Amelia Pickard shares tips on challenging Level 3 asset valuations, with practical guidance on possible audit procedures.
For auditors, obtaining sufficient appropriate audit evidence for valuations of pension scheme assets can often prove as much – or more – of a challenge than it is for valuation of the liability.
On the liability side, management’s actuaries are engaged directly by management to produce pension disclosures that are explicitly intended to be used in the accounts. Actuaries therefore expect to engage with the audit team and are usually able to provide the underlying information supporting their liability valuation that the audit team can assess and challenge.
There is only one method allowed to calculate pension liabilities under accounting standards, so audit teams are generally familiar with the standard assumptions and data that is used.
In contrast, asset valuers, who could either be investment managers or custodians, are selected and engaged by the trustees as part of their investment strategy for the scheme and are likely to produce periodic valuations to be used by a range of investors and stakeholders for a variety of different purposes.
These parties may be less accessible to the audit team and their processes and valuation methods can be opaque. Auditors don’t generally have the right to obtain underlying information from third-party custodians or investment managers regarding how they calculated their valuations, and within a pension scheme there may be a number of different valuation experts working from different organisations and using different valuation methods for different assets, so it can be much harder to understand and challenge each of these.
The majority of pension assets for most schemes are invested in Level 1 and Level 2 assets, for which quoted market pricing is generally available. There is limited judgement involved in valuing these kinds of assets, and the valuation provider is not generally considered to meet the definition of a management expert in the International Standard on Auditing ISA 500 and ISA (UK) 500.
The only assets that generally require an expert valuation are Level 3 assets, which have “unobservable valuation inputs”. Valuers need to use judgement to value these assets, and so for the purpose of the sponsoring employer’s audit, auditors generally consider them management’s experts. At a high level this is because management is relying on the expertise of the valuer to produce the figure that will be reported in the accounts. However, it is important to note that these experts are contracted to the scheme trustees, not the sponsoring employer, so are not “management’s expert” in a legal sense. They do not generally interact with management directly or provide valuations to management.
As Level 3 assets tend to be less liquid than other types of asset, they generally make up a minor proportion of a pension scheme’s asset portfolio, if they are held at all. The balance of Level 3 assets is therefore likely to be much less material than the liability.
The risk of material misstatement for these types of assets is usually disaggregated, as there may be several different investment managers producing smaller Level 3 asset valuations that get consolidated into the total pension asset figure. Often, the overall balance of Level 3 assets can be material, but is made up of several individually immaterial items held with different investment managers. In these cases, large errors would need to independently take place in multiple third-party expert valuations for a material misstatement to occur. As this is unlikely, the risk of material misstatement might be considered low by the auditor, despite the judgement and estimation uncertainty involved in producing the valuations. Conversely, on the liability side, one actuary is responsible for producing the total figure, so an error would be more likely to affect the total balance and have a material impact.
Recognising asset levels
Observable inputs reflecting quoted prices for identical assets in an active market, such as shares valued on an observable and active market.
Inputs other than quoted market prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. For example, there may be quoted prices for similar, but not identical, assets or quoted shares are traded infrequently and there may have been a considerable lapse of time since they were last traded.
Prices for identical assets are unobservable, as with investment in an unquoted company, for instance.
How should auditors approach such assets?
To launch an effective challenge over the valuation of Level 3 assets, it’s important to have as much information as possible about the data, method and assumptions used by the expert.
The auditor might consider the following:
- Obtain a breakdown of the assets held by the scheme and identify whether they are Level 1, 2 or 3. Management’s actuary will be likely to be able to provide a full asset listing that auditors can use to make this classification.
- Perform a risk assessment and consider which investments should be scoped in for testing, with reference to materiality for the engagement. As Level 3 assets may have a higher level of inherent risk due to the judgment involved in performing the valuation, but there may be no individually material balances, the auditor might think instead about the risk in aggregate and design audit tests as appropriate.
- Identify the source of the valuations that end up in the sponsor accounts – are these performed by the investment manager or the asset custodian? This will determine which third party the auditor needs to request information from, and who may potentially need to be assessed as a management’s expert.
- Check the date that the Level 3 assets were last valued – Level 3 assets are generally valued infrequently and so the most recent valuation available may be three or six months before the employer’s year end. If this is the case, understand how the valuation has been rolled forward to the correct date and verify that this has been performed appropriately by checking contributions and disbursements during the roll-forward period, as well as market movements in any quoted indices that can be used as a proxy. For some large corporate employers with accelerated reporting timetables, this issue could potentially also affect the values of Level 1 or Level 2 assets if preliminary asset values are the only ones available when the entity closes its books. If an updated valuation becomes available before the accounts are signed, then the values should be updated in the sponsor accounts, or a misstatement recognised.
- Identify which types of Level 3 asset the scheme holds and design appropriate procedures to provide evidence over the appropriateness of the valuation.
Potential approaches for the most commonly held types of Level 3 asset could include:
Buy-in insurance policies
- In the year that the transaction takes place, obtain the contract and assess whether the accounting treatment for the policy is appropriate – has it been correctly classified as a buy-in vs buy-out and has the gain/loss been recognised within other comprehensive income (OCI) or the profit and loss account?
- As the valuation of the policy should match the valuation of the associated liability, the insurance provider does not need to be assessed as an expert, as management’s actuary (who should have already been assessed as an expert due to their work on the liability) will be valuing the asset through their liability calculations.
- Procedures over the valuation of the asset are covered through the procedures already being performed over the pension liability, although if it’s a partial buy-in there may be a need to check the member data of the covered members as a proportion of the liability to work out what the value of the policy should be.
Pooled investment vehicles
- Assess the fund valuer as a management’s expert.
- Obtain most recent audited financial statements for the fund – if the fund year end date is the same as the audited entity’s, then calculate the proportion of the total fund value held by the scheme as per the audited financial statements and agree this to management’s figure.
- If the fund year end date is different to that of the audited entity, then also obtain the fund’s unaudited net asset value (NAV) statement as at the same date of the most recent audited financial statements and perform a retrospective review to determine whether the fund valuer has a history of producing accurate valuations.
- In cases of increased risk, where some of the underlying holdings within a Level 3 pooled fund are quoted, obtain the breakdown of the underlying assets, and check the pricing using external market data where possible.
- Assess the property valuer as a management’s expert.
- Decide if it is necessary to engage a real estate valuations expert to review and challenge valuations.
- Obtain the breakdown of the properties within the portfolio and consider a sample in detail. Assess prices of similar properties in the area, the rental history of the property, etc to determine whether the assumptions used by the valuer are reasonable.
- Check whether any disposals in the year were in line with the valuer’s previous estimates to determine whether they have a pattern of over- or under-valuing properties.
- Verify the purchase price of any acquisitions in the year and understand the reasons for any movement from this starting point in the final values.
Amelia Pickard, Technical Manager, Audit & Assurance, ICAEW
For more information about the various parties that can be involved in the audit of pension scheme figures in sponsor entity accounts, and the relationships between them, please see Part 1 of the ICAEW guidance: