Section I—Background Information about Financial Instruments
Different definitions of financial instruments may exist among financial reporting frameworks. For example, Australian Accounting Standards define a financial instrument as any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Financial instruments may be cash, the equity of another entity, the contractual right or obligation to receive or deliver cash or exchange financial assets or liabilities, certain contracts settled in an entity’s own equity instruments, certain contracts on non-financial items, or certain contracts issued by insurers that do not meet the definition of an insurance contract. This definition encompasses a wide range of financial instruments from simple loans and deposits to complex derivatives, structured products, and some commodity contracts.
Financial instruments vary in complexity, though the complexity of the financial instrument can come from difference sources, such as:
- A very high volume of individual cash flows, where a lack of homogeneity requires analysis of each one or a large number of grouped cash flows to evaluate, for example, credit risk (for example, collateralised debt obligations (CDOs)).
- Complex formulae for determining the cash flows.
- Uncertainty or variability of future cash flows, such as that arising from credit risk, option contracts or financial instruments with lengthy contractual terms.
The higher the variability of cash flows to changes in market conditions, the more complex and uncertain the fair value measurement of the financial instrument is likely to be. In addition, sometimes financial instruments that, ordinarily, are relatively easy to value become complex to value because of particular circumstances, for example, instruments for which the market has become inactive or which have lengthy contractual terms. Derivatives and structured products become more complex when they are a combination of individual financial instruments. In addition, the accounting for financial instruments under certain financial reporting frameworks or certain market conditions may be complex.
Another source of complexity is the volume of financial instruments held or traded. While a “plain vanilla” interest rate swap may not be complex, an entity holding a large number of them may use a sophisticated information system to identify, value and transact these instruments.
Purpose and Risks of Using Financial Instruments
Financial instruments are used for:
- Hedging purposes (that is, to change an existing risk profile to which an entity is exposed). This includes:
- The forward purchase or sale of currency to fix a future exchange rate;
- Converting future interest rates to fixed rates or floating rates through the use of swaps; and
- The purchase of option contracts to provide an entity with protection against a particular price movement, including contracts which may contain embedded derivatives;
- Trading purposes (for example, to enable an entity to take a risk position to benefit from short term market movements); and
- Investment purposes (for example, to enable an entity to benefit from long term investment returns).
The use of financial instruments can reduce exposures to certain business risks, for example changes in exchange rates, interest rates and commodity prices, or a combination of those risks. On the other hand, the inherent complexities of some financial instruments also may result in increased risk.
Business risk and the risk of material misstatement increase when management and those charged with governance:
- Do not fully understand the risks of using financial instruments and have insufficient skills and experience to manage those risks;
- Do not have the expertise to value them appropriately in accordance with the applicable financial reporting framework;
- Do not have sufficient controls in place over financial instrument activities; or
- Inappropriately hedge risks or speculate.
Management’s failure to fully understand the risks inherent in a financial instrument can have a direct effect on management’s ability to manage these risks appropriately, and may ultimately threaten the viability of the entity.
The principal types of risk applicable to financial instruments are listed below. This list is not meant to be exhaustive and different terminology may be used to describe these risks or classify the components of individual risks.
- Credit (or counterparty) risk is the risk that one party to a financial instrument will cause a financial loss to another party by failing to discharge an obligation and is often associated with default. Credit risk includes settlement risk, which is the risk that one side of a transaction will be settled without consideration being received from the customer or counterparty.
- Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Examples of market risk include currency risk, interest rate risk, and commodity and equity price risk.
- Liquidity risk includes the risk of not being able to buy or sell a financial instrument at an appropriate price in a timely manner due to a lack of marketability for that financial instrument.
- Operational risk relates to the specific processing required for financial instruments. Operational risk may increase as the complexity of a financial instrument increases, and poor management of operational risk may increase other types of risk. Operational risk includes:
- The risk that confirmation and reconciliation controls are inadequate resulting in incomplete or inaccurate recording of financial instruments;
- The risks that there is inappropriate documentation of transactions and insufficient monitoring of these transactions;
- The risk that transactions are incorrectly recorded, processed or risk managed and, therefore, do not reflect the economics of the overall trade;
- The risk that undue reliance is placed by staff on the accuracy of valuation techniques, without adequate review, and transactions are therefore incorrectly valued or their risk is improperly measured;
- The risk that the use of financial instruments is not adequately incorporated into the entity’s risk management policies and procedures;
- The risk of loss resulting from inadequate or failed internal processes and systems, or from external events, including the risk of fraud from both internal and external sources;
- The risk that there is inadequate or non-timely maintenance of valuation techniques used to measure financial instruments; and
- Legal risk, which is a component of operational risk, and relates to losses resulting from a legal or regulatory action that invalidates or otherwise precludes performance by the end user or its counterparty under the terms of the contract or related netting arrangements. For example, legal risk could arise from insufficient or incorrect documentation for the contract, an inability to enforce a netting arrangement in bankruptcy, adverse changes in tax laws, or statutes that prohibit entities from investing in certain types of financial instruments.
Other considerations relevant to risks of using financial instruments include:
- The risk of fraud that may be increased if, for example, an employee in a position to perpetrate a financial fraud understands both the financial instruments and the processes for accounting for them, but management and those charged with governance have a lesser degree of understanding.
- The risk that master netting arrangements may not be properly reflected in the financial report.
- The risk that some financial instruments may change between being assets or liabilities during their term and that such change may occur rapidly.
See Australian Accounting Standard 132 (AASB 132) Financial Instruments: Presentation, paragraph 11.
An entity that undertakes a number of financial instrument transactions with a single counterparty may enter into a master netting arrangement with that counterparty. Such an agreement provides for a single net settlement of all financial instruments covered by the agreement in the event of default of any one contract.
Controls Relating to Financial Instruments
The extent of an entity’s use of financial instruments and the degree of complexity of the instruments are important determinants of the necessary level of sophistication of the entity’s internal control. For example, smaller entities may use less structured products and simple processes and procedures to achieve their objectives.
Often, it is the role of those charged with governance to set the tone regarding, and approve and oversee the extent of use of, financial instruments while it is management’s role to manage and monitor the entity’s exposures to those risks. Management and, where appropriate, those charged with governance are also responsible for designing and implementing a system of internal control to enable the preparation of financial report in accordance with the applicable financial reporting framework. An entity’s internal control over financial instruments is more likely to be effective when management and those charged with governance have:
- Established an appropriate control environment, including active participation by those charged with governance in controlling the use of financial instruments, a logical organisational structure with clear assignment of authority and responsibility, and appropriate human resource policies and procedures. In particular, clear rules are needed on the extent to which those responsible for financial instrument activities are permitted to act. Such rules have regard to any legal or regulatory restrictions on using financial instruments. For example, certain public sector entities may not have the power to conduct business using derivatives;
- Established a risk management process relative to the size of the entity and the complexity of its financial instruments (for example, in some entities a formal risk management function may exist);
- Established information systems that provide those charged with governance with an understanding of the nature of the financial instrument activities and the associated risks, including adequate documentation of transactions;
- Designed, implemented and documented a system of internal control to:
- Provide reasonable assurance that the entity’s use of financial instruments is within its risk management policies;
- Properly present financial instruments in the financial report;
- Ensure that the entity is in compliance with applicable laws and regulations; and
- Monitor risk. The Appendix provides examples of controls that may exist in an entity that deals in a high volume of financial instrument transactions; and
- Established appropriate accounting policies, including valuation policies, in accordance with the applicable financial reporting framework.
Key elements of risk management processes and internal control relating to an entity’s financial instruments include:
- Setting an approach to define the amount of risk exposure that the entity is willing to accept when engaging in financial instrument transactions (this may be referred to as its “risk appetite”), including policies for investing in financial instruments, and the control framework in which the financial instrument activities are conducted;
- Establishing processes for the documentation and authorisation of new types of financial instrument transactions which consider the accounting, regulatory, legal, financial and operational risks that are associated with such instruments;
- Processing financial instrument transactions, including confirmation and reconciliation of cash and asset holdings to external statements, and the payments process;
- Segregation of duties between those investing or trading in the financial instruments and those responsible for processing, valuing and confirming such instruments. For example, a model development function that is involved in assisting in pricing deals is less objective than one that is functionally and organisationally separate from the front office;
- Valuation processes and controls, including controls over data obtained from third-party pricing sources; and
- Monitoring of controls.
The nature of risks often differs between entities with a high volume and variety of financial instruments and those with only a few financial instrument transactions. This results in different approaches to internal control. For example:
- Typically, an institution with high volumes of financial instruments will have a dealing room type environment in which there are specialist traders and segregation of duties between those traders and the back office (which refers to the operations function that data-checks trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers). In such environments, the traders will typically initiate contracts verbally over the phone or via an electronic trading platform. Capturing relevant transactions and accurately recording financial instruments in such an environment is significantly more challenging than for an entity with only a few financial instruments, whose existence and completeness often can be confirmed with a bank confirmation to a few banks.
- On the other hand, entities with only a small number of financial instruments often do not have segregation of duties, and access to the market is limited. In such cases, although it may be easier to identify financial instrument transactions, there is a risk that management may rely on a limited number of personnel, which may increase the risk that unauthorised transactions may be initiated or transactions may not be recorded.
Completeness, Accuracy, and Existence
Paragraphs 25–33 of this Guidance Statement describe controls and processes which may be in place in entities with a high volume of financial instrument transactions, including those with trading rooms. By contrast, an entity that does not have a high volume of financial instrument transactions may not have these controls and processes but may instead confirm their transactions with the counterparty or clearing house. Doing so may be relatively straightforward in that the entity may only transact with one or two counterparties.
Trade Confirmations and Clearing Houses
Generally, for transactions undertaken by financial institutions, the terms of financial instruments are documented in confirmations exchanged between counterparties and legal agreements. Clearing houses serve to monitor the exchange of confirmations by matching trades and settling them. A central clearing house is associated with an exchange and entities that clear through clearing houses typically have processes to manage the information delivered to the clearing house.
Not all transactions are settled through such an exchange. In many other markets there is an established practice of agreeing the terms of transactions before settlement begins. To be effective, this process needs to be run separately from those who trade the financial instruments to minimise the risk of fraud. In other markets, transactions are confirmed after settlement has begun and sometimes confirmation backlogs result in settlement beginning before all terms have been fully agreed. This presents additional risk because the transacting entities need to rely on alternative means of agreeing trades. These may include:
- Enforcing rigorous reconciliations between the records of those trading the financial instruments and those settling them (strong segregation of duties between the two are important), combined with strong supervisory controls over those trading the financial instruments to ensure the integrity of the transactions;
- Reviewing summary documentation from counterparties that highlights the key terms even if the full terms have not been agreed; and
- Thorough review of traders’ profits and losses to ensure that they reconcile to what the back office has calculated.
Reconciliations with Banks and Custodians
Some components of financial instruments, such as bonds and shares, may be held in separate depositories. In addition, most financial instruments result in payments of cash at some point and often these cash flows begin early in the contract’s life. These cash payments and receipts will pass through an entity’s bank account. Regular reconciliation of the entity’s records to external banks’ and custodians’ records enables the entity to ensure transactions are properly recorded.
It should be noted that not all financial instruments result in a cash flow in the early stages of the contract’s life or are capable of being recorded with an exchange or custodian. Where this is the case, reconciliation processes will not identify an omitted or inaccurately recorded trade and confirmation controls are more important. Even where such a cash flow is accurately recorded in the early stages of an instrument’s life, this does not ensure that all characteristics or terms of the instrument (for example, the maturity or an early termination option) have been recorded accurately.
In addition, cash movements may be quite small in the context of the overall size of the trade or the entity’s own balance sheet and may therefore be difficult to identify. The value of reconciliations is enhanced when finance, or other back office staff, review entries in all general ledger accounts to ensure that they are valid and supportable. This process will help identify if the other side to cash entries relating to financial instruments has not been properly recorded. Reviewing suspense and clearing accounts is important regardless of the account balance, as there may be offsetting reconciling items in the account.
In entities with a high volume of financial instrument transactions, reconciliation and confirmation controls may be automated and, if so, adequate IT controls need to be in place to support them. In particular, controls are needed to ensure that data is completely and accurately picked up from external sources (such as banks and custodians) and from the entity’s records and is not tampered with before or during reconciliation. Controls are also needed to ensure that the criteria on which entries are matched are sufficiently restrictive to prevent inaccurate clearance of reconciling items.
Other Controls over Completeness, Accuracy, and Existence
The complexity inherent in some financial instruments means that it will not always be obvious how they should be recorded in the entity’s systems. In such cases, management may set up control processes to monitor policies that prescribe how particular types of transactions are measured, recorded and accounted for. These policies are typically established and reviewed in advance by suitably qualified personnel who are capable of understanding the full effects of the financial instruments being booked.
Some transactions may be cancelled or amended after initial execution. Application of appropriate controls relating to cancellation or amendment can mitigate the risks of material misstatement due to fraud or error. In addition, an entity may have a process in place to reconfirm trades that are cancelled or amended.
In financial institutions with a high volume of trading, a senior employee typically reviews daily profits and losses on individual traders’ books to evaluate whether they are reasonable based on the employee’s knowledge of the market. Doing so may enable management to determine that particular trades were not completely or accurately recorded, or may identify fraud by a particular trader. It is important that there are transaction authorisation procedures that support the more senior review.
Valuation of Financial Instruments
Financial Reporting Requirements
In many financial reporting frameworks, including Australian Accounting Standards, financial instruments, including embedded derivatives, are often measured at fair value for the purpose of balance sheet presentation, calculating profit or loss, and/or disclosure. In general, the objective of fair value measurement is to arrive at the price at which an orderly transaction would take place between market participants at the measurement date under current market conditions; that is, it is not the transaction price for a forced liquidation or distressed sale. In meeting this objective, all relevant available market information is taken into account.
Fair value measurements of financial assets and financial liabilities may arise both at the initial recording of transactions and later when there are changes in value. Changes in fair value measurements that occur over time may be treated in different ways under different financial reporting frameworks. For example, such changes may be recorded as profit or loss, or may be recorded in the other comprehensive income. Also, depending on the applicable financial reporting framework, the whole financial instrument or only a component of it (for example, an embedded derivative when it is separately accounted for) may be required to be measured at fair value.
Some financial reporting frameworks, for example, Australian Accounting Standards, establish a fair value hierarchy to develop increased consistency and comparability in fair value measurements and related disclosures. The inputs may be classified into different levels such as:
- Level 1 inputs―Quoted prices (unadjusted) in active markets for identical financial assets or financial liabilities that the entity can access at the measurement date.
- Level 2 inputs―Inputs other than quoted prices included within level 1 that are observable for the financial asset or financial liability, either directly or indirectly. If the financial asset or financial liability has a specified (contractual) term, a level 2 input must be observable for substantially the full term of the financial asset or financial liability. Level 2 inputs include the following:
- Quoted prices for similar financial assets or financial liabilities in active markets.
- Quoted prices for identical or similar financial assets or financial liabilities in markets that are not active.
- Inputs other than quoted prices that are observable for the financial asset or financial liability (for example, interest rates and yield curves observable at commonly quoted intervals, implied volatilities and credit spreads).
- Inputs that are derived principally from, or corroborated by, observable market data by correlation or other means (market-corroborated inputs).
- Level 3 inputs―Unobservable inputs for the financial asset or financial liability. Unobservable inputs are used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the financial asset or financial liability at the measurement date.
In general, measurement uncertainty increases as a financial instrument moves from level 1 to level 2, or level 2 to level 3. Also, within level 2 there may be a wide range of measurement uncertainty depending on the observability of inputs, the complexity of the financial instrument, its valuation, and other factors.
Australian Accounting Standards may require or permit the entity to adjust for measurement uncertainties, in order to adjust for risks that a market participant would make in the pricing to take account of the uncertainties of the risks associated with the pricing or cash flows of the financial instrument. For example:
- Model adjustments. Some models may have a known deficiency or the result of calibration may highlight the deficiency for the fair value measurement in accordance with the financial reporting framework.
- Credit-risk adjustments. Some models do not take into account credit risk, including counterparty risk or own credit risk.
- Liquidity adjustments. Some models calculate a mid-market price, even though the financial reporting framework may require use of a liquidity adjusted amount such as a bid/offer spread. Another, more judgemental, liquidity adjustment recognises that some financial instruments are illiquid which affects the valuation.
- Other risk adjustments. A value measured using a model that does not take into account all other factors that market participants would consider in pricing the financial instrument may not represent fair value on the measurement date, and therefore may need to be adjusted separately to comply with the applicable financial reporting framework.
Adjustments are not appropriate if they adjust the measurement and valuation of the financial instrument away from fair value as defined by the applicable financial reporting framework, for example for conservatism.
Observable and Unobservable Inputs
As mentioned above, financial reporting frameworks often categorise inputs according to the degree of observability. As activity in a market for financial instruments declines and the observability of inputs declines, measurement uncertainty increases. The nature and reliability of information available to support valuation of financial instruments varies depending on the observability of inputs to its measurement, which is influenced by the nature of the market (for example, the level of market activity and whether it is through an exchange or over-the-counter (OTC)). Accordingly, there is a continuum of the nature and reliability of evidence used to support valuation, and it becomes more difficult for management to obtain information to support a valuation when markets become inactive and inputs become less observable.
When observable inputs are not available, an entity uses unobservable inputs (level 3 inputs) that reflect the assumption that market participants would use when pricing the financial asset or the financial liability, including assumptions about risk. Unobservable inputs are developed using the best information available in the circumstances. In developing unobservable inputs, an entity may begin with its own data, which is adjusted if reasonably available information indicates that (a) other market participants would use different data or (b) there is something particular to the entity that is not available to other market participants (for example, an entity-specific synergy).
Effects of Inactive Markets
Measurement uncertainty increases and valuation is more complicated when the markets in which financial instruments or their component parts are traded become inactive. There is no clear point at which an active market becomes inactive, though financial reporting frameworks, including Australian Accounting Standards, may provide guidance on this issue. Characteristics of an inactive market include a significant decline in the volume and level of trading activity, available prices vary significantly over time or among market participants or the prices are not current. However, assessing whether a market is inactive requires judgement.
When markets are inactive, prices quoted may be stale (that is, out of date), may not represent prices at which market participants may trade or may represent forced transactions (such as when a seller is required to sell an asset to meet regulatory or legal requirements, needs to dispose of an asset immediately to create liquidity or the existence of a single potential buyer as a result of the legal or time restrictions imposed). Accordingly, valuations are developed based on level 2 and level 3 inputs. Under such circumstances, entities may have:
- A valuation policy that includes a process for determining whether level 1 inputs are available;
- An understanding of how particular prices or inputs from external sources used as inputs to valuation techniques were calculated in order to assess their reliability. For example, in an active market, a broker quote on a financial instrument that has not traded is likely to reflect actual transactions on a similar financial instrument, but, as the market becomes less active, the broker quote may rely more on proprietary valuation techniques to determine prices;
- An understanding of how deteriorating business conditions affect the counterparty, as well as whether deteriorating business conditions in entities similar to the counterparty may indicate that the counterparty may not fulfil its obligations (that is, non-performance risk);
- Policies for adjusting for measurement uncertainties. Such adjustments can include model adjustments, lack of liquidity adjustments, credit risk adjustments, and other risk adjustments;
- The capability to calculate the range of realistic outcomes given the uncertainties involved, for example by performing a sensitivity analysis; and
- Policies for identifying when a fair value measurement input moves to a different level of the fair value hierarchy.
Particular difficulties may develop where there is severe curtailment or even cessation of trading in particular financial instruments. In these circumstances, financial instruments that have previously been valued using market prices may need to be valued using a model.
Management’s Valuation Process
Techniques that management may use to value their financial instruments include observable prices, recent transactions, and models that use observable or unobservable inputs. Management may also make use of:
- A third-party pricing source, such as a pricing service or broker quote; or
- A valuation expert.
Third-party pricing sources and valuation experts may use one or more of these valuation techniques.
In many financial reporting frameworks, including Australian Accounting Standards, the best evidence of a financial instrument’s fair value is found in contemporaneous transactions in an active market (that is, level 1 inputs). In such cases, the valuation of a financial instrument may be relatively simple. Quoted prices for financial instruments that are listed on exchanges or traded in liquid over-the-counter markets may be available from sources such as financial publications, the exchanges themselves or third-party pricing sources. When using quoted prices, it is important that management understand the basis on which the quote is given to ensure that the price reflects market conditions at the measurement date. Quoted prices obtained from publications or exchanges may provide sufficient evidence of fair value when, for example:
- The prices are not out of date or “stale” (for example, if the quote is based on the last traded price and the trade occurred some time ago); and
- The quotes are prices at which dealers would actually trade the financial instrument with sufficient frequency and volume.
Where there is no current observable market price for the financial instrument (that is, a level 1 input), it will be necessary for the entity to gather other price indicators to use in a valuation technique to value the financial instrument. Price indicators may include:
- Recent transactions, including transactions after the date of the financial statements in the same instrument. Consideration is given to whether an adjustment needs to be made for changes in market conditions between the measurement date and the date the transaction was made, as these transactions are not necessarily indicative of the market conditions that existed at the date of the financial statements. In addition it is possible that the transaction represents a forced transaction and is therefore not indicative of a price in an orderly trade.
- Current or recent transactions in similar instruments, often known as “proxy pricing.” Adjustments will need to be made to the price of the proxy to reflect the differences between them and the instrument being priced, for example, to take account of differences in liquidity or credit risk between the two instruments.
- Indices for similar instruments. As with transactions in similar instruments, adjustments will need to be made to reflect the difference between the instrument being priced and the instrument(s) from which the index used is derived.
It is expected that management will document its valuation policies and model used to value a particular financial instrument, including the rationale for the model(s) used, the selection of assumptions in the valuation methodology, and the entity’s consideration of whether adjustments for measurement uncertainty are necessary.
Models may be used to value financial instruments when the price cannot be directly observed in the market. Models can be as simple as a commonly used bond pricing formula or involve complex, specifically developed software tools to value financial instruments with level 3 inputs. Many models are based on discounted cash flow calculations.
Models comprise a methodology, assumptions and data. The methodology describes rules or principles governing the relationship between the variables in the valuation. Assumptions include estimates of uncertain variables which are used in the model. Data may comprise actual or hypothetical information about the financial instrument, or other inputs to the financial instrument.
Depending on the circumstances, matters that the entity may address when establishing or validating a model for a financial instrument include whether:
- The model is validated prior to usage, with periodic reviews to ensure it is still suitable for its intended use. The entity’s validation process may include evaluation of:
- The methodology’s theoretical soundness and mathematical integrity, including the appropriateness of parameters and sensitivities.
- The consistency and completeness of the model’s inputs with market practices, and whether the appropriate inputs are available for use in the model.
- There are appropriate change control policies, procedures and security controls over the model.
- The model is appropriately changed or adjusted on a timely basis for changes in market conditions.
- The model is periodically calibrated, reviewed and tested for validity by a separate and objective function. Doing so is a means of ensuring that the model’s output is a fair representation of the value that marketplace participants would ascribe to a financial instrument.
- The model maximises the use of relevant observable inputs and minimises the use of unobservable inputs.
- Adjustments are made to the output of the model to reflect the assumptions marketplace participants would use in similar circumstances.
- The model is adequately documented, including the model’s intended applications and limitations and its key parameters, required data, results of any validation analysis performed and any adjustments made to the output of the model.
An Example of a Common Financial Instrument
The following describes how models may be applied to value a common financial instrument, known as an asset backed security. Because asset backed securities are often valued based on level 2 or 3 inputs, they are frequently valued using models and involve:
- Understanding the type of security—considering (a) the underlying collateral; and (b) the terms of the security. The underlying collateral is used to estimate the timing and amounts of cash flows such as mortgage or credit card interest and principal payments.
- Understanding the terms of the security—this includes evaluating contractual cash flow rights, such as the order of repayment, and any default events. The order of repayment, often known as seniority, refers to terms which require that some classes of security holders (senior debt) are repaid before others (subordinated debt). The rights of each class of security holder to the cash flows, frequently referred to as the cash flow “waterfall,” together with assumptions of the timing and amount of cash flows are used to derive a set of estimated cash flows for each class of security holder. The expected cash flows are then discounted to derive an estimated fair value.
The cash flows of an asset backed security may be affected by prepayments of the underlying collateral and by potential default risk and resulting estimated loss severities. Prepayment assumptions, if applicable, are generally based on evaluating market interest rates for similar collateral to the rates on the collateral underlying the security. For example, if market interest rates for mortgages have declined then the underlying mortgages in a security may experience higher prepayment rates than originally expected. Estimating potential default and loss severity involves close evaluation of the underlying collateral and borrowers to estimate default rates. For example, when the underlying collateral comprises residential mortgages, loss severities may be affected by estimates of residential housing prices over the term of the security.
Third-Party Pricing Sources
Entities may use third-party pricing sources in order to obtain fair value information. The preparation of an entity’s financial statements, including the valuation of financial instruments and the preparation of financial statement disclosures relating to these instruments, may require expertise that management does not possess. Entities may not be able to develop appropriate valuation techniques, including models that may be used in a valuation, and may use a third-party pricing source to arrive at a valuation or to provide disclosures for the financial statements. This may particularly be the case in smaller entities or in entities that do not engage in a high volume of financial instruments transactions (for example, non-financial institutions with treasury departments). Even though management has used a third-party pricing source, management is ultimately responsible for the valuation.
Third-party pricing sources may also be used because the volume of securities to price over a short timeframe may not be possible by the entity. This is often the case for traded investment funds that must determine a net asset value each day. In other cases, management may have their own pricing process but use third-party pricing sources to corroborate their own valuations.
For one or more of these reasons most entities use third-party pricing sources when valuing securities either as a primary source or as a source of corroboration for their own valuations. Third-party pricing sources generally fall into the following categories:
- Pricing services, including consensus pricing services; and
- Brokers proving broker quotes.
Pricing services provide entities with prices and price-related data for a variety of financial instruments, often performing daily valuations of large numbers of financial instruments. These valuations may be made by collecting market data and prices from a wide variety of sources, including market makers, and, in certain instances, using internal valuations techniques to derive estimated fair values. Pricing services may combine a number of approaches to arrive at a price. Pricing services are often used as a source of prices based on level 2 inputs. Pricing services may have strong controls around how prices are developed and their customers often include a wide variety of parties, including buy and sell side investors, back and middle office functions, auditors and others.
Pricing services often have a formalised process for customers to challenge the prices received from the pricing services. These challenge processes usually require the customer to provide evidence to support an alternative price, with challenges categorised based on the quality of evidence provided. For example, a challenge based on a recent sale of that instrument that the pricing service was not aware of may be upheld, whereas a challenge based on a customer’s own valuation technique may be more heavily scrutinised. In this way, a pricing service with a large number of leading participants, both buy and sell side, may be able to constantly correct prices to more fully reflect the information available to market participants.
Consensus pricing services
Some entities may use pricing data from consensus pricing services which differ from other pricing services. Consensus pricing services obtain pricing information about an instrument from several participating entities (subscribers). Each subscriber submits prices to the pricing service. The pricing service treats this information confidentially and returns to each subscriber the consensus price, which is usually an arithmetical average of the data after a data cleansing routine has been employed to eliminate outliers. For some markets, such as for exotic derivatives, consensus prices might constitute the best available data. However, many factors are considered when assessing the representational faithfulness of the consensus prices including, for example:
- Whether the prices submitted by the subscribers reflect actual transactions or just indicative prices based on their own valuation techniques.
- The number of sources from which prices have been obtained.
- The quality of the sources used by the consensus pricing service.
- Whether participants include leading market participants.
Typically consensus prices are only available to subscribers who have submitted their own prices to the service. Accordingly not all entities will have direct access to consensus prices. Because a subscriber generally cannot know how the prices submitted were estimated, other sources of evidence in addition to information from consensus pricing services may be needed for management to support their valuation. In particular, this may be the case if the sources are providing indicative prices based on their own valuation techniques and management is unable to obtain an understanding of how these sources calculated their prices.
Brokers providing broker quotes
As brokers provide quotes only as an incidental service for their clients, quotes they provide differ in many respects from prices obtained in pricing services. Brokers may be unwilling to provide information about the process used to develop their quote, but may have access to information on transactions about which a pricing service may not be aware. Broker quotes may be executable or indicative. Indicative quotes are a broker’s best estimate of fair value, whereas an executable quote shows that the broker is willing to transact at this price. Executable quotes are strong evidence of fair value. Indicative quotes are less so because of the lack of transparency into the methods used by the broker to establish the quote. In addition the rigour of controls over the brokers’ quote often will differ depending on whether the broker also holds the same security in its own portfolio. Broker quotes are often used for securities with level 3 inputs and sometimes may be the only external information available.
Further considerations relating to third-party pricing sources
Understanding how the pricing sources calculated a price enables management to determine whether such information is suitable for use in its valuation, including as an input to a valuation technique and in what level of inputs the security should be categorised for disclosure purposes. For example, third-party pricing sources may value financial instruments using proprietary models, and it is important that management understands the methodology, assumptions and data used.
If fair value measurements obtained from third-party pricing sources are not based on the current prices of an active market, it will be necessary for management to evaluate whether the fair value measurements were derived in a manner that is consistent with the applicable financial reporting framework. Management’s understanding of the fair value measurement includes:
- How the fair value measurement was determined―for example, whether the fair value measurement was determined by a valuation technique, in order to assess whether it is consistent with the fair value measurement objective;
- Whether the quotes are indicative prices, indicative spread, or binding offers; and
- How frequently the fair value measurement is estimated by the third-party pricing sources―in order to assess whether it reflects market conditions at the measurement date.
Understanding the bases on which third-party pricing sources have determined their quotes in the context of the particular financial instruments held by the entity assists management in evaluating the relevance and reliability of this evidence to support its valuations.
It is possible that there will be disparities between price indicators from different sources. Understanding how the price indicators were derived, and investigating these disparities, assists management in corroborating the evidence used in developing its valuation of financial instruments in order to evaluate whether the valuation is reasonable. Simply taking the average of the quotes provided, without doing further research, may not be appropriate, because one price in the range may be the most representative of fair value and this may not be the average. To evaluate whether its valuations of financial instruments are reasonable, management may:
- Consider whether actual transactions represent forced transactions rather than transactions between willing buyers and willing sellers. This may invalidate the price as a comparison;
- Analyse the expected future cash flows of the instrument. This could be performed as an indicator of the most relevant pricing data;
- Depending on the nature of what is unobservable, extrapolate from observed prices to unobserved ones (for example, there may be observed prices for maturities up to ten years but not longer, but the ten year price curve may be capable of being extrapolated beyond ten years as an indicator). Care is needed to ensure that extrapolation is not carried so far beyond the observable curve that its link to observable prices becomes too tenuous to be reliable;
- Compare prices within a portfolio of financial instruments to each other to make sure that they are consistent among similar financial instruments;
- Use more than one model to corroborate the results from each one, having regard to the data and assumptions used in each; or
- Evaluate movements in the prices for related hedging instruments and collateral.
In coming to its judgement as to its valuation, an entity may also consider other factors that may be specific to the entity’s circumstances.
Use of Valuation Experts
Management may engage a valuation expert from an investment bank, broker, or other valuation firm to value some or all of its securities. Unlike pricing services and broker quotes, generally the methodology and data used are more readily available to management when they have engaged an expert to perform a valuation on their behalf. Even though management has engaged an expert, management is ultimately responsible for the valuation used.
Issues Related to Financial Liabilities
Understanding the effect of credit risk is an important aspect of valuing both financial assets and financial liabilities. This valuation reflects the credit quality and financial strength of both the issuer and any credit support providers. In some financial reporting frameworks, including Australian Accounting Standards, the measurement of a financial liability assumes that it is transferred to a market participant at the measurement date. Where there is not an observable market price for a financial liability, its value is typically measured using the same method as a counterparty would use to measure the value of the corresponding asset, unless there are factors specific to the liability (such as third-party credit enhancement). In particular, the entity’s own credit risk can often be difficult to measure.
An asset backed security is a financial instrument which is backed by a pool of underlying assets (known as the collateral, such as credit card receivables or vehicle loans) and derives value and income from those underlying assets.
Own credit risk is the amount of change in fair value that is not attributable to changes in market conditions.
Presentation and Disclosure about Financial Instruments
Most financial reporting frameworks, including Australian Accounting Standards, require disclosures in the financial report to enable users of the financial report to make meaningful assessments of the effects of the entity’s financial instrument activities, including the risks and uncertainties associated with financial instruments.
Most frameworks require the disclosure of quantitative and qualitative information (including accounting policies) relating to financial instruments. The accounting requirements for fair value measurements in financial statement presentation and disclosures are extensive in most financial reporting frameworks and encompass more than just valuation of the financial instruments. For example, qualitative disclosures about financial instruments provide important contextual information about the characteristics of the financial instruments and their future cash flows that may help inform investors about the risks to which entities are exposed.
Categories of Disclosures
Disclosure requirements include:
- Quantitative disclosures that are derived from the amounts included in the financial report―for example, categories of financial assets and liabilities;
- Quantitative disclosures that require significant judgement―for example, sensitivity analysis for each type of market risk to which the entity is exposed; and
- Qualitative disclosures―for example, those that describe the entity’s governance over financial instruments; objectives; controls, policies and processes for managing each type of risk arising from financial instruments; and the methods used to measure the risks.
The more sensitive the valuation is to movements in a particular variable, the more likely it is that disclosure will be necessary to indicate the uncertainties surrounding the valuation. Certain financial reporting frameworks, including Australian Accounting Standards, may also require disclosure of sensitivity analyses, including the effects of changes in assumptions used in the entity’s valuation techniques. For example, the additional disclosures required for financial instruments with fair value measurements that are categorised within level 3 inputs of the fair value hierarchy are aimed at informing users of financial report about the effects of those fair value measurements that use the most subjective inputs.
Some financial reporting frameworks, for example, Australian Accounting Standards, require disclosure of information that enables users of the financial report to evaluate the nature and extent of the risks arising from financial instruments to which the entity is exposed at the reporting date. This disclosure may be contained in the notes to the financial statements, or in management’s discussion and analysis within its annual report cross-referenced from the audited financial report. The extent of disclosure depends on the extent of the entity’s exposure to risks arising from financial instruments. This includes qualitative disclosures about:
- The exposures to risk and how they arise, including the possible effects on an entity’s future liquidity and collateral requirements;
- The entity’s objectives, policies and processes for managing the risk and the methods used to measure the risk; and
- Any changes in exposures to risk or objectives, policies or processes for managing risk from the previous period.