July 20, 2011

Fair Value, The Global Way

By J Michael Silvia, CPA, Director, Marcum LLP's Alternative Investment Group

Fair Value, The Global Way

In the post-2008 aftermath of Bernie Madoff, financial markets meltdown and sweeping financial regulatory reform impacting alternative investment funds, investment advisors and broker-dealers, it was easy to forget that in 2006 the Financial Accounting Standards Board (“FASB” or “the Board”) and the International Accounting Standards Board (“IASB”) issued a Memorandum of Understanding that would form the foundation for the convergence of U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) and International Financial Reporting Standards (“IFRS”) intended to create a common set of high quality global accounting standards.

This convergence has come to fruition for those reporting entities who measure assets and liabilities at fair value. In May 2011, the FASB issued 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”), 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 U.S. GAAP and IFRS. The amendments in ASU 2011-04 explain how to measure fair value but do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. The amendments in this update apply to all reporting entities that are required or permitted to measure or disclose fair value of an asset, liability or an instrument classified in a reporting entity’s shareholders’ equity in the financial statements.

How will ASU 2011-04 impact fair value measurement and financial reporting for private investment funds?

The good news is the changes should not significantly impact current valuation techniques or disclosures, as they are fairly consistent with the existing fair value measurement principals in Topic 820. 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 as they relate to a particular requirement for measuring fair value and disclosure of information about fair value measurements. 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 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 notes (eg: certain loans).

The following is a summary of selective certain amendments and new disclosure requirements that could have an impact on private investment funds:

More 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 fair value of assets and liabilities categorized within Level 3 as well as a description of the valuation processes used. This is now an explicit requirement to do so with the intent to increase the comparability between U.S. GAAP and IFRS. This requirement will be most onerous for investment funds that hold investments whose valuations are based on models with significant unobservable inputs. Management should ensure that the appropriate time and resources are given to develop these disclosures while preparing the financial statements. The disclosure would be presented in a tabular format by investment class. For example, if the reporting entity held venture capital investments in a particular industry sector, the tabular disclosure may include the valuation technique used for that class of investments (such as discounted cash flow) and a listing of each unobservable input, including a weighted average range of all the unobservable inputs used (such as weighted cost of capital, long-term revenue growth rate, discount for lack of marketability, control premium, etc.). The disclosure requirements also include qualitative information on how the reporting entity determines its valuation policies and procedures and a discussion of the changes in fair value measurements from year to year.

The ASU does not require the entity to create and report on quantitative information if it doesn’t develop the quantitative unobservable inputs in measuring fair value. Prices of prior transactions and the use of net asset value as a practical expedient are examples of unobservable inputs that are not developed by the reporting entity. Reporting entities that use these inputs would not be required to quantify these inputs and assumptions for these investments even though they may be level 3 investments.

“Highest & Best Use” Concept

The application of the highest and best use and valuation premise concepts in fair value measurements are only relevant for nonfinancial assets, as they would not apply to financial assets. The Board determined that the highest and best use concept would not apply when measuring the fair value of financial assets or liabilities because these items do not have alternative uses and their fair values do not depend on their use within a group of other assets or liabilities. Prior to the amendment, Topic 820 did not distinguish between financial and nonfinancial assets relative to the concept of highest and best use. This amendment, had itbeen applied to financial assets, would have dramatically changed the valuation of over-the-counter derivatives, which are generally measured based on net exposure. To maintain current practice, FASB provides an exception that allows a reporting entity to consider the sale or transfer of its net position for a particular risk exposure if certain criteria are met. This exception applies only to the measurement of financial instruments. The exception is also limited to portfolios of both financial assets and liabilities that have offsetting risks (see below).

Offsetting Financial Assets & Liabilities

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 reporting entity 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. U.S. GAAP and IFRS still differ in balance sheet presentation in this area. Further differences exist between U.S. GAAP and IFRS which are highlighted later in this article.

Use of Premiums and Discounts

ASU 2011-04 clarifies when the application of a discount or premium to fair value measurements is permissible. In the absence of a Level 1 input, a reporting entity should apply premiums and discounts when market participants would do so when pricing the asset or liability consistent with the unit of account in the Topic 820 that requires or permits the fair value measurement. The boards maintain their position that unit-of-account guidance is outside of the scope of the fair value measurement project therefore Topic 820 will continue to focus on how to measure fair value and not what is being measured at fair value or when an asset or liability should be measured at fair value. Premiums and discounts are permitted when they are related to the characteristic of the asset or liability (such as a control premium or non controlling discount) and when market participants would consider them in a transaction for the asset or liability. Fair value adjustments would not be permitted regardless of the hierarchy level when related to the size of the reporting entity’s holding (specifically a blockage discount applied when the entity’s holdings are significant compared to the average daily trading volume).

The amendments summarized above are to be applied prospectively. The effective date for ASU 2011-04 is interim or annual periods beginning after December 15, 2011 for public entities and annual periods beginning after December 15, 2011 for non-public entities (December 31, 2012 year-end financial statements.)Early application for public entities is not permitted; however, non-public entities may apply amendments early, but no earlier than interim periods beginning after December 15, 2011.

Although the FASB and IASB strived to ensure that Topic 820 and IFRS 13, Fair Value Measurements, were identical, some differences still remain. Many of the differences are style in nature and should not result in inconsistent interpretations in practice by entities applying U.S. GAAP and IFRS. However, there are a few noteworthy differences including:

  1. Investments in Investment Companies: Topic 820 provides a practical expedient that permits a reporting entity to use the reported net asset value of the investment company, without adjustment, as the fair value of the investment. IFRS does not have accounting requirements that are specific to investment companies, and therefore has not included this guidance. Additionally, these entities may require consolidation under IAS 27, Consolidated and Separate Financial Statements, which would not be required under U.S. GAAP.The boards are reviewing the valuation of investment companies in a separate convergent project.
  2. Fair Value of a Demand Liability: under U.S. GAAP, the fair value measurement of a demand liability is the amount payable on demand at the reporting date; however, IFRS indicates the fair value cannot be less than the present value of the amount payable on demand.
  3. Quantitative sensitivity analysis information for financial instruments categorized within Level 3 is required by IFRS, regardless of whether it’s a public or non-public entity.
  4. Additional disclosures: various differences such as the net presentation of derivatives allowed under U.S. GAAP but not allowed under IFRS, and other disclosure exemptions for non-public entities allowed under U.S. GAAP which are not recognized under IFRS.

Overall, there have been great strides made to ensure the comparability of fair value measurement under U.S. GAAP and IFRS, but, as always, there are still some wrinkles to iron out. What we expect to see in the horizon are more joint ASUs and IAS. There are several joint projects on the horizon between the FASB and IASB that may have an impact on private investment funds, most notably an exposure draft due out in the third quarter of 2011 on consolidation that will address investments in investment companies as described in this article. We will keep you apprised of new developments as the Boards continue to institute new convergence projects.

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Alternative Investments