Management’s Role in Valuing Alternative Investments with NAV’s April 19, 2011.
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Transcript of Management’s Role in Valuing Alternative Investments with NAV’s April 19, 2011.
2 April 19, 2011
Presenter
Paul AndersonDirector of Assurance ServicesGBQ Partners [email protected]
Jeff AltonManager – Assurance ServicesGBQ Partners, [email protected]
Today’s presenters:
3
Objectives
• What are alternative investments with NAV?
• How are alternative investments valued?
• Disclosure requirements
• Management’s responsibilities
• Auditor considerations
April 19, 2011
4
What are Alternative Investments?
Generally,
• complex in nature
• limited regulation
• illiquid
• low correlation with standard asset classes
Defined as anything that is not stocks, bonds or cash.
April 19, 2011
5
Types of Alternative Investment
• Hedge funds
• Managed futures accounts
• Real estate/REITS
• Commodities
• Derivative contracts
• Venture capital
April 19, 2011
How are Alternative Investments Valued?
FASC 820 (Old FAS 157) requires measurement at fair value, except:
• Shared based payments of equity
• Leases
6 April 19, 2011
Alternative Investments with NAV
Able to estimate fair value using NAV if the following conditions exist:
• No ready determinable fair value
• Investment has the certain attributes
7 April 19, 2011
No Ready Determinable Fair Value
• No sales prices or bid-an-asked quotations are available over a securities exchange registered with the SEC
• Same as above for foreign securities if not traded on comparable exchange
• No fair value for mutual funds is determined and published and is basis for transactions
8 April 19, 2011
Investment Attributes
• Primary activity is investing in assets for current income or appreciation
• Unit ownership
• Pooling of funds to utilize professional management
• An investment company is the primary reporting entity
9 April 19, 2011
Fair Value Measurements for Investments with NAV
• Allowed to measure fair value using the NAV, if the NAV is calculated in a manner consistent with Investment Company guidelines (FASC 946) and as of balance sheet date
If not at balance sheet date or not calculated consistent with FASC 946, must consider if adjustment is necessary
• Must be applied on a per investment basis
10 April 19, 2011
Fair Value Measurements for Investments with NAV
If probable that a sale of an investment will occur, cannot use estimate of fair value, based on NAV, as of balance sheet date:
• Management commits to plan of sale
• Active program to locate a buyer
• Investment is available for immediate sale
• Unlikely that plans will change or that plan will be withdrawn
Must use estimated net proceeds as value
11 April 19, 2011
Always an Exception!
If plan to sell has been adopted, but individual securities have not been identified:
oContinue to value at estimated NAV, but disclose plans to sell and any actions to complete sale
12 April 19, 2011
FASC 820 Refresher
Defined as price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants:
Assumes highest and best use, even if intended use is different
The effect on a fair value measurement of a restriction on the sale or use of an asset by a reporting entity will differ depending on whether the restriction would be considered by market participants in pricing the asset.
13 April 19, 2011
Level 1
Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets that the Company has the ability to access. Level 1 is the highest and most reliable level in the fair value hierarchy.
Example: Publicly traded security
14 April 19, 2011
Level 2
Inputs to the valuation methodology include:
•Quoted prices for similar assets or liabilities in active markets
•Quoted prices for identical or similar assets or liabilities in inactive markets
•Inputs other than quoted prices that are observable for the asset or liability
•Inputs that are derived principally from or corroborated by observable market data by correlation or other means
15 April 19, 2011
Level 2
If the asset or liability has a specified (contractual) term, the level 2 input must be observable for substantially the full term of the asset or liability.
Example:
Real estate agent who pulls comparable sales to determine asking price for home.
16 April 19, 2011
Level 3
Inputs to the valuation methodology are unobservable and significant to the fair value measurement. Level 3 is the lowest level of reliability.
Basically, under Level 3, management is determining a value for an asset, subject to generally accepted valuation techniques.
17 April 19, 2011
How to Measure Fair Value
Valuation techniques used to measure fair value shall be consistently applied. However, a change in a valuation technique or its application is appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances.
Examples of factors that might affect valuation:
a. New markets develop
b. New information becomes available
c. Information previously used is no longer available
d. Valuation techniques improve
18 April 19, 2011
Classification of Investments with NAV
• Ability to redeem with investee at NAV – treat as Level 2
• If no ability to redeem with investee at NAV – treat as Level 3
• Ability to change from Level 3 to Level 2 once beyond any lockup or other redemption limitation
19 April 19, 2011
Disclosures – Overall Objective
Must disclose information that enables users of financial statements to understand the nature and risks of the investments and whether the investments are probable of being sold at amounts different from net asset value per share.
20 April 19, 2011
Disclosures
Must disclose by major category of investment:
•Fair value
•Expectation of liquidation
•Unfunded commitments
•Redemption terms and conditions
•Any redemption limitations or restrictions
•Sales or plans to sell
21 April 19, 2011
Major Categories
Must consider nature and risk of security. Considerations:
• Activity or business sector
• Vintage
• Geographic concentrations
• Credit quality
• Economic characteristics
22 April 19, 2011
Fair Value
As noted, estimated of fair value, based on NAV, is allowed if:
• As of balance sheet date
• No plans to sell
23 April 19, 2011
Expectation of Liquidation
By category, management’s estimation of the period of time over which the underlying investments are to be liquidated.
Does the fund have a 5 or 7 year expectation?
24 April 19, 2011
Unfunded Commitments
By major category, details of any unfunded commitment on staged investments.
25 April 19, 2011
Redemption Terms and Conditions
A general description of the terms and conditions upon which the investor may redeem.
Example: Quarterly redemption with 60 day notice
By major category, any restrictions on redemptions in terms of date or amount.
Management must estimate of when restrictions may lapse.
If cannot estimate, must disclose how long restrictions have been in effect.
26 April 19, 2011
Sales or Plans to Sell
• Total amount of investments under a plan to sell
• Any remaining actions necessary to complete the sale
• Disclosure of plans to sell if individual securities have not been identified
27 April 19, 2011
Management’s Responsibility
AU 328.04 states:
Management is responsible for making the fair value measurements and disclosures included in the financial statements. As part of fulfilling its responsibility, management needs to establish an accounting and financial reporting process for determining the fair value measurements and disclosures, select appropriate valuation methods, identify and adequately support any significant assumptions used, prepare the valuation, and ensure that the presentation and disclosure of the fair value measurements are in accordance with GAAP.
28 April 19, 2011
Management’s Responsibility
The responsibility for determination of fair value cannot, under any circumstances, be outsourced or assigned to a party outside of the investor entity’s management.
Although the investor entity’s management may look to the fund manager for the mechanics of the valuation, management must have sufficient information to evaluate and independently challenge the fund’s valuation.
The underlying investments generally are measured at estimated fair value by the fund manager in accordance with its stated valuation policies for determining net asset value.
29 April 19, 2011
Keeping the Auditor’s Happy
More information that you have available, the easy it will be for the auditor to complete his work.
If you rely on the auditor for assistance in determining fair value:
• Independence issue
• Deficiency in internal control
30 April 19, 2011
Auditor Tool
ALTERNATIVE INVESTMENTS – AUDIT CONSIDERATIONS
A Practice Aid for Auditors
31 April 19, 2011
Auditors Areas of Emphasis
• Internal controls
• Existence
• Valuation
• Managements’ representations
32 April 19, 2011
Internal Control Attributes
• Process to determine fair value
• Availability of information used in determining estimated fair value
• Nature of the investments, including complexity, liquidity and frequency
• How often management interacts with the fund manager and the nature of such interactions
33 April 19, 2011
Internal Control Attributes
• Competence and experience of management to monitor and estimate fair value
• Availability of SAS 70 reports (being replaced by SSAE 16, effective for periods ending after June 15, 2011)
• Use of an investment adviser to monitor the alternative investments
• Availability of financial information of individual investments
34 April 19, 2011
Existence
• Whether alternative investments exist at a given date and whether recorded transactions have occurred during a given period
• Generally achieved through confirmation, but alternative procedures may be necessary
35 April 19, 2011
Alternative Procedures
• Observing management site visits or telephone calls to investee funds (or reviewing documentation of such calls or visits)
• Reviewing executed partnership, trust, limited liability corporation, or similar agreements
• Inspecting other documentation supporting the investor’s interest in the fund (for example, correspondence from the fund or trustee acknowledging transactions with the fund)
• Reviewing periodic statements from the fund or trustee reflecting investment activity and comparing activity with amounts recorded by the investor
• Vouching relevant cash receipts and disbursements
36 April 19, 2011
Valuation
• The valuation assertion addresses whether alternative investments are reflected in the investor entity’s financial statements at appropriate amounts
• Appropriate disclosures are contained within financial statements
37 April 19, 2011
Management Representations Required by Auditor
• Appropriateness of the measurement methods and consistency in the application of the methods
• Completeness and adequacy of the disclosures related to estimated fair value information
• Subsequent events requiring adjustment to the estimated fair value measurements and disclosures
38 April 19, 2011
Management Representation
The auditor must evaluate:
•The reasonableness of significant assumptions
•Whether the assumptions appropriately reflect management’s intent and ability to carry out specific courses of action
39 April 19, 2011