The FAS 157 Hustle Hedge Funds and Auditors Level Up Negotiations in Redefining Transparency and Liquidity FAS 157 is an accounting rule which was supposed to initially have a big impact on the hedge fund industry. For those who are unfamiliar, FAS 157 was first implemented in November 2007. FAS 157 created a framework for categorizing valuations. Valuations are supposed to be categorized into one of three categories according to the inputs utilized to value each position. The higher the level the less readily observable market prices and therefore, the position is generally more thinly traded and thought to be more illiquid. Level 1 assets are those with readily observable inputs. Level 2 assets are those with no directly observable prices themselves, but those assets do have price inputs that are based on them (i.e. an interest-rate swap whose components are observable points â€“ like a Treasury bond). The Level 3 Anathema Finally we come to Level 3 assets. These are supposed to be assets with no readily observable inputs. There is a general stigma against Level 3 assets - both hedge funds and investors seemingly want to avoid them at all costs. Why? Well for starters there is the perception of the market premium placed on liquidity. Whether or not you agree that the desire for enhanced liquidity is rational - the fact of the matter is when given the choice most groups (hedge funds and investors) would generally prefer the more liquid asset. Hedge funds in particular do not like Level 3 assets. When FAS 157 was first implemented in hedge fund's 2008 audited financial statements there was much hesitation among auditors and hedge funds alike regarding how to classify those assets with questionable inputs or uncertain levels of liquidity. Many auditors took a conservative hard-line approach and classified these questionable assets and liabilities as being in Level 3. While investors may have been originally unhappy to learn that a hedge fund which they thought may have seemingly been more liquid than the FAS 157 levels in the audited financial statements suggested, at least investors took some comfort in knowing that the auditors had most likely been conservative to their approach in level classification. Where are We Now? - A Floating FAS 157 Standard Flash-forward a few years to the present and the FAS 157 level classification system has reached a tipping point which threatens to render level classification virtually useless. What has happened, is that hedge funds have recently rediscovered an important fact - the auditor works for them, and they are not too subtly reminding auditors of this fact. Unhappy with their assets being classified as Level 2 or Level 3, many hedge funds have continually argued with their auditors over the past few years that certain assets inputs are really observable and that they should be moved up from one level to another. This has resulted in the gradual transition of assets from Level 3 to Level 2 and from Level 2 to Level 1.
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Part of the transition may justifiably come from auditors increased comfort ability with the FAS 157 rules over time, coupled with increased guidance from the author of FAS 157 the Financial Accounting Standards Board ("FASB"). But FASB guidance and auditor knowledge levels aside, it would not be unreasonable to hazard a guess that the increased hedge fund pressure towards auditors to re-categorize assets and liabilities as being more liquid has something to do with it. After all, if a hedge fund and an auditor cannot agree a hedge fund can always threaten to switch auditors or split up their audit work for different funs among multiple audit firms. While many auditors may publicly portray the image that they would not consider compromising their standards at the beck and call of hedge funds, for issues such as FAS 157 level classification, it seems as if the auditors have found some wiggle room in which to operate with regards to FAS 157. Auditors now seem comfortable in kowtowing to hedge fund requests for FAS 157 level reclassification as long as they have a leg to stand on, albeit a shaky one, in the form of some sort of observable input. The problem is that an input that was once not readily observable when FAS 157 was first implemented has now entered a gray area of observeabiity, which the auditor use to level up assets and keep the hedge fund as their paying client. Further complicating the issue is that many hedge funds have begun creating their own FAS 157 classification systems which they use to distribute FAS 157 statements to investors throughout the year. Some hedge fund administrators have also gotten into the FAS 157 business and begun providing classification guidance as well. Reconciling these levels to any FAS 157 levels in audited financial statements can yield an interesting glimpse into potential differences in classification methodologies. Furthermore, by analyzing FAS 157 levels over time an investor could begin to understand how classification levels may have changed over time. Operational Due Diligence Insights into FAS 157 Today Detailed operational due diligence can provide useful insights into these types of issues. Often times yellow or red flags such as a virtually captured auditor, inconsistencies in valuation methodologies and overly optimistic statements about liquidity come to light when analyzed in the context of a comprehensive operational due diligence review. Such analysis can be time consuming but may yield some useful insights into any latent operational risks which may be present in a fund. Originally posted on the Corgentum Consulting blog at www.Corgentum.com/blog For More Information
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ÂŠ 2011 Corgentum Consulting, LLC