Alternative Investment Accounting Frameworks & Models

Alternative investments include assets like private equity, hedge funds, real estate, and private credit. Unlike public stocks and bonds, these assets are often illiquid, meaning they cannot be easily sold. Their complex legal and financial structures present unique accounting challenges.

Standard accounting practices are often insufficient because these investments lack daily quoted prices. For instance, a private company investment or a hedge fund position involves strategies and assets that are difficult to value. This requires specialized accounting frameworks that move beyond historical cost to more dynamic valuation models to ensure financial statements are reliable.

The Framework for Fair Value Measurement

The main guidance for valuing alternative investments under U.S. Generally Accepted Accounting Principles (GAAP) is Accounting Standards Codification (ASC) 820. This standard defines fair value as the price received to sell an asset in an orderly transaction between market participants, known as an “exit price.” This is a market-based measurement, reflecting the assumptions of independent parties rather than the reporting company’s intentions for the asset.

The standard introduces the fair value hierarchy, which categorizes valuation inputs into three levels. The hierarchy prioritizes observable inputs over unobservable ones to increase consistency in fair value measurements. An investment’s classification is based on the lowest-level input that is significant to its overall measurement.

Level 1

Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities. An active market is one where transactions occur with sufficient frequency and volume to provide ongoing pricing information. This is the most reliable evidence of fair value.

Most alternative investments do not qualify for Level 1 classification, as a direct investment in private real estate or a venture capital fund does not have a quoted price on an active exchange.

Level 2

When a quoted price for an identical asset is unavailable, an entity uses Level 2 inputs. These are inputs other than Level 1 quoted prices that are observable for the asset, either directly or indirectly.

Observable inputs are developed using market data, such as interest rates and credit spreads, that can be corroborated by external sources. For example, an interest rate swap’s value can be derived from observable swap rates and yield curves.

Level 3

Level 3 inputs are unobservable inputs used when there is little market activity for the asset. Fair value must be determined using an entity’s own assumptions about what market participants would use, which requires significant management judgment. The vast majority of alternative investments, such as private equity and direct real estate holdings, are categorized as Level 3.

Three primary valuation techniques are used for Level 3 assets. The market approach uses prices from market transactions involving comparable assets, such as analyzing the valuation multiples of similar public companies. The income approach converts future amounts, like cash flows, to a single discounted amount, often using a Discounted Cash Flow (DCF) analysis. The asset approach reflects the amount required to replace an asset’s service capacity.

Accounting Models for Alternative Investments

After valuation, an accounting model is selected to reflect the investment’s economic substance, depending on the investor’s level of influence over the investee. U.S. GAAP provides several models that dictate how the investment is initially recorded and how value changes are recognized over time, either in net income or as direct adjustments to the investment account.

Fair Value through Net Income (FVTNI)

The Fair Value through Net Income (FVTNI) model is the default accounting treatment for most equity investments that do not qualify for other models, like the equity method. This is common for investments in vehicles like hedge funds where the investor exerts no significant influence.

Under this model, the investment is reported on the balance sheet at its fair value each period. Any changes in the investment’s fair value, realized or unrealized, are recorded directly in the income statement, affecting the company’s reported net income.

Equity Method Accounting

The equity method is required when an investor can exercise “significant influence” over an investee’s policies. Owning between 20% and 50% of an investee’s voting stock is generally presumed to constitute significant influence, but other factors like board representation can also indicate this.

Under the equity method, governed by ASC 323, the investment is initially recorded at cost. The carrying amount is then increased by the investor’s share of the investee’s net income and decreased by its share of net losses and any dividends received.

Consolidation of Variable Interest Entities (VIEs)

Many alternative investment structures are set up as Variable Interest Entities (VIEs), as defined in ASC 810. A VIE is a legal entity where equity investors lack sufficient financial resources to support its activities or do not possess control through voting rights.

An investor must consolidate a VIE if it is the “primary beneficiary.” This is determined if the investor has both the power to direct the VIE’s significant activities and the obligation to absorb its losses or the right to receive its benefits. If an investor is the primary beneficiary, it must consolidate the VIE’s assets, liabilities, and operations into its own financial statements.

NAV Practical Expedient

For certain fund investments without a readily determinable fair value, GAAP provides a practical expedient. This allows a reporting entity to estimate fair value using the fund’s reported Net Asset Value (NAV) per share if certain criteria are met.

The primary condition is that the investment is in an investment company that records its own underlying investments at fair value, per standards like ASC 946. If an investor elects to use this expedient, the investment is not categorized within the Level 1, 2, or 3 hierarchy and is disclosed separately in the financial statement footnotes.

Financial Statement Reporting and Disclosure

Financial statement presentation and disclosures for alternative investments are designed to provide transparency into their valuation and risks. Because many of these assets use subjective inputs, disclosure requirements are extensive to help users understand the investments and the uncertainty in their reported values.

Financial Statement Presentation

On the balance sheet, alternative investments are presented in a dedicated line item, such as “Investments, at fair value.” They are commonly classified as non-current assets due to their illiquid nature.

On the income statement, the presentation of gains and losses depends on the accounting model. For FVTNI investments, gains and losses are reported in a line item like “Net gains (losses) on investments.” For equity method investments, the investor’s share of earnings is shown as a single line item.

Required Disclosures

The standard mandates a comprehensive set of disclosures. A central requirement is a table that categorizes all assets measured at fair value according to the fair value hierarchy (Level 1, 2, and 3). This table shows the amount of investments valued using quoted prices, observable market data, and unobservable inputs.

For investments classified as Level 3, public companies must provide a detailed reconciliation that shows the changes in the balance of these investments from the beginning of the period to the end. This reconciliation separately presents purchases, sales, issuances, settlements, and total gains or losses, both realized and unrealized.

Furthermore, for Level 3 measurements, companies must disclose the valuation techniques used and provide quantitative information about the significant unobservable inputs. For instance, if a DCF model was used, the company would need to disclose the discount rate and growth rate assumptions. This detail allows financial statement users to assess the potential variability in the reported fair value.