Mutual Fund Directors Forum

Transcription

1 Mutual Fund Directors Forum ACCOUNTING AND FINANCIAL REPORTING ISSUES ASSOCIATED WITH VALUATION Deloitte & Touche LLP

2 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 1

3 Valuation Challenges & Issues in the Current Environment 2

4 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 3

5 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 3 rd Party Pricing Vendors 4

6 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 3 rd 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 5

7 Fair Value Guidance 6

8 Fair Value Guidance Fair Value guidance comes from many places SEC Center for Audit Quality, AICPA Fair Value PCAOB FASB 7

9 Defining Fair Value What is Fair Value? 8

10 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 Determining Fair Value of a Financial Asset When the Market for That Asset Is Not Active October

11 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. 10

12 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 11

13 Fair Value Hierarchy Level 1 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 2 Inputs 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 3 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 12

14 Challenges of FAS 157 Implementation 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 Ongoing Administration Monitoring thousands of security types Completeness of disclosure Ensuring communication among different support groups 13

15 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 14

16 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 15

17 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 16

18 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? 17

19 FASB Staff Position 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 18

20 Oversight of Valuation Function Step 1 Establish roles and responsibilities over the valuation function Step 7: Revise elements of valuation function as warranted Step 2: Determine, assess and enhance the appropriateness of the valuation policies and procedures and gain approval Step 6: Perform oversight and monitoring activities Step 3: Determine the appropriate sources (pricing services, brokers, management,etc.) for valuations Step 5: Establish level and frequency of oversight and monitor activities Step 4: Assess the controls over the valuation function 20

21 Valuation Procedures (External Source) Use price Perform back-testing Yes Evaluate results Yes Validate price Are results satisfactory? Consider need to revise policies & procedures External Source Is the source capable of providing a price today? Yes No Is it an exchangetraded security? Identify another external source & restart process No 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 Evaluate source s methodology Compare to internal model No Identify additional sources and restart process Use internal source & move to Internal Source diagram) Consider revising policies & procedures Use internal source & move to Internal Source diagram 21

22 Valuation Procedures (Internal Source) Continue to use internal process as necessary Yes Does methodology conform to policies & procedures? Yes Use price Perform backtesting Are results satisfactory? Yes Consider need to revise policies & procedures Internal Source Is the source capable of providing a fair value estimate? Are assumptions valid and appropriate? No Request and obtain revised fair value estimate. Move to Yes above No Revise fair value methodology Consider need to revise policies & procedures No Obtain appropriate assistance to move to Yes above 22

23 Appendices 23

24 Appendix A FAS 157 Mutual Fund Disclosure Examples See Accompanying Handout 24

25 Appendix B Valuation Case Studies 25

26 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 26

27 Case Study Scenario 2 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 27

28 Case Study Scenario 3 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 28

29 Case Study Scenario 4 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 a.m. Wednesday, CFO indicted for financial fraud Noon Wednesday, stock trades at 65 29

30 Case Study Scenario 5 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 30

31 Case Study Scenario 6 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 31

32 Case Study Scenario 7 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 32

33 Case Study Scenario 8 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 33

34 Case Study Scenario 9 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 34

35 Case Study Scenario 10 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 35

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