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Classifying investments in investment funds in the three-level fair value hierarchy

The International Accounting Standards Board (IASB) finalised its amendments to IFRS 7 Financial Instruments: Disclosures in March 2009. These amendments reflect the IASB's response to the request by users of financial statements that IFRS 7 introduce a fair value hierarchy in its required disclosures, similar to that used in US GAAP, Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures (precodification FASB Statement of Financial Accounting Standards (SFAS) No. 157 Fair Value Measurements). Overall, these amendments are intended to enhance disclosures about fair value measurement and liquidity risk - and are particularly relevant given the current economic turmoil.

For investments in investment funds, classification in the fair value hierarchy can be particularly difficult and require considerable judgment. This is due to the wide range of funds which are available to investors through a variety of channels (e.g., listed regulated funds available to the public and unlisted unregulated funds which are only available for investment via invitation). Furthermore, the financial information available to investors, such as the quality of prices available and information about the underlying investments, also varies considerably. This article provides practical guidance to preparers on how to classify fund investments measured at fair value within the new three-level hierarchy. Guidance for other types of instruments recorded at fair value and further insight about the IFRS 7 amendments can be obtained in Ernst & Young's publication, Classification of financial instruments within the IFRS 7 fair value hierarchy. In Addition, examples of IFRS 7, and other disclosures can be found in Ernst & Young's illustrative financial statements Good Investment Fund Limited 2009.


Three-level hierarchy

IFRS 7 requires the classification of financial instruments at fair value to be determined by reference to the source of inputs used to derive the fair value. This classification uses the following three-level hierarchy:

1) Level 1 — quoted prices (unadjusted) in active markets for identical assets or liabilities
2) Level 2 — inputs other than quoted prices included within level 1 that are observable for the asset or liability, either directly (i.e., as prices) or indirectly (i.e., derived from prices)
3) Level 3 — inputs for the asset or liability that are not based on observable market data (unobservable inputs)


Level 1

An investment in a fund is classified in level 1 of the hierarchy when that investment is quoted in an active market and measured at the unadjusted quoted price at the reporting date. An instrument is considered to be quoted in an active market when:

- Prices are regularly available to market participants (e.g., unadjusted price for a fund traded on an exchange or Net Asset Value (NAV) published by a fund not traded on an exchange), and
- Those prices represent actual and regularly occurring transactions (e.g., on a daily basis) at arm's length.

An unlisted fund can also be considered to be quoted in an active market if it publishes a NAV that is the price for regularly (e.g., on a daily basis) issuing and redeeming its instruments to and from the broader public.

If the published NAV (e.g., unlisted funds) is considered to be a quoted price in an active market, it must be used for fair value measurement purposes. In these cases, the NAV is more than an input to the fair value measurement (i.e., levels 2 and 3) because the unadjusted NAV meets the two criteria for level 1.

When transactions in the fund's instruments do not occur regularly, the price is not a quoted price in an active market. Further, if the transaction price can be adjusted subsequently (e.g., due to errors in calculating the price or NAV), the NAV published by the fund may not be considered a quoted price in an active market. Accordingly, in these cases, the investment may not be classified in level 1 of the hierarchy.


Levels 2 and 3

An investment in a fund is classified in level 2 of the hierarchy when that investment is measured using inputs that are directly observable at the reporting date. This is provided that any adjustments to the directly observable inputs are not significant to the fair value measurement of the instrument in its entirety (e.g., insignificant adjustments for a lack of liquidity).

An investment in a fund is classified in level 3 of the hierarchy when the investment is measured using unobservable inputs at the reporting date (e.g., a significant liquidity discount is applied to the directly observable inputs because of restrictions on redemptions such as lock-up periods, redemption gates, etc.).

When a fund fails a level 1 classification, its fair value measurement is normally derived, at least in part, from inputs such as price on an exchange, or a published NAV. While these funds may regularly publish a NAV, or similar measure, the NAV should not automatically be used as the fair value measurement, unless there is evidence that transactions occur at that unadjusted price.

IFRS 7 states that the level within the hierarchy at which an instrument measured at fair value is categorised, is determined on the basis of the lowest level input that is significant to the measurement of fair value in its entirety. Fair value measurements based on observable inputs are classified in level 2, whereas measurements based on unobservable inputs are classified in level 3.

Determining whether the inputs to a fair value measurement are observable or unobservable, and significant to that measurement in its entirety, requires judgment based on the facts and circumstances. Furthermore, entities would need to repeat the assessment of significance as the sensitivity of the fair value of the investment in a fund to an input may change over its life.

For instance, an entity initially classifies a fund in level 2 of the hierarchy, as amongst other factors, the fund publishes a NAV and those instruments are redeemable at that NAV at the reporting date, but is not considered quoted in an active market.

However, in a subsequent period, circumstances change whereby the instruments are no longer redeemable at NAV on the entity's reporting date. As the NAV and the ability to redeem are considered significant to the fair value measurement of the fund, the fund's fair value measurement is adjusted to reflect the lack of liquidity or uncertainty. If that adjustment is significant to the fair value measurement the fund is classified in level 3 of the hierarchy. This is particularly relevant when the most recent NAV or redemption date is a long period of time from the reporting entity's reporting date.

Entities should have a documented policy for determining the significance of unobservable inputs on their fair value measurements of funds and that policy should be applied consistently. In addition, significant judgments and assumptions are disclosed in the financial statements in accordance with IAS 1 Presentation of Financial Statements.

It is important to remember that classification in the hierarchy is of an investment in a fund, not of the fund's underlying investments. While information about the fund's underlying investments can provide an indication about the quality of a fair value measurement, this information is not, in itself, sufficient to classify a fund in the hierarchy without considering all the other facts and circumstances.

Notwithstanding this, if preparers are able to determine at the reporting date how the fund measures the underlying investments used to calculate the NAV, this information can provide further evidence to support the fund's classification in the hierarchy, particularly when such classification is marginal (uncertainty between levels 2 and 3). For example, a fund's underlying investments which are all classified in level 1 of the hierarchy can indicate that the fund's own classification in level 2, based on an evaluation of all the other facts and circumstances, is reasonable.

When level 1 criteria have not been met, the indicators in the following table, amongst others, should be considered when making a determination of whether a fund is classified as level 2 or 3 in the hierarchy.


Funds not classified in the hierarchy

When an investment in a fund is an equity instrument and it is not possible to determine that equity instrument's fair value, the IFRS 7 fair value disclosures are not required. For these investments, paragraph 30 of IFRS 7 requires disclosure of other information to help users of the financial statements make their own judgments about the extent of possible differences between the carrying amount of those financial assets  or financial liabilities and their fair value.


Summary

Classification of an investment in a fund in the three-level hierarchy can be very challenging. Reporting entities should consider all facts and circumstances of each investment when classifying funds. Due to the judgmental nature of the classification, we recommend that entities adequately consider and document the judgments they make. An open dialogue with their auditors and other stakeholders will also assist in a smooth transition to the new requirements.

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