Evaluating Pricing Information from a Third Party
By Kerry Stegman, Manager, Alternative Investment Group
In July 2020, the AICPA Auditing Standards Board issued Statement on Auditing Standards No. 143, Auditing Accounting Estimates and Related Disclosures. SAS No. 143 addresses the auditor’s responsibilities relating to accounting estimates and introduces specific requirements for evaluating pricing information from a third party, including pricing services and broker-dealers.
Auditor Considerations
When an auditor obtains pricing of securities from a third party to support independent expectations, or evaluates pricing information provided by a third party used by the reporting entity, the auditor may perform procedures to determine whether the pricing information provides sufficient appropriate evidence to respond to the risks of material misstatement.
It is important for the auditor to assess the reliability of the pricing information provided by the pricing service by obtaining an understanding of the pricing service, its experience and expertise in pricing different types of securities. For example, some pricing services have the ability to price certain fixed income securities through proprietary methodologies. In this case, the auditor would evaluate the experience and expertise of the pricing service relative to the types of financial instruments being valued, including whether they are routinely priced by the pricing service, and determine whether the methodology used in establishing fair value is in conformity with the applicable financial reporting framework.
The auditor should also determine the relevance of audit evidence such as whether the fair values of financial instruments are based on quoted prices in active markets for identical financial instruments. In circumstances where fair values are based on transactions of similar financial instruments, the auditor should assess whether the transactions are considered comparable to the financial instruments being valued. If there are no recent transactions for either the financial instrument being valued or similar financial instruments, or a broker quote is used, the auditor will need to obtain an understanding from management of how the fair value was developed, including whether the inputs used represent the assumptions that market participants would use when pricing the financial instrument.
Using Multiple Pricing Services
In order to reduce the amount of support requested by auditors to corroborate the pricing of a portfolio of securities, it is recommended that the reporting entity obtain pricing from multiple pricing services. Less information is needed about the particular methods and inputs used by the individual pricing services when market or industry data, prices, or price-related data are obtained from multiple independent pricing sources and they are consistent across those sources.
When information obtained from multiple information sources points to deviating market views, the auditor may seek to understand the reasons for the differences. The difference may result from the use of different methods, assumptions, or data. For example, one source may be using an internally developed valuation model, and another may be using broker quotes. When the difference relates to estimation uncertainty, the auditor is required to obtain an understanding of how the estimate was developed, as well as whether the methodology is consistent with the accounting standards and is appropriately disclosed in the financial statements.
Evaluating Pricing Services
The new guidance is emphasizing the need to take a more comprehensive look at how pricing information from third parties determines the value of a security. Although there are a number of pricing services out there, determining which ones are best to provide appropriate and transparent pricing for a fund’s portfolio can get complicated. The larger pricing services, such as Bloomberg and Refinitiv, will be able to price most asset types, but some specialize in pricing certain asset classes and may not be as strong on other asset classes.
The larger pricing services are generally more expensive and offer features for pricing complex securities at an additional cost. There are smaller and more cost-effective pricing sources, but they are, at times, limited when it comes to pricing the more difficult to value asset classes, such as fixed income. Therefore, some research will be required to decide which pricing services will help to satisfy the requirements of the new guidance.
Another factor to consider is that there may be securities priced by the services using methods other than obtaining pricing from an active market. The pricing services offer different levels of transparency into how the prices are determined, so when deciding on a pricing service, consider the transparency allowing the user to see the methodology and inputs used to price the security.
Recent Pricing Service Compliance Deficiencies
A recent SEC case highlights the need for this transparency into the pricing of securities. On December 9, 2020, the Securities and Exchange Commission charged ICE Data Pricing & Reference Data LLC for compliance deficiencies relating to delivering prices for fixed income securities based on quotes it received from a single market participant, while failing to implement adequate and reasonably designed policies and procedures to address the risk that these prices would not reasonably reflect the fair value of the securities. According to the SEC, these failures impaired ICE Data PRD’s ability to assess the reliability of quotes it received from market participants and determine whether the provider of the quote was an accurate source of information. For example, certain providers of single broker quotes at times submitted quotes that showed large movements, or no movements at all, from previous quotes, when such movements, or lack thereof, appeared inconsistent with the nature of the security or quotes that were subject to frequent client challenges, due to their deviation from trade data. PRD did not have policies or procedures to assess whether it should discontinue delivering single broker-quoted prices from those providers. The SEC’s order found that, due to these failures, ICE Data PRD at times provided clients with prices based on single broker quotes that were inconsistent with the nature of, and that did not reasonably reflect the value of, certain securities.
Conclusion
This example demonstrates why using two or more pricing sources as a check against each other could potentially detect and mitigate pricing errors in a portfolio. However, some of the smaller pricing services obtain their prices from the larger services, so be sure to know the underlying source utilized. Internal control enhancements and pricing policy updates, such as those discussed above, should be considered and implemented by management, as they will be expected by auditors.
Talk to your audit engagement team should you have questions on how SAS 143 will impact your organization.
