Establishing a standard

Private equity managers now have an answer on convergence and it’s good news.

The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) last month issued new guidance on fair value measurement and disclosure requirements for International Financial Reporting Standards (IFRSs) and US generally accepted accounting principles (GAAP).

It’s significant news for private equity managers as IFRS 13 Fair Value Measurement will provide, for the first time, a precise definition of fair value and a single source of fair value measurement and disclosure requirements for use across IFRSs.

David Larsen, a San Francisco-based managing director and member of the portfolio valuation practice at Duff & Phelps, says that there are several positive aspects to the news including decisions on disclosure requirements.

“FASB listened to the comment letters provided during the public consultation process and are not requiring private companies, including non-public funds to provide quantitative sensitivity disclosures,” notes Larsen.“It is a positive development that FASB listened to the concerns of the industry that requiring quantitative sensitivity disclosures is not meaningful to private equity investors.”

It took quite some time to get consensus between the boards on the disclosure point. Completion of the project is the culmination of more than five years’ work to improve and align fair value measurement and disclosure requirements.

Last June, FASB and IASB jointly issued a proposed accounting standard update (ASU), Fair Value Measurements and Disclosures, Amendments for Common Fair Value Measurement and Disclosure Requirements in US GAAP and IFRSs.

As part of the exposure draft, the boards agreed that information on sensitivity analyses would be required in disclosures if changing one or more of the unobservable inputs used in the fair value measure to a different amount that could have been used would have resulted in a significantly higher or lower fair value measurement.

“This means that a range of potential valuation outcomes based upon varying assumptions and sensitivities would need to be disclosed in the financial statements,” says a valuation expert. “This would provide additional information to investors by showing the potential impact of various assumptions on the value conclusions, but may also create more uncertainty around valuations if the range of potential valuations is relatively wide.”

Meanwhile, Larsen notes that it’s very positive that the US GAAP definition of fair value and the IFRS definition of fair value are now identical.

The guidance changes the wording used to describe the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements. The amendments include the following:

• Those that clarify the board’s intent about the application of existing fair value measurement and disclosure requirements; and

• Those that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements.

“The result is clearer and more consistent guidance on measuring fair value, where its use is already required,” says David Tweedie, chairman of the IASB, in a statement.

FASB did not intend to make major changes in how the fair value of private equity investments are estimated, says Larsen.“

However, because of the wording used to converge with IFRS and desires of the IASB, some investments may be valued differently because of reinterpretation of the unit of account. Time will tell the extent, if any, of such reinterpretation.”

Meanwhile, FASB reinforced a focus on “unit of account” or the basis upon which a fair value measurement is made; for example a single share of stock. FASB leaves the determination of “unit of account” to other accounting standards that require fair value, says Larsen.

“For the private equity industry, fair value is required by ASC Topic 946 (Investment Company Accounting Rules),” he says.“Topic 946 is not overly clear on describing unit of account. Therefore, it is possible that there could be some who apply the revised guidance in ASC topic 820 differently than they did in the past.”

This is most likely to occur in situations where a fund owns both debt and equity in the same portfolio company. It may also impact valuation estimates for venture capital investments: series A vs series B, etc., he says

“It may take some time to see how auditors interpret and apply their view on unit of account,” says Larsen.

The harmonisation of fair value measurement and disclosure requirements internationally also forms an important element of the boards’ response to the global financial crisis.

“Having a consistent meaning of the term fair value will improve the consistency of financial information around the world,” said Leslie Seidman, chairman of the FASB, in a statement. “We are also responding to the request for enhanced disclosures about the assumptions used in fair value measurements.

The harmonisation news comes at a time when the US Securities and Exchange Commission said it would sponsor a roundtable in July to discuss the pros and cons of potentially adopting IFRS as the financial reporting system for US issuers. The agency is expected to make a decision on the matter before the end of the year, assuming full convergence work is completed by the two boards by then.

More than three quarters (80 percent) of companies believe the IFRS will be adopted at some point, according to a 2011 PricewaterhouseCoopers survey.

H a r mo n i s a t i o n should mean financial statements will be read more easily across borders, by both fund managers and increasingly curious investors.