IFRS 13 Driving Level 3 Coding Work

With the International Financial Reporting Standard (IFRS) 13 for fair value accounting in place since January 1, the next concern about “Level 3” unobservable quotes is the coding of this data, states Joel Brown, senior manager of pricing and corporate actions at Invesco.

IFRS 13 has clarified how to measure Level 3 quotes, Brown adds, but investment firms like his own are obligated to show what they’re doing to make sure these prices are accurate and appropriate, especially if they come from third-party vendors. This requires an understanding of providers’ methodologies, data inputs, and objective and subjective information, says Brown.

The industry is also seeing a “push for transparency” as a result, according to Matthew Berry, director and head of fair value services for bonds and equities at data provider Markit. This applies particularly to complex financial instruments such as derivatives or securitized bonds such as mortgage-backed securities.

The transparency demand is being felt through more user requests for details about data inputs and valuation methods, says Berry. “If we were pricing a CDS [credit default swap], for example, we would not only provide the value of the CDS but also the credit spread curve used and the recovery rate assumption,” he says. “On the valuation methodology, we’d be expected to provide documentation around the pricing model, sources of data and number of sources used.”

Disclosure Requirements
In the US, the Public Company Accounting Oversight Board (PCAOB) has also pushed for greater transparency on valuations, and justification of value assigned to complex instruments. Similar organizations (PCAOB is a private oversight corporation) in other countries are taking the same kind of actions, Berry observes. Based on their accounting standards, firms are trying to include more information in their disclosures.

“If they have that information and can say it came from an independent third party, that helps them more effectively meet the disclosure requirement,” says Berry.

Reporting is more complicated with IFRS in place, and requires careful management of resources, he explains. “If they’re reporting on a quarterly or annual basis, that work tends to spike periodically through the year, like at the end of a quarter,” says Berry. “There’s a lot of explaining about how a complex instrument is valued. Whether you agree with that valuation, it requires skilled resources who may not otherwise be required at a particular company at other points during the year. A pension fund that farms out all its money to third-party advisers may not have many internal resources with this skill set.”

Finding Levels
Determining which valuations can be classified as Level 3 can fall into a “gray area,” says Berry. “The reporting entity needs to justify what level an instrument should be placed into,” he says. “If a fund holds two mortgage-backed securities and we provide them with liquidity indications such as the number of prices we’re seeing on that instrument through the day and the number of dealers active in the instrument, if one appears to be very liquid and the other appears to be less liquid, the less liquid one will likely be a Level 3 instrument. The more information you have, the more readily a valuation can be assigned to Level 1, 2 or 3.”

Once a valuation is known to be in Level 3, auditors, accounting agencies and regulators have to make sure coding is correct, explains Brown. Accounting agency recommendations may differ from those of regulators. “This adds a bit of confusion and uncertainty for financial institutions, to find out what the common ground is,” says Brown.

Prices obtained from third-party vendors have to be checked for accuracy, he adds. “We can’t just take their word for it,” says Brown. “We must understand their methodologies, their data inputs and objective and subjective info. That’s where a lot of our attention has been focused lately.”