Valuation Governance – How Does the PCAOB’s Recently Effective Fair Value Audit Standard Fit with the SEC’s New Fair Value Rule?

In December 2018 the Public Company Accounting Oversight Board (PCAOB) released a new audit standard that applies to auditing accounting estimates including fair value measurements. The new standard, AS 2501, became effective for audits of entities with fiscal years ending on or after December 15, 2020. Also, in December 2020 the U.S. Securities and Exchange Commission (SEC) announced the adoption of a new rule focused on fund valuation practices (Rule 2a-5). Rule 2a-5 is applicable to all registered investment companies which includes mutual funds, business development companies (BDCs) and unit investment trusts (UITs), and provides insight into how the SEC is thinking about valuation governance and valuation best practice for not only registered investment companies but also for private funds managed by registered investment advisers.

PCAOB Audit Standard (AS) 2501 replaced three prior standards with a single uniform approach to auditing estimates. It emphasizes that auditors need to apply professional skepticism, including addressing potential management bias when auditing accounting estimates. Most importantly, for purposes of this discussion, the new standard provides specific direction on auditing the fair value of financial instruments that are based on information from third-party pricing sources.

Interestingly, also in December 2020, the SEC issued an administrative order and an $8 million settlement with a pricing service that provided pricing data to clients which was deemed inconsistent with and did not reasonably reflect the value of certain securities. Both the PCAOB standard and the SEC rule specifically highlight a focus on pricing services and using broker quotes to value certain securities. When taken together these directives highlight the need for registered investment advisers and boards of registered investment companies to reassess their fair value governance procedures, especially as they relate to the use of broker quotes and other pricing data.

PCAOB Audit Standard 2501

With AS 2501 being effective at the end of 2020, auditors now have expanded responsibilities with respect to auditing fair value estimates. This article focuses on only one specific area of these responsibilities—the level of evidence needed when pricing services or brokers provide fair value information that a board or fund manager relies on when coming to their fair value determination.
AS 2501.A4 lists several factors that impact the relevance of pricing service data, including:

  • The experience and expertise of the pricing service relative to the types of financial instruments being valued, including whether the types of financial instruments being valued are routinely priced by the pricing service;
  • Whether the methodology used by the pricing service in determining fair value of the types of financial instruments being valued is in conformity with the applicable financial reporting framework [e.g. compliant with ASC Topic 820]; and
  • Whether the pricing service has a relationship with the company by which company management has the ability to directly or indirectly control or significantly influence the pricing service.

Further, AS 2501.A5 lists additional factors which the auditor must consider when evaluating the information provided by a pricing service:

  • Whether the fair values are based on quoted prices in active markets for identical financial instruments;
  • When the fair values are based on transactions of similar financial instruments, how those transactions are identified and considered comparable to the financial instrument being valued; and
  • When no recent transactions have occurred for either the financial instrument being valued or similar financial instruments, or the price was developed using a quote from a broker or dealer, how the fair value was developed, including whether the inputs used represent the assumptions that market participants would use when pricing the financial instruments.

The newly effective PCAOB audit standard (AS 2501.A9) also focuses on broker quotes, where the relevance and reliability of the audit evidence provided is dependent upon whether:

  • The broker or dealer is free of relationships with the company by which company management can directly or indirectly control or significantly influence the broker or dealer;
  • The broker or dealer making the quote is a market maker that transacts in the same type of financial instrument;
  • The broker quote reflects market conditions as of the financial statement date;
  • The broker quote is binding on the broker or dealer; and
  • There are any restrictions, limitations or disclaimers in the broker quote and, if so, their nature.

If the pricing service data or the broker quote information does not meet the criteria noted above, the auditor is required to extend their audit procedures to obtain appropriate relevant and reliable pricing information. The December 2020 SEC order and fine for deficiencies was because the pricing service used only single broker quotes and the pricing service did not reasonably reflect the value of the securities being priced.

The need to obtain relevant and reliable pricing information ties directly to the SEC’s new fair value rule.

SEC Rule 2a-5, Determining Fair Value in Good Faith

Rule 2a-5 highlights that “to determine the fair value of fund investments in good faith requires a certain minimum, consistent framework for fair value and standard of baseline practices across funds…” While the new rule allows delegation of certain valuation responsibilities, a fund board or manger retains the responsibility for the good faith determination of fair value and managing and overseeing the risks in the valuation process including oversight of third-party valuation support. The rule specifically states that the board is responsible for “evaluating pricing services.” 
In many ways the rule codifies practices which have evolved over the past decades. Board’s retain responsibility for oversight but may use advisers and other engaged valuation expertise to assist in fulfilling their fair value obligations.


The SEC’s $8 million fine, combined with the new audit standard now required to be applied, in the context of Rule 2a-5 highlight the need for the boards of registered investment companies and registered investment advisors to reassess the valuation governance process they have in place, specifically when using pricing services and brokers to provide valuation data. Depending on individual facts and circumstances the pendulum may swing where funds will estimate fair value using calibrated models as their primary estimation techniques and use pricing services and brokers as corroborating information. What is clear is that the pendulum has swung requiring greater valuation oversight by boards and managers especially as they respond to expanded testing by auditors and the demand for increased valuation rigor by investors.

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