Auditing Complex Investment Types

Transcription

1 Auditing Complex Investment Types Learning Objectives Discuss types of non-readily marketable securities. Describe fair value modeling techniques for Level 3. Explain requirements when using the work of a specialist. Discuss using Service Organization Control Reports. Describe fair value presentation and disclosure for complex investments. 2 1

2 Fair Value Definition Per ASC 820 As used in FASB ASC 820, Fair Value Measurement, 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. Fair value is based on an exit price. Not forced liquidation or distress sale. 3 Basic Steps in the Fair Value Measurement Process Step 1 -- Determine the asset or liability to be fair valued and its unit of account. Step 2 -- Identify the principal market or most advantageous market. Step 3 -- Identify the characteristics of the market participant. Step 4 -- Identify the likely inputs and determine their level in the fair value hierarchy. Step 5 -- Apply the appropriate valuation technique(s). 4 2

3 Inputs to Valuation Techniques FASB ASC 820 recognizes two distinct types of inputs: Observable inputs -- Developed using market data, such as publicly available information about actual events or transactions, reflecting assumptions market participants would use when pricing an asset or liability; and Unobservable inputs -- Market data is not available and are developed using the best information available about the assumptions that market participants would use when pricing an asset or liability. 5 The Fair Value Hierarchy FASB ASC 820 establishes a fair value hierarchy which: Categorizes the inputs to valuation techniques into three levels -- Level 1, Level 2, and Level 3. Gives the highest priority to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs. Observable Inputs 6 3

4 Level 1 Inputs Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. Emphasis within Level 1 is on determining both: The principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability; and Whether the reporting entity can enter into a transaction for the asset or liability at the price in that market at the measurement date. 7 Typical Level 1 Securities Exchange traded securities in an active market. Mutual funds. Most U.S. government securities. Certain other sovereign government securities. Listed derivatives. Future contracts traded in active market. Over-the-counter (OTC) securities traded in an active market. 8 4

5 Level 2 Inputs Level 2 inputs are inputs that are observable, either directly or indirectly, other than quoted prices included within Level 1, for an asset or liability. Examples: Quoted prices for similar assets or liabilities in active markets. Quoted prices for identical or similar assets or liabilities in markets that are not active. Inputs other than quoted prices that are observable for an asset or liability. 9 Typical Level 2 Securities Not actively traded securities and listed derivatives. Most OTC derivatives. Restricted stock. Corporate and municipal bonds. Certain corporate loans and high-yield debt securities. Asset-backed securities with observable and timely inputs. Fixed income securities. Futures and forward contracts. 10 5

6 Level 3 Inputs Level 3 inputs are unobservable inputs for an asset or liability. They are based on: The reporting entity s own assumptions. The best information available in the circumstances. Exhaustive efforts are not necessary. 11 Typical Level 3 Securities Certain corporate and mortgage loans with lower emphasis on observable inputs. Certain high-yield debt. Distressed debt (bankruptcy or insolvency). Investments in real estate funds. Investments in private equity. Venture capital investments. Complex OTC derivatives. 12 6

7 The Fair Value Audit Process 1. Understand the entity s process for determining fair value measurements and disclosures. 2. Evaluate the conformity of fair value measurements with the applicable financial reporting framework. 3. Test the entity s fair value measurements. 4. Evaluate the entity s disclosures about fair values. 5. Evaluate the results of audit procedures. 6. Obtain management representations. 7. Communicate with those charged with governance. 13 Test the Entity s Fair Value Measurements Substantive tests of fair value measurements generally involve: Testing management s significant assumptions for reasonableness. Testing the valuation method and the underlying data. Developing independent fair value estimates for corroborative purposes. Reviewing subsequent events and transactions. Based on end of reporting period, not additional information between balance sheet date and report issuance without adjusting backwards. 14 7

8 Test Management s Significant Assumptions, the Valuation Method, and the Underlying Data The acronym RRC (Reasonable, Realistic, Consistent): The general economic environment, the specific industry, and the entity s economic circumstances. Existing market information. The plans of the entity and strategies. Risk associated with cash flows and effect on the discount rate. Management s intent and ability. Past experience. 15 Examples of Measurement Uncertainty Model adjustments -- Known deficiencies or calibration corrections. Credit risk adjustments -- Counterparty or own credit risk. Liquidity adjustments -- Some models calculate a mid-market price, even though a liquidity adjusted amount may be required (such as bid-ask spread). Other risk adjustments -- Model does not take into account all market participant pricing considerations. 16 8

9 Effects of Inactive Markets Significant decline in volume and level of trading activity, or available prices vary significantly over time or amount. Gain an understanding of the following: How inputs from external sources are determined. Deteriorating conditions affecting counterparty that may result in nonperformance of obligations. Policies for adjusting for measurement uncertainty. Performing sensitivity analysis, or other range of realistic outcomes. Policies for determining when a fair value measurement moves to a different hierarchy level. 17 Sources for Price Indicators Current observable market price always given preference. Recent transactions, including after the F/S date, with adjustment. Proxy pricing of current or recent transactions in similar transactions: Adjust for differences in liquidity, credit risk, or similar. Indexes for similar instruments, with adjustments. Transactions on thinly traded markets, such as OTC. Models, such as bond pricing formulas, discounted cash flow, Black-Scholes for options, or Zero Coupon for interest rate swaps. 18 9

10 Observable Transaction Prices Are Not Always Fair Value Transaction price might not represent the fair value of an asset or a liability at initial recognition if: The transaction is between related parties. The transaction takes place under duress or the seller is forced to accept the price in the transaction. The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. The market in which the transaction takes place is different from the principal market (or most advantageous market). 19 Modeling Technique Elements Methodology -- Rules or principles governing the relationship between the valuation variables. Assumptions -- Estimates of uncertain variables that are used. Data -- May comprise actual or hypothetical information about the financial instrument or other inputs to the financial instrument. Ensure output is fair representation of value that market participants would ascribe? Maximizes use of relevant observable inputs. Output adjusted, as necessary

11 Establishing or Validating a Model Validate prior to usage, periodic reviews to ensure that it is still suitable for its intended use: Methodology s theoretical soundness and mathematical integrity, including appropriateness of parameters and sensitivities. Consistency and completeness of inputs with market practices. Appropriate change control policies, procedures, and security. Changed or adjusted timely with varying market conditions. Maximizes use of relevant observable inputs. Appropriately adjusted for market participant assumptions. 21 Black-Scholes Valuation Model Best known and widely-used mathematical model for estimating option prices using five variables: 1. Time to option expiration. 2. Exercise or strike price. 3. Risk-free interest rate. 4. Price of the underlying stock (which may be estimated if not publicly traded). 5. Volatility of the price of the underlying stock (most subjective). Computerized versions widely available

12 Price Volatility The greater the standard deviation, the flatter a bell-shaped curve and the more dispersed the data. Volatility is the standard deviation of the price of a specific stock: Statistically, approximately 68% of values in a normal distribution are within +/- 1 standards deviation of the mean, 95% are within +/- 2 standard deviations. Expressed as a percentage of the stock value -- e.g., a volatility of 10% means that over the course of a year the stock price is projected to be within 10% of its current price 68% of the time. Assess the assumed volatility for reasonableness, and consider the impact of multiple variations in calculating a range estimate. 23 Zero-Coupon Valuation Model Present value model in which net settlements from the interest rate swap are estimated and discounted back to their current value. Variables include: Timing of cash flow, which is usually a contractual manner. Discount rate, which are the spot interest rates implied by the yield curve for hypothetical zero-coupon bonds due on the date of each future net settlement on the swap. Estimated net settlement cash flows, calculated using the net settlement value that would be required if future interest rates are equal to the rates implied by the current yield curve

13 Auditing the Zero-Coupon Method Understand the assumptions underlying the discount rate used: To the extent possible, verify the objective elements of the rate. Understand the assumptions underlying the estimate of future cash flows: Examine management s documentation to see whether these assumptions are adequately supported. 25 Engaging a Valuation Specialist Whether engaged by company or auditor is irrelevant. Select a specialist having the necessary competence, capabilities, and objectivity. Determine with the specialist (preferably in writing): The nature, scope, and objectives of the specialist s work. The roles and responsibilities of each party. The nature, timing, and extent of communication, including the form of any report to be provided by the specialist. Confidentiality agreements

14 Auditor s Responsibilities When Using the Work of an Auditor s Specialist Sufficiently understand the specialist s field of expertise to enable the auditor to determine the nature, scope, and objectives of the specialist s work and evaluate the adequacy of that work for the auditor s intended purposes. Has sole responsibility for the audit opinion expressed, and that responsibility is not reduced by the auditor s use of the work of an auditor s specialist. Should not refer to the work of an auditor s specialist in an auditor s report containing an unmodified opinion: If referenced in a modified report, must indicate that does not reduce the auditor s responsibility for that opinion. 27 Evaluating Work of Auditor s Specialist Relevance and reasonableness of findings and conclusions: Consistency with other audit evidence. Obtain an understanding of significant methods and assumptions: Consider whether method may result in material misstatement. Make appropriate tests of source data provided to the specialist. Assess appropriateness of using the work for the intended purpose: May need to perform alternative or additional procedures. Evaluate whether findings support related assertions

15 Evaluating Adequacy of Work of an Auditor s Specialist Make appropriate inquiries, including consultations with other specialists when necessary. Review the specialist s working papers and reports. Perform corroborative procedures, such as: Examining published data. Confirming relevant matters with third parties. Perform detailed analytical procedures. Reperform calculations. 29 Third-Party Pricing Sources Provide prices and price-related data, often daily valuations of large numbers of financial instruments. May include inputs from a variety of sources. Formalized process for customers to challenge pricing. Consensus pricing services: Obtain pricing from several participating entities (subscribers). Only available to subscribers, with confidentiality maintained. Usually an arithmetical average after cleansing for outliers. Subscribers not privy to how submitted prices estimated

16 Third-Party Pricing Considerations Type of third-party source. Nature of inputs used and complexity of valuation technique. Reputation and experience of the third-party pricing source. Objectivity of the third-party pricing source. Entity s controls over the use of third-party pricing sources. Third-party pricing source s controls: Service Organization Control Report available? 31 Pricing Service -- Evaluate Underlying Assumptions and Data Determine the nature of the information provided: E.g., what were the inputs and assumptions? If the price is not based on Level 1 or 2 inputs, the auditor should obtain an understanding of the model and evaluate whether the assumptions are reasonable. Evaluate whether the assumptions used by the pricing service reflect the price to sell the asset or paid to transfer the liability in the reporting entity s principal/most advantageous market: Would traded or quoted prices be available to the entity? 32 16

17 Broker-Dealer Quotes Broker-dealer quotes: Indicative quote -- Best estimate of fair value. Executable quote -- Price broker willing to transact at. Narrow range between bid/ask price suggests an active market. If only one quote with a large bid-ask spread with a legal disclaimer on the quote, Level 3 if not a firm commitment: Lack of transparency = alternate support need. 33 Multiple Broker-Dealer Quotes If multiple quotes: Use the one from the market that is the principal or most advantageous, not an average; and Observable only if quotes are readily available in a transparent marketplace

18 Use of Service Organizations AU-C 402, Audit Considerations Relating to an Entity Using a Service Organization. Provides services relevant to a user entity s internal control over financial reporting: E.g., initiate transactions, maintain records, value investments. May affect nature, timing, and extent of audit procedures. Service Organization Control Report: SSAE No. 16, Reporting on Controls at a Service Organization. 35 Exhibit 1: Service Organization Control Report Exercise 18

19 What If Service Organization Control Report Is Not Adequate? Service Organization Control report may not cover pricing. May use third-party pricing agent: Third-party pricing agent may not have Service Organization Control Report. There is a risk that pricing service may lag in volatile markets. Review the investment portfolio to identify potentially significant Level 2/3 securities warranting further work: Be alert for signs of active market with observable inputs. Consider identified internal control deficiency. 37 Mutual Funds Registered investment companies with published information, so generally Level 1. Units of participation valued at quoted market value: Confirm units of participation held with mutual fund. Compare unit values to market quotations. Obtain most recent F/S and analyze consistency with other audit evidence: May not be as of same measurement date

20 Alternative Investments Readily determinable fair value does not exist: E.g., not listed on national exchanges or OTC markets, published data not available. Includes private investment funds meeting the definition of an investment company per ASC Topic : E.g., hedge funds, private equity funds, real estate funds, venture capital funds, commodity funds, offshore fund vehicles, funds of funds, common or collective trust funds, etc. May be structured as limited partnerships, limited liability corporations, trusts, or corporations. 39 Alternative Investments with Net Asset Value Per Share Practical expedient -- Allows use of the net asset value reported by the fund to estimate fair value. Apply to an investment that meets both of the following criteria as of the reporting entity s measurement date: Investment does not have an otherwise readily determinable fair value; and The investment is in an entity that has all of the attributes specified in FASB ASC , Financial Services Investment Companies (exceptions apply). If not as of same measurement date, may adjust most recent NAV. Must not be probable that will dispose of at different price

21 ASC Investment Entities Defined Report their investment assets at fair value. Primary business activity is asset investing for income/appreciation. Ownership represented by proportionate shares of net assets (units). Funds of investment company s owners are pooled. Investment company is the primary reporting entity. Separate legal entity, except separate account of an insurance company. Real estate investment trusts (REITs) qualify for practical expedient if meet same measurement and reporting principles. 41 NAV -- Redemption Terms If cannot redeem at measurement date, but can in future, then consider length of time in FV measurement. Generally, redemptions only permitted with advance notice (e.g., days). Level 2 if redemption notice not submitted effective on the measurement date; and reporting entity has the contractual and practical ability to redeem in the near term (typically 90 days or less). Level 3 if entity does not know when it will have the ability to redeem; and entity does not have the ability to redeem in the near term

22 ASU : Fair Value Measurement Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent). Removes requirement to categorize within the fair value hierarchy all investments measured using the net asset value per share practical expedient. Requires additional disclosures for these investments elected to be measured using the practical expedient. 43 ASU : Disclosures Disclose nature, characteristics, and risks of investments by class: E.g., fair value using practical expedient, redemption frequency, redemption notice period, and unfunded commitments. Example classes include global opportunities hedge funds, multi-strategy hedge funds, real estate funds, etc. Disclose whether, if sold, probable of being sold at amounts different from NAV per share or equivalent

23 Effective Dates & Transition Public business entities FYB after 12/15/15, including interim periods within. All other entities FYB after 12/15/16, including interim periods within. Earlier adoption permitted. Transition retrospectively to all periods presented. 45 Possible Audit Procedures for Evaluating Alternative Investments Confirm with fund manager, either in aggregate or on a securityby-security basis: May not by itself constitute sufficient appropriate audit evidence in addressing valuation. Consider confirming description, ownership percentage, and estimated fair value. Aggregated confirmation may not be sufficient. Review and test significant assumptions and underlying data used by investor entity management: Confirmation on security-by-security basis may support the data

24 Possible Audit Procedures for Evaluating Alternative Investments Reconcile to audited F/S as of the same date: If as of different date, perform procedures over stub period, such as obtaining interim financial information or testing management s tracking analysis. Review transactions at or near the balance sheet date: Investment in, or liquidation of, a portion of an alternative investment may support valuation. Consider settlement terms and timeliness for consistency with applicable financial reporting framework. 47 Alternative Investment Funds -- Records Management Considerations Identify reports/records of required data: How is required data reconciled to fund financial reports; and How are front- and back-end systems adapted to continually evolving market conditions. Tagging securities on a monthly basis: Can the entity generate level designations by security? 48 24

25 Alternative Investment -- Supporting Documentation Options Audited F/S as of the investor entity s balance sheet date most persuasive audit evidence: Limited visibility into underlying investments detracts from evidence strength. Obtained detailed listing of underlying securities must be evaluated. Condensed schedule of investments or detailed listing as of a different date; supplement with alternate procedures, (e.g., sector data, indexes, and cash distributions). 49 Private Equity Funds Generally, Level 3: Lack of observable market inputs. Historically, recorded at initial cost and adjusted when new financing round: Cost is not fair value, but fair value can approximate cost. Internal analysis, portfolio company financials, comparable public securities, etc.: Use multiple techniques to corroborate recent financing round fair value

26 Exhibit 2: Alternative and Other Complex Investment Valuation Examples Common Derivatives -- Hedge Exposure Fair value -- Gain/Loss reflected in earnings: Protects against changes in FV of an asset, liability, or firm commitment. Cash flow -- Gain/Loss on effective portion reflected in OCI: Protects against variable cash flows of a forecasted transaction. If ineffective, recognize loss in earnings. Foreign currency -- Gain/Loss reflected in OCI: Protects against exposure of a net investment in a foreign operation or foreign currency denominated transaction

27 Typical Risks -- Put Option Hedge Accounting Applying hedge accounting when the exposure does not qualify. Lack of appropriate documentation for hedge accounting. Incorrect assessment of hedge effectiveness, resulting in application of hedge accounting when not permitted. Recording gains/losses of the put option and the investment in wrong period or for wrong amount. Unreasonable fair value estimates. All gains/losses not recorded. Inadequate presentation and disclosure. 53 Exhibit 3: Put Option to Hedge Fair Value Risk Example 27

28 Typical Risks -- Derivative Embedded in Bond Failure to identify the option and account for it separately from the bonds only. Errors in determining fair value of the components when allocating the purchase price and subsequent measurement. Errors in accounting for fair value changes. Inadequate presentation and disclosure. Departures from ASC 320, Investments Debt and Equity Securities, measurement and disclosure requirements for the bonds only. 55 Exhibit 4: Derivative Embedded in a Bond Example 28

29 Audit Report Impact Emphasis-of-matter paragraph: As explained in Note X, the financial statements include investments valued at $X (X% of net assets), whose fair values have been estimated by management in the absence of readily determinable fair values. Management s estimates are based on information provided by the fund managers or the general partners. May qualify or disclaim opinion due to scope limitation in obtaining sufficient evidence. 57 Internal Control Deficiencies Lack of understanding of nature/extent of alternative investments and related risks. Lack of comprehensive policy on alternative investment strategies/objectives, including list of allowable products. Lack of segregation of duties. Failure to obtain and monitor detailed supporting information to support FV. Risk not consistent with investment policy

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