Are Broker Quotes Sufficient in Estimating Fair Value?

New standards for auditing the fair value of financial instruments released by the Public Company Accounting Oversight Board (PCAOB) are set to commence for fiscal years ending on or after December 15, 2020.

For investments deemed not active but valued using observable inputs (Level II inputs) additional audit procedures are required. In particular, broker quotes and transaction data must be assessed in the context of the broader market environment and the unique circumstances surrounding each quote, transaction and price.

The new PCAOB standards specify that when a company's fair value measurement is based on a quote from a broker or dealer (broker quote), the relevance and reliability of the evidence provided by the broker quote depend on 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.

While these requirements apply to the auditor, they likely will have an indirect impact on other stakeholders such as chief financial officers and other members of management and staff involved in and responsible for preparing financial statements. Management will need to provide additional evidence that supports the fair value estimate. Broker quotes should, wherever possible, be multiple, sourced consistently and accessed by the valuation service provider independently without intervention by the investment/portfolio manager. If the consistency, quantity or actionability of broker quotes or transaction data is absent, it may be necessary to move to alternative Level II or Level III (unobservable model-based) inputs.

With continued uncertainty moving into 2021, estimating fair value requires significant informed judgement and support. If broker quotes lack relevance or reliability, a model-based approach to valuation using discounted cash flows or other market inputs will likely be necessary. Given the approaching audit standards commencement, we stand ready to assist our clients and contacts with making these critical judgements required to estimate fair value.

David L. Larsen, CPA/CEIV/ABV is a managing director with the Alternative Asset Advisory practice at Duff & Phelps and serves as a member of the Standards Review Board of the International Valuation Standards Council, an advisor to International Private Equity and Venture Capital Valuations Board, a member of the AICPA PE/VC Valuation guide taskforce and former member of FASB’s Valuation Resource Group.

Jennifer Press is a managing director with the Alternative Asset Advisory practice at Duff & Phelps where she is responsible for service capabilities in structured credit and whole loans.

Robert Maxim is a director with the Alternative Asset Advisory practice at Duff & Phelps where he leads a team focused on valuation and advisory services for commercial real estate loans and structured products.