Magazine article The CPA Journal

Estimating the Fair Value of Investments in Entities That Calculate Net Value per Share

Magazine article The CPA Journal

Estimating the Fair Value of Investments in Entities That Calculate Net Value per Share

Article excerpt

In September 2006, FASB issued Statement of Financial Accounting Standards (SFAS) 157, Fair Value Measurements (now Accounting Standards Codification [ASC] section 820-10, Fair Value Measurements and Disclosures), with the stated objective of simplifying the measurement and disclosure of fair value information. The application of this guidance to investments in certain nonpublic entities, such as alternative investments, proved more difficult than originally envisioned. In the authors' opinion, this was due to diverging views on fair value and the difficulty in obtaining information on alternative investments.

Individuals and institutions purchase alternative investments to achieve a specific investment objective while diminishing risk. Typically, alternative investments sell ownership interests; invest the proceeds, mostly in securities, to achieve specific investment objectives; and distribute to their owners the net income earned on investments and net gains realized on the sale of investments. Alternative investments diminish risk by holding many different securities and receiving professional investment management services. In addition, individuals and institutions may diminish their risk by investing in ownership interests not directIy exposed to the volatility of the public market, while realizing greater riskadjusted returns.

Alternative investments include ownership interests in hedge funds, private equity funds, real estate funds, venture capital funds, offshore fund vehicles, and fund of funds. These investments are often not listed on national exchanges or over-the-counter markets or traded in active markets and, thus, do not have a quoted market price. Investors typically redeem their ownership interest from the alternative investment rather than sell it in a secondary market. This redemption is not always readily available, in that many alternative investments require a minimum period of time between a redemption request and the actual transfer of cash, such as lockups and redemption gates. The investees often provide their investors with net asset value (NAV) per share, such as member units or an ownership interest in partners' capital proportional to their share of net assets. Redemptions are measured at NAV. Exhibit 1 presents an example of calculating NAV.

As discussed in the following section, fair value is defined as the price that would be received to sell an asset in an orderly transaction. Because the ownership interests of most alternative investments are not traded in an active market and do not have a quoted market price, investors would estimate the fair value of those interests based on other observable inputs. Certain alternative investments provide an NAV based on the fair values of their underlying assets and liabilities. The question arose whether, in these cases, the NAV can be considered an input based on observable market information in order to estimate the fair value of ownership interests in alternative investments.

As a consequence, FASB, in September 2009, issued Accounting Standards Update (ASU) 2009-12, investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent), to permit, as a practical expethent, the measurement of fair value of certain alternative investments based on net asset value. The practical expethent is available to those alternative investments whose underlying assets and liabilities are measured at fair value because, for such entities, the NAV reflects fair value. ASU 200912 is effective for interim and annual periods ending after December 15, 2009, with earlier application permitted.

This article provides guidance in identifying investments for which the fair value may be determined in conformity with ASU 2009-12, measuring the fair value of those investments, classifying the investments in the fair value hierarchy, and providing disclosures.

Objectives of Fair Value Measurement

ASC section 820-10 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction consummated at the measurement date. …

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