Expertise Beyond the Numbers

Gray Areas in the Fair Value Hierarchy

FASB Accounting Standards Codification 820, Fair Value Measurement, outlines the fair value hierarchy in which investments are to be categorized. Typically it’s more straightforward to differentiate between Level 1 and 2, however, it can be a little more difficult to differentiate between Level 2 and 3.

Level 2 uses observable inputs, whereas Level 3 uses unobservable inputs. Level 2 observable inputs include: (1) Quoted prices for similar assets or liabilities in active markets; (2) Quoted prices for identical or similar assets or liabilities in non-active markets; (3) Inputs that are observable for substantially the full term of the asset or liability; and (4) Inputs derived from or corroborated by observable market data. Level 2 investments may include restricted stock, corporate and municipal bonds that trade infrequently, interest rate and currency swaps, and certain residential and commercial mortgage related assets. LIBOR rates, yield curves, and credit risks are examples of Level 2 observable inputs for over-the-counter securities.

For Level 3 investments, often a reporting entity is using its own best assumptions about inputs. Level 3 unobservable inputs include valuation multiples, discounts for lack of marketability, and default rates. Considerations in Level 3 investments may include the credit quality of a security’s issuer, liquidity risk adjustments, and issuer-specific circumstances. In certain cases, inputs may start out as Level 2, but there may be further adjustments to the fair value needed that require unobservable inputs, which would result in the investment being classified as Level 3. For instance, an illiquidity discount for thinly traded securities that uses unobservable inputs would result in the investment being classified as Level 3.

Thinly Traded Investments

When securities such as exchange-traded securities have few or no recent trades to help set pricing, there are often large discrepancies between bid and ask prices, fewer interested buyers, illiquidity issues and inability to trade out, increased price volatility, and discounted pricing for thinly traded market. Thinly traded investments commonly include smaller and newer exchange-traded funds, private equities, real estate, distressed assets, and smaller cap stocks.

Pricing Services and Availability of Information

While pricing services can certainly provide leveling inputs, the fund managers should have transparency and understanding of the inputs and methodologies to determine that they are reasonable, complete, and that they were derived as close as possible to the valuation date. The SEC position is that due diligence must be performed on the pricing services’ models and assumptions, and that sufficient information to do so must be available. Fund managers should ensure their vendors are providing sufficient information, that there are internal procedures to assess the information and ensure that they are in agreement with pricing and hierarchy leveling, and that there is opportunity to dispute or challenge a price. Additionally, larger firms may likely have better access to observable inputs as they may conduct businesses with more brokers and have access to more broker quotes. As such, a smaller investment company may not assess an investment at the same level as a larger firm if the inputs they used differ.

If you would like to discuss your investment level determinations, please don’t hesitate to Contact Us.