Refer To SAS No 157: Suppose Your Company Has Investments

Refer Tosfas No 157 Suppose A Your Company Has Investments In A Wide

Refer to SFAS No. 157: Suppose a company has investments in a wide array of assets, including (a) common stocks; (b) bonds; (c) real estate; (d) coal mine investments, which receive cash flows from sales of coal; (e) private equity funds; and (f) illiquid asset-backed securities. Consider how the portfolio manager would estimate the fair values of each of those classes of assets, and characterize the inputs you identify as Level 1, Level 2, or Level 3.

Paper For Above instruction

Financial reporting standards, such as SFAS No. 157 (now codified under ASC 820), provide guidance on valuing assets and liabilities at fair value, emphasizing the importance of hierarchy levels that reflect the transparency and observability of inputs used in valuation. When an investment portfolio encompasses diverse asset classes—ranging from publicly traded securities to illiquid assets—the determination of fair value becomes complex and requires careful consideration of the inputs involved in each valuation. This paper explores the methods a portfolio manager would use to estimate fair values of six asset classes and characterizes these inputs according to the Level 1, Level 2, or Level 3 hierarchy levels.

Starting with common stocks, which are traded on active markets, the fair value is readily observable and reliable. The prices are quoted prices in active markets, which make these valuations straightforward and classified as Level 1 inputs per SFAS No. 157. The market price provides the most direct evidence of fair value, reducing estimation uncertainty and reliance on management assumptions.

Bonds, especially those traded in liquid markets, also typically fall under Level 1 if they are actively traded. For bonds with readily available market quotes, the quoted prices are used directly. However, for less liquid bonds or those with infrequent trading, valuation may rely on observable inputs such as yield curves, credit spreads, or recent comparable transactions, classifying this as Level 2. These inputs are observable, but not directly from active markets, and require adjusting or extrapolating existing observable data.

Real estate investments pose a higher valuation challenge due to illiquidity and lack of active markets. The fair value estimation often involves appraisal methods such as income capitalization or comparable sales approaches. Since these appraisal techniques depend on inputs that are not directly observable and require management judgment, the fair value of real estate investments generally falls into Level 3. The inputs include projected income, discount rates, and comparable sale prices, which can vary significantly based on market conditions and appraisal assumptions.

Coal mine investments, which generate cash flows primarily from the sale of coal, are even less liquid and often involve complex valuation techniques. These may include discounted cash flow (DCF) analysis based on internal projections of future coal sales, costs, and discount rates. Because these estimates involve significant assumptions and the absence of observable market inputs, they are classified as Level 3 inputs. The valuation heavily depends on management’s estimates of future cash flows, commodity prices, operating costs, and economic conditions.

Private equity funds represent investments in companies that are not traded on public markets. The valuation of private equity holdings typically involves valuation techniques such as using recent financing rounds, income-based approaches, or comparable company analyses. Due to the lack of observable market prices, and reliance on management estimates and assumptions, the fair value of private equity investments often falls into Level 3. Valuation is based on complex models incorporating private company financials, market comparables, and discounted cash flow estimates.

Illiquid asset-backed securities (ABS) — especially those that are not actively traded — also call for valuation methods that incorporate observable inputs where possible, but often involve significant estimation. For liquid ABS, market quotes can be used, classifying them as Level 2. For illiquid or complex ABS, valuation relies on discounted cash flow models, credit risk assessments, and residual cash flows, which are typically considered Level 3 inputs. These valuations depend on assumptions about prepayment speeds, default rates, and recovery values, which are often subjective.

In conclusion, the classification of inputs as Level 1, 2, or 3 in SFAS No. 157 depends on the observability and reliability of the data used in the valuation process. Publicly traded securities, like common stocks and many bonds, generally qualify as Level 1 due to readily available market prices. Real estate, private equity, coal mine investments, and certain illiquid securities depend more on management assumptions and estimates, falling into Level 3 due to their less transparent valuation inputs. Understanding these distinctions is essential for financial statement users to interpret the reliability and accuracy of reported fair values and to assess the risks associated with each asset class.

References

  • FASB. (2006). Accounting Standards Codification Topic 820 (ASC 820), Fair Value Measurements and Disclosures.
  • FASB. (2011). Accounting Standards Update No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.
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