COVID-19 has impacted our lives in many ways, but for the investment management industry, the accounting and reporting issues are not as “novel” as the virus causing the issues. The AICPA Investment Companies Expert Panel held their March 2020 meeting and discussed the potential implications of COVID-19, highlighting issues that are not so different from those dealt with during the economic crisis over a decade ago. In addition to the omnipresent issue of fair value, subsequent events and going concern may also warrant the attention of financial statement preparers. These issues will certainly be highlighted and discussed in our annual updates for the investment management industry, but I thought we would give you a sneak peak at these issues in case I’m still in quarantine this fall!
Fair value under ASC 820:
Let’s start with fair value. One of the biggest issues as a result of the coronavirus outbreak, is the significant changes in markets and market prices since the economy has been shut down. For some funds, certain investments held may be less liquid with less frequent observable transactions, not to mention significant price fluctuations. This also occurred during the financial crisis of 2007-2008, causing a need for the FASB to issue specific guidance related to:
- Active versus inactive markets
- Disorderly transactions (i.e. distressed transactions)
It is important to keep in mind that just because an investment becomes “less” actively sold, it does not mean that it is now trading in an “inactive market” and observable transactions can be ignored. In fact, even when there is an inactive market, the most recent observable transactions should be a factor in developing an estimate of fair value. Remember, an active market is defined as one “in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.” A market that is less active may still have a sufficient number of transactions to still be considered active for purposes of applying ASC 820 and therefore, observable prices must be used.
Regarding disorderly transactions, remember that the hurdle for qualifying as disorderly is quite high. An orderly transaction is defined as “a transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities.” Therefore, just because a market is volatile, it does not make the transaction distressed or disorderly, just a representation of market participants’ assessment of value as of the measurement date. Forced transactions are the exception… not the norm, even during a crisis!
Special considerations should be given to Level 3 fair valuations as well as those investments that move from Level 2 to Level 3 as a result of current market conditions. The economic upheaval as a result of the coronavirus outbreak will clearly impact valuations, even for those hard to value instruments. However, this does not mean you can “do whatever you want” when estimating these securities. Entities are expected to continue to apply a consistent methodology as they did before the outbreak (or justify its change in approach). They must continue to maximize observable inputs, not ignoring market information. Also, calibration, which was a big emphasis in the recent AICPA Valuation Guide (of portfolio company investments), will be important to update models to account for the recent market volatility.
Lastly, disclosures will continue to be important related to fair value and will be a focus of auditors and regulators, given the recent volatility.
Subsequent events under ASC 855
Given the timing of the outbreak, an interesting issue surrounding subsequent events arises. As you are probably aware, ASC 855 distinguishes subsequent events as:
- Recognized (Type I) - events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements
- Nonrecognized (Type II) - events that provide evidence about conditions that did not exist at the date of the balance sheet but arose subsequent to that date
The first type of subsequent event is “recognized” and therefore requires adjustments to reported figures in the financial statements, whereas the nonrecognized type may require disclosures if they are of such a nature that they must be disclosed to keep the financial statements from being misleading.
Some issues that arise related to ASC 855 include identifying the coronavirus outbreak as a Type I or Type II subsequent event. For most funds, it will be a Type II (nonrecognized) subsequent event given the timing of the outbreak and when it impacted global markets; however, as information is made available, we may determine that the “root cause” of many of the issues facing funds stem from events that could be traced back to late 2019.
For the vast majority who consider these subsequent events to be nonrecognized, the primary issue becomes whether they require disclosure and what information should be presented. Disclosures may be qualitative and/or quantitative and require considerable judgment. Funds should consider disclosing the negative impact of the crisis on net assets (e.g. in percentage terms or in terms of it being “material”). However, given the significant swings taking place on a daily basis, it may be appropriate to avoid being too precise with disclosures related to these impacts. Other disclosures that may be considered include:
- Portfolio composition and whether there is a concentration in an affected industry or geographic region
- Material decreases in net assets
- Significant redemption requests from investors, changes in terms for redemptions by the fund (e.g. gates, redemption suspensions, etc.), and liquidity of the fund
- Financing agreements or debt covenants are significantly impacted/breached
Going concern considerations under ASC 205-40:
Management is required to evaluate the fund’s ability to continue as a going concern for a period of at least one year after the date of the issuance of the financial statements. If substantial doubt exists (or it has plans to alleviate that substantial doubt), disclosures are required. Substantial doubt exists when it is probable that the fund will be unable to meet its obligations as they become due, given current conditions and events in the aggregate.
This issue will most likely impact funds with substantial debt (e.g. leveraged funds) whose portfolio has become illiquid. However, other factors may lead to consideration of going concern status, including:
- Funds with investors that are unable to make capital call commitments
- Significant redemption requests subsequent to year end
- Loss of financing facilities
- Needs to post additional collateral
- Breach of covenants that result in lender to demand immediate repayment of loan
- Among other circumstances
While other industries may have more broad issues impacting them as a result of COVID-19, the investment management industry is certainly not immune to accounting and reporting challenges. Keep these items in mind as you consider financial reporting for year end and the most recent quarter. And most importantly, stay healthy, stay safe, and stay home… until one day, hopefully soon, we will see you out on the road!
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