Management Must Assume Responsibility for Fair Value
Estimating the fair value of a municipality’s investments — particularly pension and other postemployment benefit plan investments held in trust — can be a difficult and subjective process. Many municipalities rely on third-party pricing sources such as broker/dealers or valuation specialists for fair value recommendations.
There’s nothing wrong with getting assistance with this complex task. But if you do, be sure that management understands its responsibility to oversee the process and implement effective internal controls for financial reporting purposes. Management, therefore, must develop an understanding of any third party’s valuation assumptions, methods and models.
Four questions to consider
How do you ensure that your municipality’s management is taking responsibility for fair value prices? In a public speech, a Securities and Exchange Commission staffer advised management to ask itself four questions when using third-party services, which are just as applicable to municipalities as they are to public companies:
1. Do we have sufficient information about the values provided by pricing services to know that we’re GAAP-compliant?
2. Have we adequately considered the judgments that have been made by third parties to be comfortable with our responsibility for the reasonableness of such judgments?
3. Do we sufficiently understand the information sources and processes used to develop prices to identify risks to reliable financial reporting?
4. Have we identified, documented and tested controls to adequately address the risks to reliable financial reporting?
If your municipality obtains fair value pricing recommendations from third parties, you should assess your current internal controls over the process. If you have no controls, or your existing controls are inadequate, add new controls to ensure that management is meeting its responsibilities.
One potential control measure is to conduct a background check on pricing sources to get a feel for their reputation, qualifications, independence and reliability. Or you could review service auditor reports on sources’ processes and controls over fair value pricing.
Other potential measures include:
- Developing an understanding of, and evaluating, each source’s valuation methodologies, including its models, assumptions and information sources,
- Conducting periodic validation checks to assess the accuracy of a source’s pricing information,
- Applying benchmarking to assess the reasonableness of inputs and assumptions used in the valuation process, as well as the resulting fair value,
- Reviewing each source’s methods and assumptions used to make fair value hierarchy determinations, and
- When using broker/dealer quotes, determining whether they’re realistic in light of the prices at which the broker/dealer or other market participants would actually make trades.
Finally, consider testing a sampling of the source’s values using your own assumptions — or by consulting other third-party pricing sources. Concentrate your testing on riskier investments, such as illiquid Level 2 and Level 3 securities or investments that have experienced wide value swings.
Help is available
Management must take responsibility for fair value pricing, but that doesn’t mean you have to go at it alone. Yeo & Yeo CPAs can help you evaluate third-party pricing services’ valuation methodologies, develop and implement appropriate internal controls over the process, and advise you on how best to comply with the required financial disclosures.