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Independent Insight - New service to address audit and corporate governance issues

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By: James Linacre | August 17, 2010

As the degree of challenge that auditors and financial institutions' audit committees are able to bring to in-house valuations of complex securities is being questioned, Green Street Capital believes it can provide the market with a solution. The advisory firm has launched a new independent valuations service for structured credit investment portfolios.

Green Street says its new service is needed by the market because auditors have not been challenging management's decisions enough. It intends to provide an additional pair of eyes, working alongside audit committees or external auditors to provide independent valuation analysis.

Dean Atkins, a principal of Green Street Capital, explains: "The focus of this new venture is really on adding some independence and market expertise to the audit process. What we have heard is increasing discussion on the nature of the audit role and a reappraisal of that whole relationship."

He adds: "The audit process tends to focus on checking assumptions made by the institution being audited, but that is where it stops. It just makes sure that what is reported is in line with accounting rules. It is a fairly benign process, which is now not seen as an effective check on management, at least with regard to illiquid asset valuations."

Espen Robak, president of Pluris Valuation Advisors, agrees that there is merit in Green Street's new venture. He says: "It is a viable business and it is a growing business. The need for outside, independent valuations is growing."

Robak explains: "The first factor driving that growth is the increased amount of investment capital held in pools of assets that are quite illiquid. Hedge funds have gradually migrated into more and more illiquid strategies. Instead of playing in very liquid markets, they are now buying a lot of illiquid stuff which is hard to price but which needs to be priced." The second factor driving the valuations business has, of course, been the push – both under IFRS and US GAAP – towards fair value accounting.

The charge that auditors have not been challenging management's decisions is a serious one and it has divided opinion. While Atkins is bullish about the need for Green Street's new offering, Robak believes auditors are doing a better job than they are credited with. He says: "I do not think that auditors are not challenging enough. I think it is a process more than an event."

He continues: "It used to be a very closed, clubby relationship between auditors and their clients – when you have a client the inclination is to never say 'no' because they pay your bills – but that is changing rapidly. Auditors are becoming more and more independent and more and more willing to challenge their clients."

Atkins remains firm, though. He says regulators are concerned about the current auditing process and want to see greater scrutiny, which is precisely what Green Street would offer.

"It is not that auditors have failed. It is more a reappraisal of what the role should be and what skills are required," says Atkins. "I suppose one way of looking at it would be to ask why they should be challenging more, because it is not part of their role. They are hired to make sure accounts adhere to the proper standards; policing above and beyond that mandate is not their role. Furthermore, they have not had the expertise to put forward an alternative view of illiquid asset valuations or approaches to modelling."

The fact that auditors are not required to offer more of a challenge does not mean that more of a challenge is not required, though. This is where Atkins believes Green Street has a role to play.

He adds: "Regulators have seen that they are not getting much of a challenge or a robust check, or even consistency. They want to see the role strengthened, partly so that more can be understood from the accounts than is currently the case. It has taken the crisis to put that into the limelight. The audit role needs to be updated to reflect current markets and current situations."

Indeed, regulators are becoming increasingly vocal. Calls for more stringent auditing are not the only demands the regulators are making and the regulatory push is expected to impact the market in more ways than one.

"There will be more transparency, which will be a good thing. That makes it much easier to understand what an institution's accounts actually mean. It also increases the chances of being able to regulate effectively," says Atkins. "Anything that moves in the direction of greater transparency has to make for a healthier financial sector."

But it isn't just regulators that will see the benefits of greater transparency. It will help senior management within institutions to make better decisions and exercise greater control over their organisations, according to Atkins. "It does not do anyone any good to have large pools of Level 3 assets modelled in a very opaque way, when it is your responsibility for valuing them."

Robak is also expecting changes, but he says it will be accounting rules and auditor independence requirements rather than regulation that will have the most impact on valuations. He concludes: "We have seen so many new valuation standards, but to me the bottom line is we have to get to fair value. Fair value is the standard and that is how securities have to be priced. Other standards are helpful, but fair value is what we have got to get to, where the standard is exit price."