Financial Services Insights - June 2012 - ASU 2011-04 to Impact Private Investment Funds’ Fair Value Measurements and Related Disclosures in 2012

Published: Jun 1, 2012
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In May, 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS (the “ASU,” “ASU 2011-04”). The issuance of ASU 2011-04 is part of the continued accounting standards convergence effort being undertaken jointly by the FASB and International Accounting Standards Board and results in substantially converged authoritative guidance in the area of fair value measurement and disclosure.

The provisions on ASU 2011-04 are generally applicable in calendar year 2012 and will impact private investment funds most significantly in the following areas:

Increased disclosure requirements related to fair value measurements
Application of premiums and discounts in fair value measurements

INCREASED DISCLOSURE REQUIREMENTS RELATED TO FAIR VALUE MEASUREMENTS

Quantitative information about significant unobservable inputs

For fair value measurements categorized within Level 3 of the fair value hierarchy, the ASU requires entities to provide certain quantitative information about significant unobservable inputs used in fair value measurements. Entities are not required to create quantitative information to comply with this disclosure requirement if quantitative unobservable inputs are not developed by the reporting entity when measuring fair value (for example, when a reporting entity uses prices from prior transactions or third-party pricing information without adjustment). However, when providing this disclosure, an entity cannot ignore quantitative unobservable inputs that are significant to the fair value measurement and are reasonably available to the reporting entity. See exhibit 1 for sample disclosure related to this requirement.

Valuation process

The ASU requires a description of the valuation processes used by an entity for level 3 investments. This description would include, for example, how an entity decides its valuation policies and procedures and analyzes changes in fair value measurements from period to period.

Transfers between level 1 and level 2 – Public entities only

For public entities only, the ASU requires disclosure of the amounts of any transfers between level 1 and level 2 of the fair value hierarchy, the reasons for those transfers, and the reporting entity’s policy for determining when transfers between levels are deemed to have occurred. Transfers into each level shall be disclosed and discussed separately from transfers out of each level. Formally, only “significant” transfers required this disclosure. Note that for nonpublic entities, subsequent to the adoption of ASU 2011-04, transfers between levels 1 and 2 are no longer required to be disclosed.

Sensitivity disclosure – Public entities only

For level 3 investments, the ASU requires that public entities include a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs if a change in those inputs to a different amount might result in a significantly higher or lower fair value measurement. Note that this is a “narrative description” only and the FASB provided the following example disclosure in the ASU:

The significant unobservable inputs used in the fair value measurement of the reporting entity’s residential mortgage-backed securities are prepayment rates, probability of default, and loss severity in the event of default. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.

APPLICATION OF PREMIUMS AND DISCOUNTS IN FAIR VALUE MEASUREMENTS

The ASU clarifies that the application of premiums and discounts in a fair value measurement is related to the unit of account for the asset or liability being measured. The amendments specify that in the absence of a Level 1 input, a reporting entity should apply premiums or discounts when market participants would do so when pricing the asset or liability. Premiums or discounts related to size as a characteristic of the entity’s holding (specifically, a blockage factor) rather than as a characteristic of the asset or liability (for example, a control premium) are not permitted in a fair value measurement.

Examples of common premiums or discounts that may be permissible in a level 2 or 3 fair value measurement include premiums or discounts related to controlling/non-controlling interests, uncertainty in cash flows, liquidity, marketability, and default/collateral value risk.

OTHER CHANGES AND CLARIFICATIONS

Highest and best use and valuation premise – The ASU clarifies that the concepts of “highest and best use” and “valuation premise” in fair value measurements are relevant only when measuring the fair value of nonfinancial assets and are not relevant when measuring the fair value of financial assets or liabilities.

Fair value of instruments measured within a portfolio – The ASU permits an exception to the requirements for measuring fair value when an entity manages its financial instruments on the basis of its net exposure, rather than its gross exposure, to those risks. This exception permits an entity to measure the fair value of such financial assets and financial liabilities at the price that would be received to sell a net asset position or to transfer a net liability position for a particular risk in an orderly transaction between market participants.

Fair value of instruments classified within shareholders’ equity – The ASU clarifies that an entity should measure the fair value of its own equity instrument from the perspective of a market participant that holds the instrument as an asset.

TRANSITION

Nonpublic entities are required to adopt the amendments prospectively for annual periods beginning after Dec. 15, 2011 (fiscal year ending Dec. 31, 2012 for calendar-year entities). For public entities, the amendments in the ASU are effective prospectively for interim and annual periods beginning after Dec. 15, 2011 (quarter ended March 31, 2012 for calendar-year entities).

Exhibit 1 – Quantitative information about significant unobservable inputs used in fair value measurements

Financial Services Insights - June 2012