the topic from directors and their legal representatives.
Generally, the proposed rule provides structure relative to directors' statutory obligation to provide adequate oversight of the fair value process and covers the following topics:
- Valuation risks
- Fair value methodologies
- Testing of fair value methodologies
- Pricing services
- Fair value policies and procedures
The dust is still settling from the rule proposal and comment process. And while there is no indication as to ultimately what form the rule will take, it seems certain there will be changes, as the SEC has indicated this rule is a priority. We would like to take this opportunity, as auditors and fellow gatekeepers, to point out some striking similarities to audit rules and practice aids that have been implemented relative to the topics of fair valuation methodologies, testing of fair value methodologies and pricing services. These similarities may be useful for fund directors to consider as the structure of their obligations evolves.
Fair Value Methodologies
As part of their oversight, directors would be responsible for considering whether the fair value methodologies of the issuer are appropriate and consistently applied in accordance with Financial Accounting Standards Board Topic 820, Fair Value Measurement. This consideration would include evaluating key inputs and assumptions for each asset class as well as considering methodologies to apply to new investments the issuer expects to purchase.
Implicit in this directive is the expectation that the directors responsible for oversight have detailed knowledge of Topic 820. As a director, do you know Topic 820 well enough to be able to use it as a barometer for whether or not your issuer's fair value measurement policies are appropriate? Perhaps this is a good time for a Topic 820 refresher.
Topic 820 generally defines fair value, sets out a framework for measuring fair value, and requires certain disclosures about fair value measurements. Certainly, understanding the definition of fair value and the framework for measuring it are relevant given the proposed rule's responsibilities for directors.
Fair value is defined as "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."
Monitoring the application of this definition is pretty straightforward when it comes to liquid assets with available market quotes but can become more complex with difficult-to-value investments. And while there is obviously no specifically prescribed method for valuing every asset type, there is a framework offered through Topic 820 that could prove helpful for directors responsible for oversight of those more complex valuations.
Topic 820 notes that when a price for an asset or liability is not observable, the issuer should focus on using another valuation methodology which maximizes the use of relevant observable inputs while considering assumptions a market participant would use when pricing. It then goes on to offer three widely used valuation approaches to be used either alone or in conjunction with one another:
- Market approach — uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.
- Cost approach — the amount that would be required currently to replace the service capacity of an asset or liability.
- Income approach — value indicated by current market expectations about future amounts (for example, cash flows or income and expenses) that are discounted.
Consistent with the proposed rule, Topic 820 also stresses the importance of the consistent application of fair value techniques tempered with the recognition that a change in technique can be warranted if the change would result in a measurement most representative of fair value.
Testing of Fair Value Methodologies
Part of understanding the appropriateness of a fair valuation methodology is monitoring how it is performing. And so, as directors are responsible for oversight of the fair valuation methodologies being used, they will also be responsible for oversight of their testing. While recognizing that the type of testing and frequency will depend on various circumstances, there is a requirement in the proposed rule that the type of testing and frequency be specifically identified, presumably by investment type or class.
Auditors recently have been afforded guidance from the Public Company Accounting Oversight Board which, in part, provides specific requirements and direction relevant to auditing fair value measurements. PCAOB Auditing Standard No. 2501- Auditing Accounting Estimates, Including Fair Value Measurements ("AS No. 2501") will take effect for audits for fiscal years ending on or after December 15, 2020. An auditor must understand and assess the application of fair valuation methodologies as part of their audit work, and so the same concepts and considerations included in this auditing standard would seem relevant to directors as they consider how best to test the appropriateness of the issuer's fair valuation methodologies.
Generally, AS No. 2501 presents a two-pronged approach for auditing fair value measurements:
- Identifying and assessing the risk of material misstatement.
- Performing procedures to determine if the auditor has sufficient appropriate audit evidence.
While directors are not obligated to identify and assess the risk of material misstatement in the proposed rule, the second prong of this standard would seem extremely relevant to the testing of fair value measurements. The auditing standard also notes that in order to obtain sufficient appropriate evidence, the auditor must have information that is both reliable and relevant. One or the other is not sufficient.
Along with the new standard, the PCAOB issued staff guidance which provides insight for auditors and specifically identifies certain testing approaches which may be used alone or in combination. Those approaches are:
- Testing the company's process used to develop accounting estimates — includes analyzing the methodology employed for valuing investments considering the investments and the reporting standards, testing certain data used in the computation of fair value whether sourced internally or externally and understanding and evaluating the reasonableness of significant assumptions used.
- Developing an independent expectation for comparison to the company's estimate — using some or all of its own data, estimates and assumptions the auditor develops as its own estimate of fair value for comparison to that of the issuer.
- Evaluating audit evidence from events or transactions occurring after the measurement date related to the accounting estimate for comparison to the company's estimate — this testing approach makes use of hindsight to analyze the issuer's fair value measurement. If the goal of fair value is to produce an exit price and subsequent to the measurement date there is a transaction that occurs, then logically that transaction should be considered as part of audit evidence. The proposed rule alludes to this concept as back testing.
In many cases, pricing services are used by issuers to value investments. As part of the fair value process, pricing services therefore also fall under the supervision of directors as part of the proposed rule. Specifically, the proposed rule requires a process be established for approval, monitoring and evaluation of each pricing service provider.
Topic 820 recognizes the appropriateness of using quoted prices from pricing services if the issuer has determined that the prices being provided are consistent with the tenets of fair value. It does, however, note that the issuer has responsibility for monitoring the underlying information used to provide pricing, such as whether the prices are the result of current information reflecting orderly transactions or a valuation technique meant to reflect certain market participant assumptions.
Specific to pricing services, AS No. 2501 applies the same consideration of relevance and reliability for determination of whether or not there is sufficient appropriate evidence as follows:
- Evaluate the expertise of the pricing vendor.
- Evaluate the methodology being used compared to the financial reporting framework.
- Evaluate for potential conflicts of interest between the issuer and the pricing service.
- Evaluate the expertise of the pricing vendor.
- Are the values based on quoted prices in active markets?
- When values are based on comparables, consider how the comparables are identified and the validity of the transactions?
- When values rely heavily on unobservable inputs, how is the instrument valued and what assumptions are being used?
- Are the values based on quoted prices in active markets?
The standard also notes that in situations when there are multiple pricing service providers offering similar consistent quotes on a given security, the auditor may take comfort from the consistency and that generally less information is needed about the inputs and methods being used.
While one certainly would expect that the final rule ends up being less prescriptive than its original proposed form, it does appear certain that there will be more structure around the expectations of directors relating to valuation of investments. One can only assume this will be used in the future as a measuring stick of the adequacy of oversight by the regulators. Given some of the requirements put forth in the proposed rule, the recent evolution of accounting and auditing standards relevant to fair valuation, and the intertwined paths the regulators seem to be weaving relative to rules for gatekeepers, it would seem prudent for a director to have an understanding of Topic 820 and AS No. 2501.
It's worth noting that the above is only a summary of certain points included in the standards and much more can be learned with a thorough reading. And at the very least, that reading might help to engage the auditor and directors in a healthy discussion about fair value measurements. And who doesn't want that?
John Braun is an audit partner with BBD and specializes in serving investment companies, including mutual funds, ETFs, closed-end funds, interval funds, as well as private funds.