With more than 40 current accounting standards within generally accepted accounting principles (GAAP) that require funds to measure assets and liabilities at fair value, clarification is in order. While fair value is by no means unfamiliar to investment fund managers and CFOs, there are different definitions of fair value and limited guidance for its application. Moreover, that guidance is isolated among the many accounting pronouncements that require fair value measurements. Differences in that guidance have created inconsistencies that add to the complexity in applying GAAP and in the area of valuation. In covering FAS 157, this article specifically handles hedge funds.
The definition of fair value retains the exchange price notion used in earlier definitions of fair value. FAS 157 is a clarification that identifies fair value with regard to an orderly transaction between market participants selling an asset, typically an investment, in the principal or most favourable market. Therefore, the definition focuses on the price received to sell the investment (an exit price), not the price paid to acquire the asset (an entry price). The valuation techniques should be appropriate for the measurement, considering the availability of data with which to develop inputs that represent the assumptions that market participants would use in pricing the investment and on the level in the fair value hierarchy at which the inputs fall.
There are three key valuation techniques employed to measure fair value: the market approach, income approach, and/or cost approach. Below are some major aspects to each approach:
Inputs generally concern the assumptions market participants would use in pricing the investment, as well as assumptions about risk. For example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. Inputs may be observable or unobservable.
Valuation techniques used to measure fair value are required to maximise the use of observable inputs and minimise the use of unobservable inputs. Valuation techniques that suggest gains and losses immediately after acquisition are suspect and should be recalibrated.
The fair value hierarchy arranges the inputs to valuation techniques used to measure fair value into three general levels, giving the highest priority to quoted prices (unadjusted) in active markets for identical investments (Level 1) and the lowest priority to unobservable inputs (Level 3). In some cases, inputs may fall into more than one level of the hierarchy. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, and consideration of factors specific to the investment. See Figure 1
This statement prohibits entities from adjusting Level 1 quoted prices for premiums or discounts based on the relative size of the position held, such as a large portion of total trading units of an instrument, which is called the blockage factor. It also eliminates the exemption for investment companies and broker-dealers provided in the respective AICPA Auditing and Accounting Guides, which permit entities under the scope of those guides to apply blockage factors.
For assets and liabilities measured at fair value on a recurring basis in periods following initial recognition (for example, trading securities), the fund shall disclose information that allows users of its financial statements to assess the inputs used to develop those measurements and for recurring fair value measurements using significant unobservable inputs (Level 3), the effect of the measurements on earnings (or changes in net assets) for the period. Quantitative disclosures must be presented in a tabular format. To meet that objective, the fund shall disclose the following information for each interim, if applicable, and annual period (except as otherwise specified) separately for each major category of investments. Upon adoption of FAS 157 during an interim period, the annual period disclosures are required.
This statement is effective for financial statements issued for fiscal years beginning after 15 Nov 2007, and interim periods within those fiscal years. The provisions of this statement should be applied prospectively as of the beginning of the fiscal year in which this statement is initially applied with certain exceptions. For calendar year funds, application of the statement would begin in the 2008 year.
This statement will have significant impact on the respective controls and procedures related to the summary and documentation of the valuation process. Funds will need to designate all securities into the three levels discussed above and provide detailed activity of profit and loss and related movement into and out of the Level 3 investments. Tracking systems may need to be designed to mirror the disclosure requirements of this statement while providing a trail for the funds management and auditors to review. Funds using outside administrators should start discussing transitional items in the next few months, which would include planning for the calculation of opening 1 January 2008 balances.