Level 3 investments: The continuing saga
Death and taxes are the two things we can always count on in life, or so the saying goes. We could add to that the continued expansion of disclosures around fair value, especially for Level 3 investments.
Topic 820, Fair Value Measurements, is the appropriate technical repository for all things relating to fair value. To keep this article's length manageable, it focuses on the impact of Accounting Standards Update 2011-4 (ASU), Fair Value Measurements, issued in May 2011 and effective for public entities for years ending after Dec.31, 2011, with private entities having an additional year. Since many not-for-profit entities are June year ends, that means a June 30, 2013 effective date for all June year-end entities without publicly traded debt. This ASU is a product of the continuing convergence of U.S. GAAP and IFRS. Its 300+ pages provide clarifying information on measuring fair value with a goal of increasing transparency, particularly for unobservable inputs; it doesn't expand existing fair value measurements or establish any new standards or practices. When a lengthy ASU is issued to clarify existing guidance, it suggests that the implementation of previous guidance has been inconsistent and inadequate, necessitating a trip back to the drawing board.
The ASU has implications for all organizations that hold financial assets and financial liabilities. This article is a broad overview focused primarily on the types of Level 3 financial assets held by exempt organizations. To fully explore the ASU's requirements, please see our white paper The impact of amendments to fair value measurement and disclosure requirements. Neither this article, nor the white paper, covers the assessment process to determine the fair value level. It would require a separate white paper to discuss the finer nuances of determining the fair value level, especially distinguishing between Levels 2 and 3.
One of the fair value concepts, cleared up by the ASU, that has been the source of some head scratching in the past, is the concept of highest and best use. The ASU clarifies that this concept does not apply to financial assets. While this concept can be applied to nonfinancial assets where alternative uses could exist, with that use influenced by the group of assets or liabilities with which it is combined, financial assets do not have alternative uses and their value is typically not influenced by, or dependent on, other assets in the group. As a result, the grouping of assets is also not permitted, except for certain managed portfolios, discussed (briefly) later. Another clarification of the ASU focuses on premiums or discounts, such as control premiums, which the ASU emphasizes may be applied when market participants include them in pricing decisions. Premiums or discounts that are more closely related to the size of the entity's holdings, commonly referred to as blockage factors, are not permitted to be included in the fair value calculation as they are an entity, not market, characteristic.
All pre-ASU disclosure requirements for Level 3 investments continue to apply, including a description of the valuation technique and any changes to it. A detailed reconciliation of beginning and ending balances for all periods presented is also required, to include:
- Total realized and unrealized gains and losses, separately disclosing activity included in other comprehensive income (where applicable), and where the activity is included in the statements
- Purchases, sales, issuances and settlements (each reported separately)
- And transfers in or out of Level 3 (each disclosed separately), along with the reasons for the transfer and an accounting policy disclosure for determining when transfers are recognized.
An existing, but commonly missed item, is the disclosure of net investment return for all Level 3 investments held at year end (i.e., the amount disclosed omits any Level 3 investments sold during the period). So, what more could the ASU possibly require to be disclosed?
One of the more significant impacts of the ASU, in terms of the management's investment in responding to the requirements, focuses on the additional disclosure requirements for Level 3 investments, to include:
- More information regarding the valuation process, focusing on quantitative information for unobservable inputs
- Sensitivity analysis regarding changes in unobservable inputs and the interrelationship between such inputs
- For nonfinancial Level 3 assets (not a topic of this article), information when the entity's use of the asset differs from the highest and best use for fair value measurement purposes
Examples of quantitative unobservable inputs for Level 3 fair value measures include volatility, growth rates, discounts for lack of marketability, control premiums, and adjustments to historical third-party transactions and quotations. When a reporting entity does not develop the unobservable input used to estimate the fair value, it is not required to create the quantitative information for that input. Examples would include the use of the practical expedient to value alternative investments, unadjusted broker quotes and historical revenue or EBITDA multiples. If adjustments to such inputs are made, those adjustments must be described and disclosed in the financial statements. A common example of this is a June year-end entity with investments in alternatives valued using the practical expedient. The accounting policy would disclose the use of the practical expedient, with the fair value disclosures describing that the audited December per share value provided by the fund is adjusted for additional investments and withdrawals, and for unaudited investment returns provided by the fund through the entity's report date.
The ASU also requires the disclosure of information about transfers between Level 1 and Level 2 investments and the fair value level categorization for financial instruments not reported at fair value in the balance sheet, such as assets reported at amortized cost, but for which the disclosure of fair value is required by Topic 825, Financial Instruments.
Several disclosure requirements of the ASU do not apply to nonpublic entities: transfers between Level 1 and Level 2; the level categorization for financial instruments not reported at fair value in the balance sheet (but for which the disclosure of fair value is required) and, for Level 3 investments, sensitivity analysis related to unobservable inputs. Currently, organizations that have publicly traded debt would not qualify as nonpublic entities. The definition of a public entity is the subject of an exposure draft issued by FASB in August 2013. While this excludes not-for-profit entities from being considered public business entities, it does not change existing requirements, so NFPs will continue to be classified as public or non-public for pre-existing GAAP requirements.
There is a particular element of the ASU that will most likely not affect most exempt organizations, that is the exception for financial assets and liabilities when they are held and managed on a portfolio based on net exposure. In this instance, the group of financial assets and financial liabilities may be valued based on a price that would be paid or received to transfer or sell the net position. There are some additional conditions to qualify for the use of this valuation technique, and some additional disclosure requirements as well. If your organization has such assets, further research and study should be performed to fully understand the requirements.
You most likely already have an expectation that disclosure requirements for Level 3 investments will continue to expand. This ASU lives up to your expectation. It is another step along the journey to greater transparency for financial statement users. As investment products continue to develop and become more complex, expect financial reporting requirements to expand accordingly.
We'd encourage you to also follow the current active FASB project on Not-for-Profit Financial Reporting: Financial Statements as it has the potential to significantly impact the format of your organization's communication to stakeholders through its financial reporting.
RSM will be sharing key events and outcomes from this and other FASB projects with you as they happen.