The theoretical scope for valuation "at cost" in alternatives funds is vanishing as a relief to investors. In addition, noninvestment companies are now expected to report nonconsolidated/nonequity method investments at fair value.
January saw the introduction of the International Accounting Standards (IAS) Board's new framework for classification and measurement of financial assets in International Financial Reporting Standard (IFRS) 9. Simplifying the complex classification system of IAS 39, an important part of the standard is the clear distinction between accounting for investments at fair value and amortized cost. In most cases, the standard makes clear that fair value is going to be the only option for alternative funds.
This, of course, is part of a wider trend. It follows the U.S. Financial Accounting Standards Board Accounting Standards Update (ASU) 2016-1 in January 2016.1 Applying to most equity investments, ASU 2016-1 also required measurements at fair value in most cases to be expanded from alternative investment funds to include corporate investments.
In both standards, there are exceptions. Under ASU 2016-1, noninvestment companies can elect to measure investments without a readily determinable fair value at cost. (Investment companies have no exception, as all investments are required to be reported at fair value.) Under IFRS 9, debt investments can be measured at amortized cost if the business model's objective is to collect contractual cash flows on the assets—provided those investments also give rise on specified dates to cash flows that are solely payments of the principal and interest.2
Even where it's available, valuation at cost will be increasingly rare, however. Under ASU 2016-1, those electing to value at cost have to complete extra steps for assessing impairment, identifying orderly transactions and remeasuring at fair value based on transactions in the security. That may reduce the attractions of the option. IFRS 9 also requires more onerous assessment of impairment for those using amortized cost.
The real pressure to move away from valuing at cost, though, will not come from the requirements of the standard but the demands of investors, which shaped them.
Institutional investors in alternative investment funds almost universally require reported Net Asset Value (NAV) to be based on the fair value of underlying investments. Institutional investors need fair value-based NAV to determine the fair value of a limited partnership interest for their own financial reporting purposes, as a common basis to make asset allocation decisions, to select investment managers, for performance evaluation and to inform incentive compensation decisions. Furthermore, without consistent and transparent information on the fair value of underlying investments, institutional investors face challenges in exercising their fiduciary responsibilities.
ASU 2016-1 and IFRS 9 have now made it crystal clear that historical cost and amortized cost are not proxies for fair value. With the standards now also clearly making fair value measurement the default, institutional investors' insistence on it will only intensify. Failure to meet this demand won't be without consequence—or cost.
1. Accounting Standards Update 2016-01, Financial Instruments-Overall: Recognition and Measurement of Financial Assets and Financial Liabilities
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