Fair Value for Investments – A Big Deal or Not?

October 10, 2018 | Article

In 2015, the Governmental Accounting Standards Board (GASB) released GASB Statement No. 72, Fair Value Measurement and Application. GASB Statement No. 72 redefines the term “fair value” and the term “investments.” It also includes additional disclosure, which may be lengthy or not, depending on the type of investments held by the government, related to the valuation of investments.

What is Fair Value?
In many ways, fair value is similar to the process of buying a house. You make an offer that is not the selling price. The seller rejects the offer. You make a counteroffer and at some point, the seller agrees. In essence, the GASB’s definition of fair value is exactly the process just described. GASB’s definition of “fair value” is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at a measurement date.

Some of the provisions of GASB Statement No. 72 allow for certain investments to remain valued at cost. Donated investments will shift from fair value to acquisition value at the date of gift. Acquisition value is the price that would be paid to acquire an asset or the amount at which a liability could be liquidated, also in an orderly transaction between market participants at a measurement date.

Other provisions allow for certain investments to be at net asset value per share (or its equivalent). For example, investments in a statewide external investment pool are allowed to be at net asset value (NAV). The pool itself may be valued at amortized cost or at fair value, depending upon a pool’s decision in accordance with the recently issued GASB Statement No. 79. NAV would also be used in some private equity, hedge funds and limited partnership investments.

What is an Investment?
The GASB has also redefined the word “investment.” Investments are a security or other asset that: (a) a government holds primarily for the purpose of income or profit and (b) has a present service capacity based solely on its ability to generate cash or to be sold to generate cash.

The updated definition may call into question whether certain assets may be investments. It really depends on management’s intent at the point of purchase or if the intent changes during the period of holding the asset or liability. For example, if a public university holds student receivables, indeed the loans serve a purpose that allows a student to gain an education. However, as the loans are repaid over a period of time, they do not meet the definition of an investment since the intent was not to hold the receivables for the purpose of income and profit.

The opposite would be true in the royalty interests of oil and gas properties in particular circumstances. If a school district holds oil and gas interests to generate income to fund the district and it does not own the land associated with the rights, there is really no governmental program associated with the ownership of the interest. Since the purpose is to generate income and the interest generates cash, the royalty interests are investments.

At What Level of Detail Does My Government Need to Value Investments?
GASB Statement No. 72 introduces a concept known as “unit of account.” Investments could be a single investment, a group of like assets or liabilities and even a pool of investments. If a government owns an interest in a mutual fund, the “unit of account” is the fund itself and not the individual securities in the mutual fund. If the government owns a basket of equities or bonds that a bank assembles and the bank allows the individual investments to be bought and sold at any time, then each investment needs to be valued.

Is There Additional Disclosure?
Like many GASB standards, additional disclosure is required, but will vary greatly depending upon the types of investments held and the types of techniques used to value investments. Most custodial banks, chief investment officers and treasurers are familiar with these techniques and disclosure to value investments as they have been used for not-for-profit and for-profit entities for years.

For many governments that do not hold many complex investments, the additional disclosure may be a few paragraphs in the existing cash and investments notes to the financial statements.

Entities such as retirement plans, endowments and external investment pools will have far more extensive disclosures. Retirement plans and other complex governments may have three levels of disclosure as follows:

  • Level 1 – Investments where a quoted price is available for identical assets and liabilities in an active market. For example, if a governmental entity owns 100 shares of Apple stock with a quoted value of $94 a share, the fair value of that investment is based upon the quoted price of the Apple stock – the identical asset held.

  • Level 2 – Where quoted prices are used to value investments using similar (not identical) assets or liabilities in active markets, or where prices are obtained based on interest rates and yield curves. For example, a six month Main Street Bank CD available today is at 0.5% and trading at par. A bank down the street from Main Street is offering a similar CD, but it has not sold today. The similar CD would be worth approximately the same as Main Street Bank’s CD, assuming the creditworthiness of both banks is also the same.

  • Level 3 – This is where the government would need to use their own data to determine a value of an investment through a calculation. For example, a retirement fund owns a commercial property. Based on the rental income from the property, the intent of the fund to own the property for 20 years and the fund’s desired rate of return, a present value calculation is used to determine the value annually.

Each type of asset or liability will be included at fair value as of the end of the reporting date. Investments in private equity and similar that report at a net asset value instead of fair value have special disclosure provisions.

For a municipal, or similar general purpose, government that invests in a statewide external investment pool that generally trades at a stable value (for example $1) or in very prudent securities such as U.S. Treasury Bills, disclosure may be limited to a few sentences describing how the investments were valued and the fair value (or net asset value) as of the reporting date.

What to Expect from the Audit of Investments
The scope of auditing investments is primarily dependent upon risk and materiality of investments and the types of investments a government may hold during the year and at year-end. The largest impact will be for governments that hold Level 3 investments, where management may want to consider hiring a valuation specialist. For governments with Level 3 investments, additional testing, especially on the assumptions and valuation process may occur. Management is ultimately responsible for determining the fair value of investments, even if the value is received from a custodial bank or trustee and for determining proper disclosure and classification of investments.

If you have questions about the changes coming this year to investments, please contact your engagement partner at Eide Bailly.

What is an Orderly Transaction?
Orderly transactions are those that occur without being forced. For example, stock transactions assume an orderly, free market. The market becomes disorderly when there is a lack of buyers and perhaps too many sellers – in which case a seller in financial distress may be forced to sell an investment at a discounted price during a time when there is a temporary lack of buyers. It’s why the daily stock market averages fall.

Who are Market Participants?
Market participants are the various buyers and sellers that establish a value to an investment at any given time. The participants are not forced to buy or sell, they only have desire to do so.

What is the Measurement Date?
The measurement date is the point at which the transaction is consummated and the assets or liabilities are legally transferred between the parties. It can also be when assets or liabilities are valued for financial statement purposes.

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