PRINT THIS PAGE The accounting standards are changing: measuring fair value of private equity funds01/11/2006. Source: Israel Venture Capital Journal (IVCJ). 
In this Israel Venture Capital Journal article, Kobi Shamash, CPA and Asher Shklar,CPA of Israeli accounting firm BDO Ziv Haft, look at the shift to fair value measurement of private equity assets that can make financial statements more relevant. Background
Over the years, finance specialists and economists have opposed measuring assets and liabilities at historic value. In the last few years, US and international standards boards realized that they could not remain faithful to the conservative historic approach, which promised to become obsolete. They therefore published new standards, adopting financial-economic methods for measuring and recognizing assets and liabilities using fair value.
The purpose of using present value in accounting measurement is to distinguish among future cash flows for different periods of time. This distinction makes present value measurement of future cash flows more relevant compared to measurement of cash flows that are not discounted.
Types of private equity fund assets The private equity industry consists of venture capital funds, hedge funds, leveraged buyout funds and merchant banking funds. The accounting treatment in this industry has special elements due to the large risk embodied in private equity investments and problematic asset measurement for early stage investments. In cases where a shareholder does not have material influence and therefore does not apply the equity method, a fair value measurement may be appropriate. Both the US and international standards allow for measuring investments at fair value.
Measuring and presenting at fair value – the ups and downs
Those who adhere to the fair value measurement approach maintain that it holds many advantages, pointing out two major arguments. The first is relevance. Fair value measurement and presentation of an entity’s assets and liabilities result in increasing relevancy of financial statement information, so that readers of the financial statements will not have to make complex adjustments in analyzing the entity. Financial strength, liquidity and cash flow become more easily assessed.
There are those, however, who continue to advocate the cost approach, pointing out disadvantages of the fair-value method. The principal drawback is reliability. Measurement at fair value when there are no quoted market prices in active markets is bound to be based on assumptions which are subject to bias and manipulation by those preparing the financial statements. The second major shortcoming is lack of consistency in the financial statements. A situation where some financial statement items are presented at fair value, while others are presented at cost may confuse financial statement readers. Furthermore, measurement at fair value may cause early recognition of unrealized profits as a result of an increase in market value. Additionally, a fair value measurement for unquoted items imposes the use of specialists, placing a significant cost burden on companies in order to obtain a reliable valuation. Fair value in US standards
About a year ago, the Financial Accounting Standards Board (FASB) proposed a standard to measure fair value that would be applicable to all assets and liabilities measured at fair-value and in accordance with other accounting pronouncements. Various professional publications carried these guidelines such as FAS 115 - Accounting for Certain Investments in Debt and Equity Securities; FAS 123 - Accounting for Stock-Based Compensation; FAS 133, Accounting for Derivative Instruments and Hedging Activities; FAS 143, Accounting for Asset Retirement Obligations; FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets; and FAS 146, Accounting for Costs Associated with Exit or Disposal Activities.
Fair value in international accounting standards
International Accounting Standard 39 – Financial Instruments: Recognition and Measurement – establishes the accounting treatment for financial instruments. This standard permits an entity to designate any financial asset or financial liability on initial recognition as one to be measured at fair value, with changes in fair value recognized as profit or loss. To impose a degree of discipline, an entity is precluded from reclassifying financial instruments into or out of this category.
How to determine fair value
Standard 39 provides the following guidance about how to determine fair value using valuation techniques:
• The objective is to establish what the transaction price would have been on the measurement date in an arm’s length exchange motivated by normal business considerations.
• A valuation technique (a) incorporates all factors that market participants would consider in setting a price and (b) is consistent with accepted economic methodologies for pricing financial instruments.
• In applying valuation techniques, an entity uses estimates and assumptions that are consistent with available information about the estimates and assumptions that market participants would use in setting a price for the financial instrument.
• The best estimate of fair value at initial recognition of a financial instrument that is not quoted in an active market is the transaction price unless the fair value of the instrument is evidenced by other observable market transactions or is based on a valuation technique whose variables include only data from observable markets.
Conclusion
Fair value as an issue is rapidly becoming more important in both US and international standards as part of the trend to make financial statements more relevant for their readers. Investment by private equity funds is unique in light of the major risks and uncertainties in investing in businesses at an early stage. Adopting international standards in Israel – as part of the overall convergence between international accounting standards and Israeli standards – increases the importance of preparation and learning the appropriate accounting treatment for private equity investments.
This article appeared in the Israel Venture Capital & Private Equity Journal (IVCJ). IVC Research Center publishes the Israel Venture Capital & Private Equity Journal, a quarterly review of trends and developments in the Israeli-related venture capital industry. IVCJ, distributed worldwide, is dedicated to provide wide-range coverage of Israel's venture capital industry. For more information please visit www.ivc-online.com
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