ASU 2011 – 04: New Financial Statement Reporting Requirements for Year-End Fund Audits

It’s January 2013 – football playoffs and financial statement reporting is in the air. Newly Registered Investment Advisors should be well aware of a myriad of SEC and other regulatory reporting requirements and deadlines that will be forthcoming within the next few months. Among them are the audited financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP) for your Fund, which are required to be issued and delivered to investors by April 30th (June 29th for a Fund of Funds). In order to meet this deadline, Hedge Fund and Private Equity Managers should have a good understanding of the new accounting guidance that affects their organizations and the new required disclosures for 2012 year-end financial statements applicable to private companies and non-public reporting entities. Even if your financial statement preparation is being outsourced to a third party, such as your administrator, it is imperative that Managers have a sufficient knowledge of the new requirements. Management is responsible for the fair presentation of the financial statements, which includes all footnote disclosures. Furthermore, the new disclosures include descriptive information about the Fund’s valuation policy’s and inputs to fair value measurements that service providers may not be involved in or aware of, and accordingly, Management will need to provide this data. So while we can’t predict who will win the Super Bowl this year, we can certainly bet that these new disclosures will require some extra effort for many funds this reporting season.

The good news is that although 2012 was a big year for new SEC and CFTC regulatory changes and filing requirements, the Financial Statements Accounting Board (the Board) issued limited accounting updates that affect alternative investment funds. The most noteworthy is Accounting Standards Update No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS (“ASU 2011-04” or “the ASU”), an amendment to Topic 820 Fair Value Measurement (“Topic 820”). The purpose of the amendments in ASU 2011-04 is to improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with GAAP and International Financial Reporting Standards (IFRS).In doing so, financial statements prepared under GAAP will require more robust fair value measurement disclosures pertaining to the Level 3 or hard to value investments. This is a consistent theme with other regulatory bodies that are focusing more efforts on and scrutinizing a reporting entity’s valuation process for these hard to value and illiquid investments.

How will ASU 2011-04 impact fair value measurements and financial reporting for Private Investment Funds?

The changes in ASU 2011-04 should not significantly impact current valuation techniques or disclosures, as they are fairly consistent with the existing fair value measurement principles. Overall, many of the amendments are being made to eliminate wording differences between U.S. GAAP and IFRS and clarify the Board’s intent about the application of existing fair value measurement and disclosure requirements. However, some of the amendments could change how the fair value measurement guidance in Topic 820 is applied and disclosed. The overall impact will bring more transparency and comparability to the valuation policys and reporting of fair value measurements, particularly the unobservable, hard to value Level 3 investments. Several of the additional disclosures do not apply to non-public companies, which is also good news for Private Investment Funds. These requirements include disclosure of all transfers between Level I and Level 2 of the fair value hierarchy, discussion of the sensitivity of fair value measurement for Level 3 investments to changes in unobservable inputs and any interrelationships between those inputs, and the classification by level for items that are not recorded on the balance sheet at fair value but are required to be disclosed in the financial statement notes (eg: entity’s own debt.)

The following is a summary of selective amendments and new disclosure requirements that may have an impact on your Private Investment Fund:

More Tabular Disclosures for Level 3
ASU 2011-04 clarifies that a reporting entity should disclose quantitative information about the unobservable inputs and assumptions used to measure the fair value of assets and liabilities categorized within Level 3 of the fair value hierarchy. This requirement will be most onerous for investment funds that hold investments whose valuations are based on models with significant unobservable inputs. These are not game day decisions. Management should ensure that the appropriate time and resources are given to develop these disclosures while preparing the financial statements. Auditors (and possibly the SEC and/or other regulators) will want to see the supporting data and documentation behind these disclosures so be sure to maintain an adequate audit trail which includes the sources and assumptions for which the inputs are developed.The disclosure should be presented in a tabular format by investment class and separated between assets and liabilities. For example, if the reporting entity held private equity investments in a particular industry sector, the tabular disclosure may include the fair value for that class of investments using a particular valuation technique (such as a discounted cash flow) and a listing of each significant unobservable input used in the valuation (such as weighted cost of capital, long-term revenue growth rate, discount for lack of marketability, control premium, etc.) For each input include a range of percentages or multiples, as well as weighted average range. Similar to existing GAAP, it is up to Management to determine the level of class disaggregation; however, it should be based on the nature and risks of the investments.Consider, for example, activity or business sector, vintage, geographic concentration, credit quality and economic characteristic when determining how to breakout and disclose an investment class.

The following is a snapshot of a table that summarizes the valuation methodology and significant unobservable inputs used for a Fund’s investments that are categorized within Level 3 of the Fair Value Hierarchy:
(Note: For liabilities, a similar table should be presented)

The ASU does not require a reporting entity to create and report on quantitative information if the reporting entity doesn’t develop the quantitative unobservable inputs in measuring fair value. Prices of third party prior transactions without adjustment (including those received from pricing services) and the use of unadjusted net asset value as a practical expedient (for Fund of Funds) are examples of unobservable inputs that are not developed by the reporting entity. Funds that use these inputs without adjustment would not be required to quantify these inputs and include them on the table above, even though they may be Level 3 investments. As a result, not all Level 3 fair value measurements are required to be disclosed on this table and therefore could differ from the totals included on the Level 3 Fair Value Measurement roll-forward table.

Description of Valuation Process

The new disclosure requirements also include qualitative information on how the reporting entity determines and ensures that its valuation policies and procedures for investments that are categorized within Level 3 of the fair value hierarchy are fair, consistent, and verifiable. This would include a description of the group responsible for valuation policies and procedures, who that group reports to, and the internal reporting procedures in place. For example, if the Fund designates that responsibility to a valuation team or committee, it should be noted who the members are (ie: are they personnel independent from portfolio management and trading functions?), how often do they meet, what is their process to develop and substantiate the inputs of the Level 3 fair value measurements, and how do they analyze changes from period to period. Does this committee report to a board or other group/person responsible for Fund governance? Also included in this discussion would be the frequency and methods for calibration, back testing and other procedures to validate valuation models used by the Fund. For instance, the Fund may use a third party valuation firm to perform an independent review of the valuation of the Fund’s Level 3 investments, and may adjust its valuations based on the recommendations from the valuation firm. Last, a discussion of how the Fund determines the reliability of third party pricing information is required. The SEC and Public Company Accounting Oversight Board (PCAOB) have both spoken of Management’s responsibility to ensure that fair value measurements based on third party information are consistent with U.S. GAAP. Management is required to have a general understanding of how pricing services obtain their prices. Conducting due diligence reviews of pricing vendors, monitoring the daily change in prices and reviewing transactions among market participants are examples of methods to comply with this requirement.

Use of Premiums and Discounts

ASU 2011-04 clarifies when the application of a discount or premium to fair value measurements is permissible. Blockage factors are prohibited for all levels in the fair value hierarchy. Previous guidance prohibited blockage factors for Level 1 investments, but was not clear in use of blockage factors for Level 2 and 3 investments. Blockage factors are defined as adjustments to fair value based on the size of the entities position and are deemed to arise from entity-specific assumptions and would not be considered by a market participant. So, even if a Fund’s holdings of a listed stock is significant compared to the average daily trading of that stock, and the Fund would not be able to sell that entire block at the listed price, a discount to the listed trading price would not be permitted under GAAP unless it was determined that the listed price is not indicative of an active market. Premiums and discounts are permitted when they are related to the characteristic of the asset or liability (such as controlling interest premiums, lack of marketability discounts, non controlling interest discounts or contractual restrictions on the sale, transfer or use) and when market participants would consider them in a transaction for the asset or liability.

Measuring Fair Value of Financial Assets & Liabilities with Offsetting Risks

ASU 2011-04 permits an exception to the basic fair value measurement principles for reporting entities that hold a group of financial assets and financial liabilities which are exposed to market risks and to the credit risk of each of its counterparties that are managed based on the entity’s net exposure to these risks, rather than its gross exposure. The exception will allow the reporting entity, if certain criteria are met, to measure the fair value of the financial assets and financial liabilities at the price that would be received to sell a net asset position for a particular risk or to transfer a net liability position for a particular risk in an orderly transaction between market participants. The ASU notes that in determining whether netting would be appropriate, the Fund should consider any existing arrangements that mitigate credit risk exposure in the event of default (for example, a master netting agreement with the counterparty or an agreement that requires the exchange of collateral on the basis of each party’s net exposure to the credit risk of the other party). It should be noted, however, that fair value measurement of a portfolio of financial assets and financial liabilities on the basis of net exposure does not affect the basis of financial statement presentation for these instruments. A reporting entity must comply with the financial statement presentation requirements of ASC 210-20.

Conclusion