GASB Fair Value: Lessons Learned

Transcription

1 GASB Fair Value: Lessons Learned October 25, 2017 Kevin Smith 2017 Crowe 2017 Crowe Horwath Horwath International LLP

2 What We Will Cover Standards Overview Definition of an Investment Definition of Fair Value Fair Value Hierarchy GASB 79 Lessons Learned Common Questions 2017 Crowe Horwath International 1

3 Definition of an Investment 2017 Crowe Horwath International 2

4 Definition of an Investment GASB 72 defines an investment and requires all investments to be measured at fair value (with limited exceptions). Investment a security or other asset that: A government holds primarily for the purpose of income or profit, and Has present service capacity based solely on its ability to generate cash or to be sold to generate cash Examples: Real property held for development Real property held by pension plan Mortgage loans - 1st time homebuyers assistance program Others? Determination of whether an asset is an investment or not is made at the time of acquisition The decision is retained for financial reporting purposes Even if changes in intended use Multi-use Asset: If multi-use at acquisition, then depends on unit of account Definition of investment uses term primarily 2017 Crowe Horwath International 3

5 Application of the Definition of Fair Value to Investments and Other Financial Instruments 2017 Crowe Horwath International 4

6 Investments/Other Assets Not Measured at Fair Value Investment Investments in nonparticipating interest-earning investment contracts Investments in unallocated insurance contracts Money market inv. and participating interest-earning inv. contracts with remaining maturity at time of purchase of one year or less Investments held by qualifying external investment pools Investments in qualifying external investment pools Synthetic guaranteed investment contracts (GICs) that are fully benefit responsive Investments in life insurance contracts Accounting Cost based measure per GASB 31.8 Reported as interest-earning investment contracts per GASB 31.8 and 59.4 Amortized cost per GASB 31.9 Amortized cost per GASB 79.4 Amortized cost per GASB 79.41, if the pool meets the criteria to measure its investments at amortized cost Contract value per GASB Cash surrender value 2017 Crowe Horwath International 5

7 Definition of Fair Value 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 The Price: Principal (or most advantageous) market The market with the greatest volume and level of activity for the asset or liability In the absence of a principle market, then use the most advantageous market for the government Does not include transaction costs Received to sell: GASB 72 requires the use of an exit price (differs from an entry price) Hypothetical transaction considered from the perspective of a market participant that holds the asset or owes the liability. Paid to Transfer a Liability: Assumes liability is transferred to a market participant (but is not extinguished) at the measurement date. Can be derivative (interest rate swap) in negative position Can t use the settlement from the counter party Need to use some other model to determine FV 2017 Crowe Horwath International 6

8 Definition of Fair Value, continued 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 Orderly Transaction: Assumes exposure to market prior to measurement date. Allows for unusual and customary market activities Not a forced transaction (i.e. forced liquidation, distressed sale). Market Participants: Independent Knowledgeable Willing and able to transact For non-financial assets utilize highest & best use of asset that market participant would consider (not necessarily the government s current use) Crowe Horwath International 7

9 Fair Value Hiearchy 2017 Crowe Horwath International 8

10 Fair Value Hierarchy (continued) LEVEL 1 Quoted prices (unadjusted) in active markets for identical assets or liabilities that a government can access at the measurement date LEVEL 2 Inputs (other than quoted market prices included within Level 1) that are observable for the asset/liability, either directly or indirectly (i.e., observable prices for similar assets in active markets, prices for identical assets in non-active markets, direct/indirect observable market inputs) LEVEL 3 Unobservable inputs for the asset/liability; used to the extent that observable inputs are not available The overall fair value level is dictated by the lowest level within the hierarchy of any significant input used in the valuation technique Crowe Horwath International 9

11 Fair Value Hierarchy LEVEL 1 Equity securities traded on NYSE, NASDAQ Listed futures and options contracts On-the-run U.S. Government and Agency bonds (only 1 to 2% of bonds o/s, however are ones mostly traded) LEVEL 2 Corporate bond issuance not traded in an active mkt Certain mortgage backed securities and asset-backed securities Municipal bonds not traded in an active market Interest rate swaps Off the run U.S. Government and Agency Bonds LEVEL 3 Private equity investments Most nonfinancial assets Subordinate (residual) tranches in securitization structures. Think of this as the quality of the information used to determine fair value 2017 Crowe Horwath International 10

12 Active Markets An active market for the asset or liability is a market in which transactions for an asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis. Indicators of an inactive market: There are few recent transactions Price quotations are not developed using current information Indices that were previously highly correlated are demonstrably uncorrelated Significant increase in implied liquidity risk premiums, yields, or performance indicators Wide bid-ask spread or a significant increase is such a spread Little information is publicly available 2017 Crowe Horwath International 11

13 Maximize Valuation Techniques: Observable vs. Unobservable Inputs Observable Inputs Unobservable Inputs Minimize A government shall use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximizing the use of relevant observable inputs, and minimizing the use of unobservable inputs Crowe Horwath International 12

14 Valuation Principles A quoted price in an active market for the identical instrument is a Level 1 measurement and provides the most reliable evidence of fair value and must be used when available ( Price x Quantity ) When Level 1 measurement is not available, GASB 72 requires valuation methods to be used based on one ore more of the following valuation approaches: Market approach Income approach Cost approach 2017 Crowe Horwath International 13

15 Management Reliance on Third-Party Pricing Service Use of quoted prices provided by third parties is permitted to arrive at the fair value of an asset, as stipulated in the standard Quoted prices provided by third parties, such as pricing services or brokers, may be used if a government has determined that the quoted prices provided by those parties are developed in accordance with the provisions of this Statements. Management still needs to understand how the fair value is determined. Management should consider: Are the inputs based on bid and ask prices? Are the inputs to the price observable? Has there been any significant decrease in the volume or level of market activity for the asset? Are the transactions on which the prices are based orderly transactions? In other words where did the third party (such as custodian) get the fair value? 2017 Crowe Horwath International 14

16 Common Processes at Custodian Obtaining multiple prices and price types from providers Checking price feeds to validate prices Employing quality checks Comparisons against prices received from multiple providers Comparisons to the previously reported price Missing prices (zero value) or Stale prices Overriding the normal thresholds in the case of extreme fluctuations 2017 Crowe Horwath International 15

17 Understanding Custodians Price Challenge Common timeline for the monthly flow of information: Last day of the month (and first few of following month): Custodian obtains month-end prices and performs internal reviews to update prices for most securities After pricing but within the first week: Investment managers review all securities and respond to the custodian with any pricing discrepancies Within a few days following challenge: Custodian responds to the investment manager challenges, noting any changes made What is the criteria for considering price challenges? How is the price challenge resolved? 2017 Crowe Horwath International 16

18 Fair Leveling Report 2017 Crowe Horwath International 17

19 Possible Custodian Fair Value Reporting Tools Report Level Determination Template Fact Sheet/Pricing Information by Asset Class Level Override Capabilities Unchanged Price Report Transfer Between Levels Template Description of Report Suggested FV hierarchy levels, at the security level Provides documentation to support fair value decision and aids auditor in understanding the basis for those decisions Provides ability to override suggested levels at security level Provides detail of securities for which the price has not changed, including the reason and the date ranges Provides comparison of pricing sources used for current period and prior period to aid in analysis of significant transfers between levels 2017 Crowe Horwath International 18

20 Management s Responsibility When using third-party pricing services for fair value information, management remains responsible for: Complying with the applicable financial reporting framework, including disclosure requirements Maintaining appropriate internal controls to prevent or detect material misstatements related to fair value measurements and disclosures Assessing the effectiveness of internal control over financial reporting Maintaining accurate books and records even if it uses a vendor To execute management s responsibilities, entities that use third-party pricing vendors for estimating the fair value of investment securities generally have processes in place to both (i) develop an understanding of a vendor s pricing methodologies, and (ii) design and implement specific internal controls over the valuation of securities Crowe Horwath International 19

21 Best Practices for Management in Using Vendors for Pricing Process should be more detailed and challenging for harder to value securities and less so for easier to value securities Obtain understanding of valuation techniques used by pricing vendors at least annually Perform analysis of prices received from pricing services Compare prices received from vendors to actual sale prices from securities sold or to prices reported by another pricing vendor/service For complex investments, consider using a valuation specialist 2017 Crowe Horwath International 20

22 Example Disaggregation of an Investment Portfolio Based on Valuation Risk Lower Valuation Risk Readily Determinable Fair Values based on Market Quotations or NAV Exchanged traded equities Over the Counter forward contracts-currencies Registered investment companies Non-registered mutual funds Exchanged-traded derivatives Matrix/Other Models with Observable Inputs Investment-grade corporate debt Higher credit quality municipal debt securities Convertible corporate debt Interest rate swap derivatives U.S. agency securities Higher Valuation Risk Non-investment grade corporate debt Non-agency residential mortgage-backed securities (RMBS)/ collateralized mortgage obligations (CMOs) Collateralized debt obligations (CDOs) Non-exchanged traded securities Investment LPs/LLCs Credit default swap derivatives Commercial mortgage-backed securities (CMBS) Bank loans Direct private equity investments Real estate investment trusts (REITs) 2017 Crowe Horwath International 21

23 Fair Value Measurement & Application Other Tidbits How to classify real estate held for both operations and investment purposes by insurance entities Based on whether unit of account meets the definition of an investment Measuring certain money market investments and participating interest-earning investment contracts at amortized cost May be measured at amortized cost to the extent permitted by paragraph 9 of Statement Crowe Horwath International 22

24 Certain External Investment Pools and Pool Participants GASB Crowe Horwath International 23

25 Certain External Investment Pools and Pool Participants What: The GASB has revised the accounting and financial reporting standards for 2a7-like investment pools Why: Securities and Exchange Commission changes to Rule 2a7 would make it difficult for external investment pools to meet the criteria to continue to report as 2a7-like When: Effective for reporting periods beginning after June 15, 2015, except for the provisions in paragraphs 18, 19, 23 26, and 40, which are effective for reporting periods beginning after December 15, Crowe Horwath International 24

26 Criteria for Pools to Use Amortized Cost An external investment pool needs to meet all of the following in order to report investments at amortized cost: Transact with participants at stable net asset value per share $1.00 per share Meet certain portfolio maturity requirements Meet certain portfolio quality requirements Meet certain portfolio diversification requirements Meet certain pool liquidity requirements Meet shadow price requirements 2017 Crowe Horwath International 25

27 Disclosures for Pools and Participants Pools that report at amortized cost should disclose the fair value measurements as required by paragraphs of Statement 72 Pools and pool participants that report at amortized cost should disclose the presence of any limitations or restrictions on participant withdrawals, such as redemption notice periods, maximum transaction amounts, and the pools authority to impose liquidity fees or redemption gates 2017 Crowe Horwath International 26

28 Lessons Learned 2017 Crowe Horwath International 27

29 Revisiting Common Pitfalls 1. Placing reliance on third-party pricing services without understanding their processes and the controls they have in place to mitigate risks of inaccurate valuation results 2. Classification of an asset in Level 1 of the fair value hierarchy without evidence supporting the conclusion that the security is traded on an active market 3. Lack of understanding of the approach and/or model used to value Level 2 or Level 3 assets 2017 Crowe Horwath International

30 Revisiting Common Pitfalls Common Pitfall #1 1.Placing reliance on third-party pricing services without understanding their processes and the controls they have in place to mitigate risks of inaccurate valuation results Understand and document your processes and controls around the determination of fair value and identify third parties that are relevant to that process Understand the processes and controls used by relevant third parties through: Discussions with the third party Obtain and understand reports on internal controls of the third party (SOC 1 Reports) Monitor pricing to identify changes or variability Use more than one source to obtain pricing information Perform testing of the pricing information provided by the third party on a periodic basis 2017 Crowe Horwath International

31 Revisiting Common Pitfalls Common Pitfall #1 (Continued) 1.Placing reliance on third-party pricing services without understanding their processes and the controls they have in place to mitigate risks of inaccurate valuation results Consider asking the following questions: Is the third party reputable and nationally recognized? Does the third party trade or make a market for the investment? Is the third party using another third party as the source for the price? Is the quote based on a model or recent trades? If it is based on a model, what model was used and what are the significant or sensitive assumptions / inputs used (both quantitative and qualitative)? Are the inputs based on available market data or unobservable inputs? Are the models / assumptions / inputs the same as the third party used for their books and records? Was the model subject to price validation procedures by other third parties? Is the estimate reflective of a market that the government can access? 2017 Crowe Horwath International

32 Revisiting Common Pitfalls Common Pitfall #2 2. Classification of a security in Level 1 of the fair value hierarchy without evidence supporting the conclusion that the security is traded in an active market Consider reviewing the following factors to aid in determination of whether there is an active market for a security: Are there recent transactions? Do the pricing quotations vary substantially over time or among market makers? Is there a wide spread between bid and ask prices? What is the 10-day average trading volume of the security? 2017 Crowe Horwath International

33 Revisiting Common Pitfalls Common Pitfall #3 3. Lack of understanding of the approach and/or model used to value Level 2 or Level 3 investments Consider employing one or more of the following methods to gain comfort with the values determined either internally or by a third party for Level 2 or Level 3 investments: Obtain independent estimate Test subsequent or recent transactions Evaluate the fair value estimate through one of the following ways Prepare independent estimate Test the model 2017 Crowe Horwath International

34 Common Questions 2017 Crowe Horwath International 33

35 Common Questions What should be included in my GASB 72 disclosure? Disclosures are required for all assets and liabilities that are reported at fair value, regardless of how they are presented on the face of the financial statements Cash equivalents Exception: Those measured at amortized cost Derivatives (both investment and hedging) Tip: Remember that valuation should consider nonperformance risk Securities lending collateral Capital assets meeting the definition of an investment 2017 Crowe Horwath International

36 Common Questions How do I handle alternative investments that do not provide valuation information as of the plan s fiscal year end? Required to adjust the valuation to date of the Statement of Fiduciary Net Position Roll the latest information forward making adjustments for the following events: Capital contributions made to the alternative Distributions received from the alternative Changes in the composition of investments in the fund reported to the plan Any fair value information reported to the plan 2017 Crowe Horwath International

37 Common Questions How do I arrive at fair value and disclose fair value information for investments in external investment pools? There are three basic types of external investment pools: Pools that meet the criteria in GASB Statement No. 79 and elect to report at amortized cost Investments in these pools are measured at amortized cost Should not be included in the fair value disclosures Pools that meet the criteria in GASB Statement No. 79 and do NOT elect to report at amortized cost Investments in these pools are measured at fair value Value based on NAV (either floating or stable $1.00) Not required to be included in fair value disclosures Pools that do NOT meet the criteria in GASB Statement No. 79 and report at fair value Investments in these pools are measured at fair value Value based on NAV (either floating or stable $1.00) Not required to be included in fair value disclosures 2017 Crowe Horwath International

38 Questions????? 2017 Crowe Horwath International 37