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The new rules regarding investment valuations require all financial reporting professionals to re-learn how to value investment assets.  The prices used to value investments for financial disclosures must now be put through a rigorous vetting process before they can be used.  All key assumptions, inputs, and methodology used to manufacture a price must be listed. Additionally, proof of why they are appropriate assumptions, inputs and methods must be provided for each price.

Previously, financial reporting professionals could simply choose a “reputable” price vendor and be done with their work - an approach that has been discarded because it failed during the stress scenario of the financial crisis. This dramatic change is one that requires a significant increase in both time and effort.

0% INDEPENDENCE!

 

The financial crisis revealed that prices being used in financial reporting were never tested using independent information. Ninety percent or more of all audit firms, for example, obtained the prices they used for testing from the same price vendor that provided the prices being tested. In short, no test was truly being performed and the basic concept of independence was ignored. Now that this is widely understood, this practice is no longer acceptable and financial reporting professionals must document that they are using a second, independent pricing source.

LACK OF PROFESSIONAL SKEPTICISM

 

The financial crisis also revealed a large amount of ignorance regarding the origin and manufacture of investment prices within the financial reporting community. This ignorance led to a series of expedient procedures which degraded the work to a point where almost no safeguards against mis-valuations and potential fraud were in place.  As a result, there are numerous law suits pending in the courts initiated by the SEC and other stakeholders.

Furthermore, it was revealed that for the more difficult to value items, the price sources used were the most biased sources possible:  the underwriters and brokers whose interests conflict with the interest of the investing community. This resulted in financial reporting professionals being unable and/or unwilling to find unbiased information and instead, dispensing with their professional skepticism in lieu of expedience.

VETTING IS AT THE INDIVIDUAL PRICE LEVEL

 

The prices used must be vetted themselves; it is no longer acceptable to vet the vendor from which they were purchased. Nor is it appropriate to vet how a price vendor approaches a sector of investments. The investigation and documentation must be specific to each price used at the individual investment level.

WHAT IS A DEEP DIVE?

 

A deep dive into an investment price is similar to ingredients in a recipe. Everything that goes into the calculation of a price as well as a narrative describing the manufacture process must be provided.  Additionally, a deep dive will include documents from observable market sources that justify the selection of each ingredient used. For example, if a bond is priced using a yield of 6%, the deep dive must show market information that supports the use of 6% as opposed to 5% or 7%. The market information used to support the price must be information that is observable and available to others. If the information is private and not observable, this must be disclosed and additional procedures must be performed.
 

 

DEEP DIVES ARE HARD TO OBTAIN

 

The financial reporting community faces challenges in obtaining this type of detailed information. Most pricing services do not derive their prices in this manner; therefore, they cannot show this type of transparent detail. Harvest is uniquely qualified to provide the deep dive needed to satisfy the new rules.


THE NEW APPROACH IS GAINING WIDE ACCEPTANCE

 

The financial reporting community responsible for SEC issuers was first in line for the new rules. However, the rest of the financial reporting community has now adopted them including the PCAOB, GASB, AIMR, PBGC, and others. Too many stakeholders, including the taxpayer, have spent too much money on the clean-up of the financial crises caused by poor and/or fraudulent valuations.

WHAT SHOULD FINANCIAL REPORTING PROFESSIONALS DO?

 

Primarily, financial reporting professionals must educate themselves, and ensure that they are receiving independent testing of investment prices.

Additionally, they must make deep dives into at least a sample of prices obtained from their vendors across all types of securities that they own. This sample should be skewed towards the harder to value and riskier types of investments. Prices obtained from biased sources such as brokers, managers, or underwriters must be specifically targeted and professional skepticism must be evident and documented.