Ultimately, it is management’s responsibility to determine the appropriateness of its fair value measurements and their classification in the fair value hierarchy, including measurements for which pricing services (such as Bloomberg, Interactive Data Corporation, Thomson Reuters, Markit, Standard and Poor’s), broker pricing information, and similar sources are used.
ASC 820-10-35-54K indicates that the use of quoted prices provided by third parties, such as pricing services or brokers, is permitted if the reporting entity has determined that the quoted prices provided by those parties are developed in accordance with the fair value standard. Therefore, reporting entities that use pricing services need to understand how the pricing information is developed and obtain sufficient information to determine where instruments fall within the fair value hierarchy.
For example, a pricing service could provide quoted prices for an actively traded equity security which, if corroborated by the reporting entity, would be considered Level 1 inputs. The same pricing service may also provide a corporate bond price based on matrix pricing, which may constitute a Level 2 or Level 3 input, depending on the information used in the model. The information provided by these sources could result in a financial instrument falling into any level in the fair value hierarchy, depending on the inputs and methods used for a particular financial instrument.
Dealer quotes are observable only if the dealer stands ready and willing to transact at that price. Brokers, on the other hand, report what they see in the market but usually are not ready and willing to transact at that price. In order for broker quotes to be observable, they need to be corroborated by other market events or data.
A broker quote may be a Level 2 input if observable market information exists for comparable assets and/or the dealer is willing and able to transact in the security at that price. In many cases, a single broker quote may be indicative of a Level 3 measure if there are no comparables and the quote is provided with no commitment to actually transact at that price.
A reporting entity should have some higher-level (i.e., observable) data to support classification of an input as Level 2. A broker quote for which the broker does not stand ready to transact cannot be corroborated with an internal model populated with Level 3 information to support a Level 2 classification. Multiple indicative broker quotes or vendor prices based on Level 3 inputs do not raise the categorization of that instrument to Level 2. However, there may be other instances in which pricing information can be corroborated by market evidence, resulting in a Level 2 input.
In some cases, reporting entities may rely on pricing services or published prices that represent a consensus reporting of multiple brokers or "evaluated prices." It may not be clear if the reporting entity can transact at the prices provided or if observable market data was used to develop the indicative price. To support an assertion that a broker quote or information obtained from a pricing service represents a Level 2 input, the reporting entity should perform further review procedures to understand how the price was developed, including understanding the nature and observability of the inputs used to determine that price. As market activity often ebbs and flows, pricing techniques often do as well. Because of this, reporting entities should perform review procedures on an ongoing basis for financial reporting purposes versus at a singular point in time. Additional corroboration could include the following:
- Use of liquidity or transparency information and metrics provided by the vendor which may include the liquidity score and depth of the quotes informing the price
- Review of vendor valuation methodology documentation
- Discussions with pricing services, dealers, or other companies to obtain additional prices of identical or similar assets to corroborate the price
- Back-testing of prices to determine historical accuracy against actual transactions. While this analysis provides more evidence on the accuracy/reliability of historical prices provided, it may also provide an initial indication of whether pricing uses observable data inputs. It is likely that additional corroboration would be necessary to determine the use of observable market data.
- Comparisons to other external or internal valuation model outputs and their corroboration with observable market data
The level of investigation necessary is highly dependent on the facts and circumstances, such as the type and complexity of the asset or liability being measured, and its observability and the level of activity in the marketplace. Generally, the more specialized the asset or liability being measured and the less actively traded it is, the more review procedures will be necessary to corroborate the price to support classification as a Level 2 input.
When performing additional procedures, reporting entities should clearly document the assessment and conclusion. Without additional supporting information, we believe prices obtained from a single or multiple broker sources or a pricing service are indicative values or proxy quotes that generally represent Level 3 inputs.
In another example, a reporting entity may obtain a price from a broker or pricing service for a municipal security. The reporting entity may be fully aware of the depth and activity of the security's trading in the marketplace based on its historical trading experience. In addition, the pricing methodology for the security may be common and well-understood (e.g., matrix pricing) and the reporting entity may be able to perform less due diligence. However, this conclusion may not be appropriate for a reporting entity that obtains a price from a broker or pricing service for a collateralized debt obligation that is not frequently traded and may not be as easily subject to common, well-understood pricing methodologies (e.g., matrix pricing), for example. Therefore, the reporting entity may need to perform more due diligence.