In May 2015, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) designed to simplify disclosure requirements for certain investments measured at net asset value (NAV). This is good news for hedge funds, funds-of-funds, and other entities that hold alternative investments.
Investments Measured at Net Asset Value Disclosure Requirements Simplified | Focus on Funds

ASU 2015-07 — Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent) — eliminates the need to categorize these investments within the fair value hierarchy. It also limits disclosure requirements to investments an entity elects to measure at NAV, rather than to all investments eligible for such treatment.

Why the Change?

U.S. Generally Accepted Accounting Principles (GAAP) allow entities to use Net Asset Value as a “practical expedient” to measure the fair value of certain investments. To qualify, an investment must be in an “investment company,” as defined under the FASB’s guidance, and can’t have a readily determinable fair value. Examples include hedge, private equity, and real estate funds.

Under current rules, entities must categorize these investments within the fair value hierarchy, which ranks assets as Level 1, Level 2, or Level 3, depending on the reliability of inputs used to measure fair value. Generally, investments measured at NAV are categorized as Level 2 or Level 3, depending on their relative liquidity. Investments redeemable at NAV on the measurement date fall into Level 2. Those that will never be redeemable at NAV are redeemable only upon liquidation of the entity. Both these and those that have an unknown redemption date, fall into Level 3.

For investments that are redeemable at NAV at a future date, the appropriate category depends on the length of time involved. Investments redeemable in the near term fall into Level 2, while others fall into Level 3. “Near term” isn’t defined, however, so choosing the right category is a judgment call, resulting in diversity in practice. Different entities categorize similar or identical investments differently, depending on how they define near term. In addition, some entities move investments between Level 2 and Level 3 from one measurement date to another.

Suppose, for example, that a calendar-year entity holds an investment that’s redeemable annually on January 1. If the entity defines near term as 120 days, then the investment would be categorized in Level 2 on September 30 and December 31 and in Level 3 on March 31 and June 30.

What’s Different?

ASU 2015-07 is designed to eliminate such inconsistencies. It gets rid of the requirement to categorize within the fair value hierarchy investments measured at Net Asset Value (or its equivalent) as a practical expedient. Entities will still be required to make certain financial disclosures regarding the nature of these investments and the risks involved, but they’ll no longer have to make disclosures for all investments that are eligible to be measured at NAV. Instead, these disclosures will be required only for investments an entity has elected to measure at NAV.

The ASU also requires entities to disclose the total amount of investments measured at NAV. This allows financial statement users to reconcile investments included in the fair value hierarchy with total investments measured at fair value in the statement of financial position.

Statement of Cash Flows

Investment companies that meet certain criteria are exempt from the requirement to provide a statement of cash flows. One of the criteria is that “substantially all of the entity’s investments are carried at fair value and classified as Level 1 and Level 2.” The ASU’s exclusion of investments measured at NAV from the fair value hierarchy, therefore, would disqualify investment companies from the exemption, requiring them to provide a statement of cash flows. To avoid this result, the ASU provides that investment companies continue to be eligible for the exemption if substantially all of their assets are carried at fair value and are classified as Level 1 and Level 2 or measured using the NAV practical expedient and are “redeemable in the near term at all times.”

Recommended Action

For public business entities, the ASU is effective for fiscal years beginning after Dec. 15, 2015, and interim periods within those fiscal years. It takes effect one year later for other entities. Early adoption is permitted. Once an entity implements the amendments, it should apply them retrospectively to all periods presented.

The new rules should simplify financial reporting for your hedge fund. Review them now and consider adopting them before the effective date. And remember to contact your Untracht Early advisor if you have questions about how to accurately report your investments.

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