SEC Accuses Auditor of Failing to Confirm Level 3 Valuations
The SEC has charged an audit firm with improper professional conduct related to its failure to confirm valuations of Level 3 assets.
A fund sponsor engaged the audit firm to provide GAAP audits of its private funds for compliance with the custody rule (206(4)-2). The SEC accuses the audit firm with failing to satisfy PCAOB auditing standards when it “failed to obtain sufficient appropriate audit evidence regarding the valuation and existence of Level 3 assets,” which are securities without readily available market quotations. Despite acknowledging the valuation risk, the audit firm failed to follow procedures for “evaluating the appropriateness of valuation models, testing Level 3 inputs, or obtaining and evaluating investment committee minutes and related documentation that included contemporaneous information regarding the valuation of Level 3 assets.” Instead, the audit firm relied mostly on its client’s representations. As a result, the audit firm “failed to obtain sufficient appropriate audit evidence to provide a reasonable basis” for its audit opinions. The SEC also charges the audit firm with violating the independence rules. Due to the firm’s failures, the SEC charges that it caused its investment adviser client to violate the custody rule.
This case is really bad news for the audit industry. In an example of how bad facts could make bad law, this deficient audit firm has raised the specter of putting more onus on auditors for checking fair valuation decisions. Depending on how this case resolves, auditors may face a higher standard of care and due diligence with respect to valuation determinations.
Read SEC order here.