January 24, 2012

Proposed Update to Topic 946, Financial Services – Investment Companies

By Marjorie Bailey, CPA, Partner-in-Charge of Alternative Investment Group California and Marni Pankin, CPA, Partner - Alternative Investment Group

Proposed Update to Topic 946, Financial Services – Investment Companies

Why Issue this Proposed Accounting Standards Update?

Many hedge and private equity structures may look and feel like a fund, but new proposed guidance is forcing managers to take a closer look at the purpose, ownership and structure of their entity to determine if they really are, in fact an investment vehicle, and are permitted to follow the accounting requirements in Topic 946, Financial Services—Investment Companies. The Proposed Accounting Standards Update (Update) issued on October 21, 2011 by the Financial Accounting Standards Board (FASB) will amend the guidance in Topic 946 for determining whether an entity is an investment company.

The investment companies project is a joint effort between the FASB and the International Accounting Standards Board (IASB). They have been working together for several years to develop a global accounting standard. The IASB issued similar proposed guidance this past summer. As part of the development of a consolidation standard, FASB thought it was important to develop consistent criteria for determining whether an entity is an investment company since investment companies, even if they hold a controlling financial interest in the investee, carry all of their investments in operating entities at fair value.

Who is Affected by the Amendments in the Update?

The proposed Update applies to both public and nonpublic entities and requires an entity to meet all six criteria described below to qualify as an investment company. However, an entity registered as an investment company under the SEC’s Investment Company Act of 1940, will be considered an investment company for purposes of applying the standard even if it doesn’t meet all the criteria. Entities that no longer qualify to be treated as an investment company under the new guidance will no longer be able to follow the fair value accounting treatment as described in Topic 946 and have to consolidate subsidiaries or account for investments using the equity method. Instead, investments will be held at their carrying value.

In addition, an entity that invests in real estate properties and meets the criteria to be an investment property entity under the proposed Accounting Standards Update, Real Estate—Investment Property Entities (Topic 973), will not be an investment company. The proposed amendments remove the scope exception in Topic 946 for real estate investment trusts.

What are the Main Provisions?

The Update affects the scope, measurement, presentation, and disclosure requirements for investment companies.The definition of an investment company is amended and includes the following six criteria that entities must follow to qualify as an investment company.

  1. Nature of Investment Activities: The investment company’s only substantive activities are investing in multiple investments (usually in the securities of other entities not under common management).
    • If management’s activities include involvement in the day-to-day operations of an investee, it does not preclude the entity from meeting this criteria, provided the activities are consistent with the investment manager’s fiduciary duties to its investors.
    • An entity does have some leeway with respect to the “multiple investments” provision, and is not required to hold multiple investments throughout its existence. If, for instance, the entity is starting up and has not yet identified suitable investments or the entity is in the process of liquidation, it will not be precluded from being an investment company. Also, an investment company that holds a single investment, but that investment holds multiple investments, i.e.: a master/feeder or a fund-of-fund structure, also complies if the underlying entity meets the definition of an investment company.
    • Furthermore, FASB did not come up with specific guidance on the number of investments an investment company may hold, however; it should be more than one investment.
  1. Express Business Purpose: The investment company is committed to invest for the purpose of providing returns from capital appreciation, investment income (such as dividends or interest), or both.
    • The offering memorandum for a fund indicates the investment objective, which should be one or both of these purposes. Entities whose objectives include developing, producing, marketing or providing products or services with its investees will not fit the definition of an investment company.
    • Furthermore, if an entity’s sole business purpose is capital appreciation, it should have one or more potential exit strategies to be considered an investment company.

For example, ABC Company was formed by five biotech companies to invest in other start-up biotech companies for capital appreciation. No plans for exiting the investments have been identified by ABC Company. Although ABC’s business purpose and investment activities are investing for capital appreciation, ABC is not an investment company because the investment plans of ABC Company do not include exit strategies for its investments. Since the company has not developed potential exit strategies, it cannot realize capital appreciation.

  1. Unit Ownership: Ownership in the investment company is represented by units, such as equity or partnership interests to which the net assets can be attributed.

  2. Pooling of Funds: The funds of the investment company’s owners are pooled together to achieve their common investment objectives. The entity has investors who are not related to the parent (if there is a parent) and those investors, in aggregate, hold a significant ownership interest in the entity. In other words, to be an investment company, the proposed update requires an entity to have a significant proportion of investors that are not related to the entity’s parent.
    • This particular criterion can be a problem for certain funds that are closely held or funds whose general partner has a significant limited partner interest in the fund. It should be noted, though, that an entity that is in its start-up phase and is actively seeking outside investors, as well as entities in their liquidation phase whom only have investors related to the parent remaining, are not precluded from meeting this criterion.

  3. Fair value management:Substantially all of the investments are managed, and their performance evaluated, on a fair value basis.
    • FASB believes that the reporting of investments should be on a fair value basis, not only externally for investors, but also internally to management personnel, since it provides the most useful decision making information.

  4. Reporting entity: The investment company provides periodic financial results about its investment activities to its investors. The entity can be, but does not need to be, a legal entity.

Another major provision of the Update relates to consolidation. An investment company will be required to consolidate with another investment company or an investment property if it holds a controlling financial interest in the investee in a fund-of-funds structure. For example, a fund of funds that owns 60% of an underlying fund vehicle (or an investment real estate property) has to present the underlying vehicle at 100% on the statement of assets and liabilities and the condensed schedule of investments and include the non-controlling 40% interest as a component of net assets on the consolidated financial statements. The investment company parent retains the specialized guidance when consolidating another investment company or an investment property entity. The investment income and unrealized appreciation or depreciation earned from the underlying vehicle will be shown at 100% on the consolidated statement of operations, with a reduction at the bottom of the statement, for the increase (decrease) in net assets attributable to the non controlling interest. The consolidated statement of changes in net assets includes a column for the non controlling interest, a column for the shareholders of the fund-of-funds, and a total column.

Entities also have to expand their financial highlights disclosures and include expense ratios with and without the amounts attributable to the non controlling interest. A reconciliation of the amounts used in the calculation to the amounts on the consolidated statement of operations will be a new required disclosure.

A new FASB update will not be complete without provisions for additional disclosures in the financial statements. Additional required financial statement disclosures include changes in an entity’s status as an investment company, whether the investment company has provided support to any of its underlying investment vehicles or investment properties and any significant restrictions on an investee’s ability to transfer funds to the investment company, such as restrictions on cash dividends, interest, or repayment of loans.

Lastly, the Update prohibits an investment company that is able to exercise significant influence over another investment company or an investment property entity from accounting for its interest using the equity method of accounting. Rather, those investments are measured at fair value.

How would the Update Differ from Current GAAP and will it be an Improvement?

The Update changes the definition of an investment company.The criteria within the definition expands. FASB believes that the updates result in more enhanced comparability of investment company financial statements prepared in accordance with GAAP and the IASB’s proposed amendments to IFRS. They also believe that the amendments enhance the consistency between investment companies that report under GAAP and also increase the transparency of the underlying assets and liabilities of an investment company’s investees.

When will the Amendments be Effective and what Happens Upon Adoption?

FASB will consider the feedback and public comments received on this exposure draft before the effective date is determined.

Upon adoption, an entity discontinues the guidance in Topic 946 if the entity no longer meets the criteria to be an investment company. The entity presents the change in its status as a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption by calculating the carrying amounts of its investees as though it had always accounted for its investments in conformity with other applicable GAAP. If not practicable, the entity applies the proposed amendments as of the beginning of the period of adoption.

If an entity that historically was not an investment company meets the criteria as a result of adopting the proposed amendments, the entity reports the effect of applying the guidance as a cumulative-effect adjustment to net assets as of the beginning of the period of adoption.

An investment company may be required to consolidate another investment company or an investment property entity as a result of the proposed amendments. In these situations, the investment company applies the requirements in Topic 810, Consolidation prospectively when the proposed amendments become effective.

Final Remarks

The proposed Updates are expected to have a significant impact on certain private equity funds, real-estate focused funds, funds of hedge funds and many other alternative investment vehicles. Time will be required to evaluate whether managed funds and other vehicles, including single investor funds, single investment funds, asset-backed securitization vehicles and other funds meet the definition of an investment company, and if not, what accounting implications will incur. The changes in presentation and disclosure relating to the consolidation of one investment company by another where a controlling financial interest is held as contained in the proposed Update needs to be evaluated and affected funds should determine how to collect and present such information, in the most cost effective way. Funds may question whether this additional information is meaningful to users and investors or does it complicate and confuse investors as to the ownership and value of certain investments. FASB encourages organizations and individuals to comment and question the proposed guidance and explain specific issues as it relates to implementation of the proposed Update for their entity.

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