10.8 Using Quoted Prices by Third Parties

Although entities may engage third-party advisers, such as pricing services or brokers, to help discharge management’s responsibilities, management must assume overall responsibility for determining both (1) the fair value of all assets, liabilities, or instruments classified within an entity’s stockholders’ equity that are measured at fair value and (2) the fair value measurement’s classification within the hierarchy. ASC 820-10-35-54K through 35-54M address management’s responsibilities related to using a pricing service or broker.

The requirement that management take responsibility for fair value measurements reported in the financial statements was also emphasized in a speech by Mark Shannon, then associate chief accountant in the SEC’s Division of Corporation Finance, at the 2011 AICPA Conference on Current SEC and PCAOB Developments. Mr. Shannon provided a sample of the types of comments that are typically issued to registrants that use third-party pricing information. The SEC staff in both the Division of Corporation Finance and the Division of Investment Management asks similar questions of registrants and registered investment companies. Such questions address topics such as how the entity uses the pricing services in complying with financial statement accounting and disclosure requirements, MD&A disclosure, management’s assessment of internal control over financial reporting, and the basic requirement to maintain books and records. Most notably, the staff has commented and asked questions about:

• Management’s evaluation of the appropriateness of the third-party models as well as the accuracy and completeness of the data used in the valuation.
• The assessment of the observability of the data used in the valuation and how the information affected the determination of the level within the fair value hierarchy.
• Third-party pricing service caveats regarding the use or reliability of the fair value estimates.
• The internal controls governing the use of the third-party pricing service.
• Management’s determination that assumptions used in the valuation are consistent with management’s accounting framework as well as with GAAP.

As indicated in ASC 820-10-35-54K and the SEC staff’s remarks, to take overall responsibility for determining fair value and the related disclosures when using a pricing service or broker, management will need to (1) understand whether the method the pricing service or broker uses to determine fair value is based on current information that reflects orderly transactions or a valuation technique that reflects market-participant assumptions (including assumptions about risks) and (2) assess the appropriateness of the values. On the basis of this understanding, management should determine the classification of the fair value measurement within the hierarchy. As noted in Section 8.5.1, an entity cannot assume that the pricing service or broker information is observable (i.e., Level 1 or Level 2) solely because the information comes from a third party. Rather, an entity needs to determine the proper classification within the fair value hierarchy as part of its process for determining that third-party information, such as broker quotes or pricing services, was developed in accordance with ASC 820. Management should also consider the implementation guidance in ASC 820-10-55-104(b), which suggests that in complying with the disclosure requirements in ASC 820, an entity might disclose “[h]ow third-party information such as broker quotes, pricing services, net asset values, and relevant market data was taken into account when measuring fair value.”

See Section 8.5 for further discussion of the classification within the fair value hierarchy of fair value measurements developed on the basis of pricing services or broker quotes.

In assessing whether a broker or pricing service quote is determinative of fair value, an entity needs to understand (1) how the broker or pricing service arrived at the quote and (2) the inputs or other information used. In a manner consistent with ASC 820-10-35-41, if a broker or pricing service quote represents the price quoted in an active market to which the entity has access, and the quote is for an identical asset, liability, or instrument classified in an entity’s stockholders’ equity, the entity is required to use this quote to determine fair value. Such a quote would represent a Level 1 input.

A broker or pricing service quote would not represent a Level 1 input in the absence of an active market or if a Level 1 input is adjusted in accordance with the criteria in ASC 820-10-35-41C. If the quote is not based on a Level 1 input but on a valuation technique that is used by market participants, reflects market-participant assumptions, and uses market-observable or market-corroborated inputs, the quote would be determinative of fair value provided that it does not need to be significantly adjusted. If a significant adjustment is needed, the quote is not determinative of fair value but could represent a relevant observable input into management’s determination of fair value.

The following are a few possible questions that entities should consider in evaluating whether a quote is determinative:

• Are there differences between the item being measured at fair value and the item for which a quote is available (e.g., differences in the terms or risk attributes)? Such differences may necessitate adjustments to the price quoted by the broker or pricing service.
• Does the quote reflect current orderly transactions for the item being measured? That is, are market participants currently transacting for the asset or liability at the price quoted by the broker or pricing service or does the quote reflect “stale” information or transactions that are not orderly? ASC 820-10-35-54L clarifies that an entity should place “less weight . . . on quotes that do not reflect the result of transactions.”
• Is the broker or pricing service using a valuation technique that complies with the fair value measurement principles in ASC 820? For example, does the valuation technique used by the broker or pricing service reflect market-participant assumptions, including assumptions about risk; maximize the use of relevant observable inputs; and minimize the use of unobservable inputs? If the valuation technique does not reflect the assumptions market participants would use in pricing the asset or liability, the price quoted by the broker or pricing service may not be relevant or may need to be adjusted.
• Is the quote provided by the broker or pricing service an indicative price or a binding offer? That is, does the broker or another market participant (or participants) stand ready to transact at the price quoted by the broker or pricing service? ASC 820-10-35-54M indicates that quotes based on binding offers should be weighted more heavily. Typically, a quote obtained from a broker or pricing service is an indicative price and not a binding offer (unless the broker is a market maker). If, however, a quote is a binding offer for an asset, the quote only definitively represents the “floor” for the fair value of the asset.
• Does the quote come from a reputable broker or pricing service that has a substantial presence in the market and the experience and expertise to provide a representationally faithful quote for the asset or liability being measured? An entity might place more weight on a quote from a broker or pricing service that has more experience and expertise related to the asset or liability being measured.

As the number of market transactions decreases, brokers or pricing services may rely more heavily on proprietary models to arrive at their quotes. An entity should determine how brokers or pricing services have arrived at their valuations as well as whether these valuations reflect market-participant assumptions (including assumptions about risk). This information may be difficult to obtain if quotes are based on proprietary models that brokers or pricing services might not be willing to share. However, although brokers or pricing services might not wish to share detailed information about their models, it might still be possible to obtain information about the nature of the assumptions and inputs used in the model (see Section 10.8.1 for more information about management’s responsibilities related to using third-party information to measure fair value). If the quote does not reflect assumptions that market participants would use in pricing the asset or liability, the quote may be a data point in the estimation of fair value but would most likely not be determinative since adjustments might be required. In addition, other indications of fair value, such as a valuation based on management’s own estimates of the inputs that market participants would use in pricing the asset or liability, may be equally or more useful to an estimation of fair value.

An entity will need to perform additional analysis when quotes for an individual security are obtained from different brokers or pricing services. Multiple quotes within a narrow range constitute stronger evidence of fair value than multiple quotes that are widely dispersed. If an entity’s own measurement of fair value is outside the range of broker or pricing service quotes, the entity should understand the cause(s) of such a difference. In addition, entities may find broker or pricing service quotes useful when calibrating their own models.

See Section 10.8.3 for additional discussion of the evaluation an entity performs when multiple quotes are obtained. See Section 10.6 for discussion of considerations related to measuring fair value when the volume or level of activity for an asset or liability has significantly decreased.

As indicated in ASC 820-10-35-54F, if there are significant differences in the quoted amounts, the entity may need to further analyze the quotes. Further, paragraphs 55–57 of the IASB Expert Advisory Panel report note that when significant differences exist, an average does not represent a price at which a transaction would take place; it is likely that one of the quotes obtained better represents fair value than the other(s).

One possible cause of the discrepancy in pricing could be that different brokers or pricing services possess different amounts of information. For example, a broker that was involved in the original sale of an instrument might have information about that instrument that enables the broker to assess its fair value better than another broker or pricing service without that information. The more information an entity has about the basis for a quote, the easier it is to validate and rely on it.

If the volume and level of market activity for the asset or liability have significantly decreased and the market is not active, the entity should perform further analysis to determine whether the quotes are based on current information that reflects orderly transactions or a valuation technique that reflects market-participant assumptions (including assumptions about risk). In addition, ASC 820-10-35-54L states, in part, “In weighting a quoted price as an input to a fair value measurement, a reporting entity places less weight (when compared with other indications of fair value that reflect the results of transactions) on quotes that do not reflect the result of transactions.” See Section 10.6 for more information about measuring fair value when the volume or level of activity for an asset or liability has significantly decreased.