Time to Say Goodbye- Proposed Guidance for Fund Liquidations

Fund managers and their auditors frequently grapple with the presentation of financial statements for liquidating funds. Because there is a lack of guidance on when it is appropriate to apply the liquidation basis of accounting, there is an inconsistency in practice. Typically, fund managers provide limited information as it relates to their fund’s liquidation process.In a world where transparency is expected, investors are most concerned with how much cash will be available to them once the fund is terminated and how long it will take to receive this cash.

This lack of guidance has led the Financial Accounting Standards Board (FASB) to issue an exposure draft, “Presentation of Financial Statements (Topic 205): The Liquidation Basis of Accounting.” This exposure draft is being issued to clarify � when an entity should apply the liquidation basis of accounting.It also provides principles for the measurement of assets and liabilities under the liquidation basis of accounting as well as any required disclosures.The FASB believes that the new guidance would improve the consistency and comparability of financial reporting. This proposed amendment would apply to all entities that issue financial statements that are presented in conformity with U.S. Generally Accepted Accounting Principles (GAAP). FASB is currently evaluating comments from constituents and is expected to issue final guidance within the next few months.

Considerations to Liquidation

The consideration to liquidate should occur after management’s decision to cease ongoing operations. The specific provision would apply when a fund determines that liquidation is imminent.Since there is no established definition of imminent liquidation, the exposure draft defines liquidation to be imminent, and would require funds to follow the liquidation basis of accounting, when either of the following exists:

• A plan of liquidation has been approved by management (General Partner, Managing Member or Investment Manager) to make such a plan effective and the likelihood is remote that the execution of the plan will be blocked by other parties.
• A plan of liquidation is imposed by outside forces, such as involuntary bankruptcy and the likelihood that the entity will return from liquidation is remote.

If a plan for liquidation was specified in the fund’s governing documents at inception, then liquidation is already considered imminent. Typically, limited life funds would fall into this category and would therefore be exempt from the criteria mentioned above. However, should a fund deviate from the liquidation plan stipulated in the governing documents, it would be required to adopt the liquidation basis.

Such deviations would include:

• The date that liquidation is expected to conclude is earlier or later than the contractually stated expiration date of the fund.
• The fund is forced to dispose of its investments in a manner that is not orderly or in exchange for an amount that does not reflect fair market value.
• The fund’s governing documents were amended since inception.

Measuring Net Assets in Liquidation

If the adoption of the liquidation basis of accounting is deemed appropriate by management, the estimated amount of cash or other consideration that a fund expects to collect or pay to carry out its plan for liquidation must be determined. The estimated costs to dispose of those assets or liabilities should be accrued for and any other costs and income that a fund expects to incur or earn shall be accrued through the date at which the fund expects to complete its liquidation. This may include, but is not limited to, legal fees, accounting and administrative fees, management fees and performance fees. For instance, if a fund expects the liquidation period to last 24 months and uses the services of a fund administrator to maintain fund books and records, there should be an accrual recorded representing 24 months of administration fees. Additionally, remaining investments will no longer be valued at fair market value, but rather at their recoverable cash value. Fair market value assumes disposition in an orderly manner, whereas recoverable cash value could be a distressed sale or a disorderly transaction. A reconciliation between fair market value and recoverable value is required to be disclosed. At each subsequent reporting date, the fund will re-measure its assets, liabilities and the accruals of disposal to reflect the actual or estimated change in value since the previous reporting date.

Reporting Requirements

The exposure draft states that, at a minimum, a statement of net assets in liquidation and a statement of changes in net assets in liquidation be presented. The statement of net assets in liquidation must include information about the net assets available for distri�bution to remaining investors or other claimants (such as creditors) as of the end of the reporting period. The statement of changes in net assets in liquidation must include information about the changes during the period in net assets avail�able for distributions to investors or other claimants (such as creditors) during the liquidation. The fund would need to accrue and disclose separately any additional costs it estimates it would incur as a result of the liquidation.

In addition to changes in the preparation of the financial statements, the exposure draft now requires funds to disclose all of the following when it prepares financial statements using the liquidation basis of accounting:

• That the financial statements are prepared using the liquidation basis of accounting, including the facts and circumstances surrounding the adoption of the liquidation basis of accounting.
• A description of the fund’s plan for liquidation, including, at a minimum, a description of the manner by which the entity expects to dispose of its assets and liabilities and the expected duration of the liquidation process.
• The methods and significant assumptions used in measuring the liquidation value of its assets and liabilities, including assumptions used in estimating future expected cash flows, as well as subsequent changes to these methods and assumptions.
• The type and amount of expenses and income accrued in the statement of changes in net assets in liquidation.

Best Practices for Liquidating Funds

For funds that decide to adopt a plan on liquidation, these are some recommended steps and considerations that each fund manager should assess before they begin the process:

• Upon the determination of imminent liquidation, ensure that the liquidation plan is pursuant to the funds governing documents.
• Contact one’s attorney and other service providers to inform them of the plans to liquidate the fund.The attorney, in particular, will be able to help guide the manager through any potential issues that may arise.
• Suspend voluntary redemptions.
• Inform investors that the fund will be liquidating and the steps being taken before the final liquidation is complete.This communication should provide an explanation of how the remaining investments will be disposed, an estimated time frame for the liquidation, as well as an estimate of recoverable cash that might be distributed to investors.
• Provide a final financial statement audit. The final audit is usually completed prior to the actual distribution of assets to the remaining investors in the fund.
• Close down, or dissolve, the fund entity after the final audit and distribution.

The additional disclosures, along with the proposed presentation of the financial statements, should alleviate investor concerns upon the liquidation of funds. However, the major challenge a fund manager faces is exiting their investments and making the appropriate distributions to its investors. This could prove particularly difficult if the fund holds illiquid investments or is a fund of hedge funds where the underlying investments have suspended redemptions. Fund managers considering liquidation need to be aware and evaluate the impact the guidance above would have on their funds.