September 14, 2010

The Quest for More Disclosure – New Accounting Pronouncements Affecting Financial Reporting for Hedge Funds

By Marni Pankin, CPA and Partner, Marcum LLP, Alternative Investment Group

The Quest for More Disclosure – New Accounting Pronouncements Affecting Financial Reporting for Hedge Funds

The Financial Accounting Standards Board (“FASB”) and other regulatory bodies have been calling for increased disclosures from investment funds in their financial reporting over the past several years. Ever since the issuance of FASB Statement 157, Fair Value Measurements, in September 2006, (now Topic 820, Fair Value Measurements and Disclosures under FASB Accounting Standards Codification), fair value has been a hot topic and on the forefront of investors’ minds. Even main stream media reported on the new pronouncement. FAS 157 was not intended to significantly change the way investments were valued, but it prompted issuers and financial statement users to think more about fair value measurements and their importance. The original goal of FAS 157 was to establish a framework for measuring fair value under U.S. Generally Accepted Accounting Principles (“GAAP”), clarify and create a single definition of fair value for that framework and expand fair value measurement disclosures. It required investment managers to disclose their valuation policies in greater detail and categorize their valuation inputs as observable (Level 1), unobservable (Level 3) and something in between (Level 2). Since then, there has been myriad of updates and amendments to FAS 157 intending to clarify the requirements and improve on the disclosures related to investments and derivatives.

More Transparency – Blessing or a Curse?

FASB believes users will benefit from the increased transparency in financial reporting. The new disclosures will help readers of the financial statements to understand the degree of subjectivity in the valuation of different types of investments, and there will be more comparability of financial reporting among issuers. Based upon feedback from the Securities and Exchange Commission (“SEC”) and other regulatory groups, and in the wake of the credit crisis and economic downturn, the FASB issued new accounting standard updates (“ASUs”) to try and fulfill its quest for transparency. Investment managers, however, have a mixed response to the new requirements. Some fear the increase in transparency hinders their competitive edge. Others fear compliance with the new requirements has put a drain on resources. These requirements, though, bring US GAAP more in line with International Financial Reporting Standards (“IFRS”) 7, which already requires similar disclosures. Establishing procedures to comply with the new requirements will give managers a head start on the inevitable conversion to IFRS in the near future.

Two significant accounting standard updates for Topic 820 issued over the past year relating to disclosure were ASU 2009-12, Investments in Certain Entities That Calculate Net Asset Value per Share (or its equivalent), issued in August 2009 and ASU 2010-06, Improving Disclosures about Fair Value Measurements, issued in January 2010. Overall, these ASUs require greater detail of disclosure in financial statements, resulting in more time and effort spent on financial reporting and financial statement preparation.

ASU 2009-12, “Investments in Certain Entities That Calculate Net Asset Value per Share (or its Equivalent)”

ASU 2009-12, Investments in Certain Entities That Calculate Net Asset Value per Share (or its equivalent), was effective for reporting periods ending after December 15, 2009 (2009 year-end financial statements). Its main objective was to offer a practical approach to measuring the fair value of investments in certain entities that calculate net asset value (“NAV”) per share. This was great news to managers investing in other hedge, private equity, venture capital and real estate funds and other investment vehicles (fund of funds managers (“FOF”)). It allowed FOF managers to use the NAV per share provided by the underlying investment vehicle to estimate the fair value of their investment, without further adjustment, if that NAV per share (or its equivalent) is calculated in a manner consistent with the measurement provisions of GAAP for investment companies as of the reporting entity’s measurement date. Attributes of the investment, such as lock ups, gates, redemption fees and unfunded commitments would not require an adjustment to the reported NAV. However, these attributes, as well as other detailed information about the investment strategy and other liquidity provisions of the investment vehicle are required to be disclosed.

FASB and most constituents agree that permitting the use of this practical expedient reduces the complexity and improves consistency and comparability in applying the updates in Topic 820. The increased disclosure requirements are intended to improve transparency and enable users to understand the nature and the risks of the investments.

Specific Disclosure Requirements of ASU 2009-12

Specifically, reporting entities must disclose for each interim and annual period the following information, separately for each major category of investment:

  • The fair value of the investments using the practical expedient
  • A description of the significant investment strategies of the investee(s)
  • For investments that can never be redeemed (eg: private equity funds or side pocket investments):
    • the reporting entity’s estimate of the length of time over which the underlying assets are expected to be liquidated by the investees
  • The amount of unfunded commitments, if any
  • Terms and conditions upon which the reporting entity may redeem its investments (eg: quarterly, upon 30 days notice)
  • The circumstances in which an otherwise redeemable investment might not be redeemable (eg: lockup, gates)
  • If redemption is restricted at the measurement date, the estimate of when that restriction might lapse
    • Disclose if estimate cannot be made
    • Disclose how long the restriction has been in effect
  • Any other significant restrictions to sell investments at the measurement date
  • If it is probable that the reporting entity will sell an investment for an amount different from NAV per share, the total fair value of all investments that meet the criteria for a probable sale and any remaining actions required to complete the sale
  • If a group of investments that qualify for the practical expedient would meet the criteria for a probable sale except that the individual investments have not been identified, the reporting entity’s plans to sell the investments and any remaining actions needed to complete
    the sale(s)

Fund of Funds- Level 2 or 3?

In addition to the enhanced disclosure requirements, ASU 2009-12 provided guidance on how to classify investments in entities that calculate a NAV per share among the fair value hierarchy. Prior to the guidance, many FOF managers reported their investments as Level 3, since the fair value is not readily determinable or observable. However, the update requires the reporting entity to consider the length of time until an investment will become redeemable in order to determine whether the fair value measurement of the investment shall be categorized as Level 2 or Level 3. For example, if the reporting entity has the ability to redeem the investment in the near term at NAV per share (or its equivalent), the fair value measurement of the investment shall be categorized as Level 2. Investment managers need to look at each investment individually and review its liquidity terms and other restrictions in determining whether or not they should be classified as Level 2 or Level 3. Managers should be cognizant of investments with side pockets with more restrictive liquidity provisions. This may require a bifurcation of the side pocket from the rest of the investment when disclosing fair value measurements.

Challenges and Best Practices for Implementation

Implementation of the disclosure requirements of ASU 2009-12 was a challenge this past audit season for some FOF managers and their service providers due to the late issuance date of the ASU. Managers without robust automated systems that separately track their investment activity had to manually separate their investments by strategy and by fair value hierarchy to comply with the new requirements. If not already in place, for 2010, managers should implement a system to gather and track the necessary data. A best practice is to populate and maintain a database which includes all required liquidity provisions by investment and tracks the timing when the investment will become redeemable. Tag investments by investment strategy and by fair value hierarchy (Level 2 or 3) so the activity (subscriptions and redemptions, realized and unrealized gain/losses, and transfers in/out of Level 3) can be tracked throughout the year. This way, the required Level 3 rollforward schedule will be easier to create come year-end.

ASU 2010-06, “Improving Disclosures about Fair Value Measurements”

On January 21, 2010, FASB issued ASU 2010-06, Improving Disclosures about Fair Value Measurements (“ASU 2010-06”). ASU 2010-06 further amends ASC 820 to add certain disclosure requirements related to fair value measurements. The new rules include new disclosure requirements regarding transfers between Levels 1 and 2 of the fair value hierarchy and presentation of activity in the Level 3 rollforward. Additionally, ASU 2010-06 clarifies existing fair value disclosures about the level of disaggregation required to be reported on and the level of detail required to be disclosed regarding the inputs and valuation techniques used to measure fair value. The new disclosure requirements apply to interim and annual reporting periods beginning after December 15, 2009, with one exception: the new rules regarding the grossing up of purchases and sales associated with Level 3 measurements will be effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.

The Need for Full Disclosure

In response to demands from investors and other interested parties for more “granular” information regarding fair value, the FASB issued ASU 2010-06. The new requirements in this ASU relate to the following two activities:

  1. Disclosure of transfers between Level 1 and Level 2, as well as those into and out of Level 3, of the fair value hierarchy. A reporting entity must disclose the amounts of, and reasons for, significant transfers between Level 1 and Level 2, as well as those into and out of Level 3, of the fair value hierarchy. Transfers into a level must be disclosed separately from transfers out of the level. Entities are required to judge the significance of transfers based on earnings and total assets or liabilities. Entities must also disclose and consistently follow their policy for when to recognize transfers into and out of the levels, which might be, for example, on the date of the event resulting in the transfer or at the beginning or end of the reporting period.

    Suppose, for example, that an investment transferred from Level 2 to Level 1 because the market for that investment becomes active again and more observable price quotes become available. Disclosing this change can help financial statement users assess the entity’s financial position more accurately.

  2. Disclosure of gross activity for Level 3 fair value measurements. In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases and sales (that is, on a gross basis rather than as one net number).

    The FASB believes that a “net” number – which indicates that overall impact on fair value of purchases and sales of investments – is less useful than a “grossed-up” disclosure that provides greater detail on the underlying transactions responsible for changes in Level 3 measurements. The FASB recognized, however, that some entities – particularly those with significant trading activities – may need to enhance their information systems to comply with this requirement. The board delayed the effective date of this provision to give entities time to make the necessary adjustments.

ASU 2010-06 also clarifies two existing disclosure requirements:

  1. Level of disaggregation. A reporting entity should provide fair value measurement disclosures for each “class” of assets and liabilities. A “class” is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities. Previously, the requirement was to disaggregate by “major categories of assets and liabilities”. Entities should determine a “class” based on the nature and risks of the securities. In determining the nature and risks of the securities, entities should consider activity or business sector, vintage, geographic concentration, credit quality, and economic characteristics.

    For example, rather than disclosing the total value of debt securities, it would be appropriate to provide details about subsets of that category, such as residential mortgage-backed securities, commercial mortgage backed securities or collateralized debt obligations. ASU 2010-06 gives an updated sample fair value measurement table that shows significant break down of fair value measurements. It not only breaks out equities from debt, which was the original presentation, but it breaks down equity securities in their significant industries and debt securities by issuer (eg: government, municipal, corporate), it breaks out FOFs into different strategies and private equity from venture capital. It is a quite detailed disclosure. This level of detail would be followed on the Level 3 rollforward schedule for all Level 3 measurements.

  2. Disclosures about inputs and valuation techniques. A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3.

    For example, if an entity has investments in Level 3 residential mortgage-backed securities, the disclosure should describe the nature of these securities (industry, geographical location, etc.), the underlying loans, and quantitative information on the significant valuation inputs such as yield, probability of default, loss severity and prepayment rates, as well as the methodology used to value the instrument, such as the market or income approach.

FASB also clarified that, if there’s been a change in valuation techniques, such as changing from the market approach to the income approach, the entity should disclose the change and the reason for making it.

Sensitivity Analysis

The FASB’s original proposal would have required entities to conduct a sensitivity analysis and to disclose the potential impact on fair value of “reasonably possible alternative Level 3 inputs.” This type of sensitivity analysis is required under IFRS 7. In light of comments expressing concern about the cost and complexity of these disclosures, the FASB dropped the requirement from the final rule and will revisit the issue as part of its convergence project with the International Accounting Standards Board (IASB). The IASB will re-expose the proposed requirement for an entity to disclose a measurement uncertainty (sensitivity) analysis about Level 3 fair value measurements given the Boards’ tentative decision to require an entity to consider the expected effects of correlation between inputs in that analysis.

Efficient Implementation

Fund managers should review the capabilities of their accounting systems now to ensure that they can handle the new disclosure requirements. These new requirements go beyond what is needed for a schedule of investments, because they not only require a snap shot of the positions at a point in time, but require the activity – including purchases and sales, realized and unrealized gains and losses and transfers – to be tracked throughout the year at a classification level. For managers with multi- strategy investment portfolios and a moderate to high volume of transactions, a manual process may be time consuming to prepare, subject to error and inefficient for third parties to review. Investing in an automated system to capture and categorize the activity may be prudent to consider.

Contributions by Linda Zhang, CPA and Manager, Assurance Services and Matthew Lyons, CPA and Senior Accountant, Assurance Services

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Alternative Investments