The Financial Accounting Standards Board’s Codification requires entities to categorize investments measured at fair value in one of three levels in the fair value hierarchy based on the observability of the inputs used in valuing the investments. The three levels are as follows:
- Level 1 – investments with objective observable inputs, such as quoted market prices
- Level 2 – investments with objective observable inputs of similar investments
- Level 3 – investments with unobservable inputs, such as investments in private equity, venture capital and hedge funds (funds)
The Codification also provides a practical expedient that allows entities to estimate the fair value of certain investments by using the net asset value (NAV) per share, generally provided by the funds who report results as an investment company. Because entities do not consider valuation inputs when they use the practical expedient, they cannot use the traditional approach of categorizing these investments in the fair value hierarchy based on the observability of inputs. Instead, today’s guidance requires entities that use the practical expedient to categorize these investments in Levels 2 or 3 of the hierarchy based on whether the investment can be redeemed in the near term, generally within 90 days.
The new guidance eliminates an inconsistency in how items are categorized in the fair value hierarchy by excluding investments measured using the NAV practical expedient from classification within the hierarchy. Because excluding these investments from the fair value hierarchy disclosure will result in differences between amounts for investments in the fair value hierarchy disclosure and the investments’ line item on the balance sheet, the new guidance requires an entity to disclose the amounts of the excluded investments, so users of financial statements can reconcile amounts reported in the fair value hierarchy disclosure to amounts reported on the balance sheet.
All information presented in the fair value hierarchy disclosure will now be based on the relative observability of inputs used to determine the fair values. This disclosure will better communicate information about the relative uncertainty of the fair value measurements underlying the financial statements and may help alleviate a misconception among some users of the financial statements who believe the fair value hierarchy provides information about the relative risk level of investments.
To help users understand the nature and risks of investments measured using the NAV practical expedient, the following disclosures will continue to be required for each of the investments measured using the NAV practical expedient:
- Description of the significant investments’ strategies
- Description of the terms and conditions under which the entity may redeem the investments
- Estimated period of redemption time for those investments that cannot be redeemed currently
- Amount of any unfunded commitments
- Any other significant restrictions
For private companies and not-for-profit organizations, the guidance will be applied for fiscal years beginning after December 15, 2016. Early adoption is permitted.
Carl Kampel, CPAis the director in charge of professional standards at Ellin & Tucker, an advisory role that ensures all aspects of client accounting, regardless of the complexity, are conducted with the highest level of service and accuracy. His rich career spanning more than 30 years and personal contributions to financial and special reporting services standards of the audit and accounting profession have rippled internationally. He is a member of the FASB Emerging Issues Task Force and past vice chair of the AICPA Financial Reporting Executive Committee.