In 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No.157, Fair Value Measurements (FAS 157), which was designed to respond to investors’ requests for expanded information about the extent to which entities, including hedge funds (funds), measure investments at fair value, the information used to measure fair value and the effect of fair value measurements on related income and performance.
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.
The Fair Value Measurement Approach
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 and 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 participant would use in pricing the investment and on the level in the fair value hierarchy at which the inputs fall.
Estimating Fair Value
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:
- The market approach uses prices and other pertinent information from market-generated transactions involving identical or comparable assets or liabilities (including a business). For example, such valuation techniques often use market multiples derived from a set of comparables. Multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range the appropriate multiple falls requires judgment considering factors specific to the measurement (qualitative and quantitative).
- The income approach uses valuation techniques to convert future values (for example, cash flows or earnings) to a single present amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts.
- The cost approach is derived from the amount that is currently required to replace the service capacity of an asset (often referred to as current replacement cost). From the perspective of a market participant (seller), the price received for the asset is determined based on the cost to a market participant (buyer) to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence.
Inputs to Valuation Techniques
Inputs generally concern the assumptions market participants would use in pricing the investment, as well as assumptions about risk. 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 are two examples. Inputs may be observable or unobservable:
- Observable inputs reflect the assumptions market participants would use in pricing the investment based on market data obtained from sources independent of the reporting entity.
- Unobservable inputs reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the investment developed based on the best information available in the circumstances.
Valuation techniques used to measure fair value shall maximise the use of observable inputs and minimise the use of unobservable inputs.
Fair Value Hierarchy
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.
| LEVEL | INPUTS | INPUT EXAMPLES | POTENTIAL EXAMPLES OF INSTRUMENTS |
|---|---|---|---|
| Level 1 | Quoted market prices in active markets for identical assets or liabilities | Input examples are prices from exchange-traded markets (NYSE, NASDAQ) and dealer markets (over-the-counter markets) | Exchange-traded investments, futures, and actively traded debt |
| Level 2 | Inputs other than level 1 inputs that are either directly or indirectly observable, including: | Restricted investments, secondary market loans, plain vanilla interest and credit swaps | |
| Quoted prices for similar assets or liabilities in active markets | Common stock of a public company that is restricted from sale under Rule 144 | ||
| Quoted prices for identical assets or liabilities in markets that are inactive | Brokered markets for unrestricted securities such as registered debt | ||
| Quoted prices for similar assets or liabilities in markets that are inactive | Brokered markets such as residential or commercial real estate markets | ||
| Inputs other than quoted prices that are observable | Interest rates and yield curves at commonly quoted intervals, implied volatilities, prepayment speeds, loss severities, credit risks, default rates | ||
| Inputs not directly observable, but derived principally from, or corroborated by, observable market data | Multiples of earnings, revenues, or similar performance measures | ||
| Level 3 | Unobservable inputs developed using the reporting entities’ estimates and assumptions, which reflect those that market participants would use | Expected cash flows, historical volatility, or forward prices for commodities beyond the term for which observable quotes exist | Mortgage servicing rights, complex derivatives, private equity, long-dated derivatives, and asset retirement obligations |
Blockage Factor
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 amends 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.
Disclosures
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.
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:
- The fair value measurements at the reporting date
- The level within the fair value hierarchy in which the fair value measurements in their entirety fall, segregating fair value measurements using quoted prices in active markets for identical assets or liabilities (Level 1), significant other observable inputs (Level 2), and significant unobservable inputs (Level 3)
- For fair value measurements using significant unobservable inputs (Level 3), a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to the following:
- Total gains or losses for the period (realised and unrealised), segregating those gains or losses included in earnings (or changes in net assets) and a description of where those gains or losses included in earnings (or changes in net assets) are reported in the statement of income (or activities)
- Purchases, sales, issuances and settlements (net)
- Transfers in and/or out of Level 3 (for example, transfers due to changes in the observability of significant inputs)
| Description | Total | Level 1 quoted prices in active markets for identical assets | Level 2 significant other observable units | Level 3 significant Unobservable inputs |
|---|---|---|---|---|
| Assets: | ||||
| Securities | $500 | $300 | $150 | $50 |
| Derivatives | 50 | 10 | 20 | 20 |
| Total | $550 | $310 | $175 | $70 |
| Liabilities: | ||||
| Securities sold short | $150 | $100 | $50 | – |
| Derivatives | 40 | 10 | 20 | 10 |
| Total | $190 | $110 | $70 | $10 |
Level 3 - Fair Value Measurement Using Significant Unobservable
| Securities | Derivatives | Total | |
|---|---|---|---|
| Assets: | |||
| Beginning Balance | $40 | $8 | $48 |
| Total realised gains or losses included in earnings | 8 | 2 | 10 |
| Total unrealised gains or losses included in earnings | 2 | 3 | 5 |
| Purchases, sales, issuances and settlements (net) | 10 | (1) | 9 |
| Transfers in and/or out of Level 3 | (10) | (2) | (12) |
| Ending Balance | $50 | $10 | $60 |
- The amount of the total gains or losses for the period in the first point above included in earnings (or changes in net assets) that are attributable to the change in unrealised gains or losses relating to those assets and liabilities still held at the reporting date and a description of where those unrealised gains or losses are reported in the statement of income (or activities)
- In annual periods only, the valuation technique(s) used to measure fair value and a discussion of changes in valuation techniques, if any, during the period
For assets and liabilities measured at fair value on a non-recurring basis in periods subsequent to initial recognition (for example, impaired assets), the reporting entity shall disclose information that enables users of its financial statements to assess the inputs used to develop those measurements. To meet that objective, the reporting entity shall disclose the following information for each interim and annual period (except as otherwise specified) separately for each major category of assets and liabilities:
- The fair value measurements recorded during the period and the reasons for the measurements
- The level within the fair value hierarchy in which the fair value measurements in their entirety fall, segregating fair value measurements using quoted prices in active markets for identical assets or liabilities (Level 1), significant other observable inputs (Level 2), and significant unobservable inputs (Level 3)
- For fair value measurements using significant unobservable inputs (Level 3), a description of the inputs and the information used to develop the inputs
- In annual periods only, the valuation technique(s) used to measure fair value and a discussion of changes, if any, in the valuation technique(s) used to measure similar assets and/or liabilities in prior periods.
Effective Date and Transition
This statement is effective for financial statements issued for fiscal years beginning after 15 November 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.
