Is this the end of consolidation under IFRS for private equity funds?
Brief history of the consolidation issue
Consolidation has always been a big issue for private equity funds reporting under IFRS with many GPs shying away from IFRS (where possible) just to avoid consolidation or reporting under IFRS with a departure from the consolidation requirements. US GPs have been more fortunate with their specific rules for investment companies which basically exempt them from consolidating their portfolio companies and instead allowing investment companies (including PE funds) to measure their investments at fair value with the changes in fair value recognised in P&L. Unlike US GAAP though, under the existing IFRS rules, there is still no such exemption from consolidation for investment entities, but hopefully, with the new development discussed below, that will finally change soon.
Finally, on 25 August 2011, after years of deliberations between IASB and FASB and reluctance by IASB to provide a carve out for the industry, as a results of many comments from constituents (questioning the usefulness of consolidation for investment entities) on Exposure Draft ED 10 Consolidated Financial Statements where no consolidation exemption for investment entities was envisaged, as well as from their interaction with FASB on the convergence process, IASB recognised that the needs of investment entities are very different from those of other entities and adopted an approach similar to the one used in US GAAP and issued Exposure Draft ED/2011/4 Investment Entities, with any resulting requirements to become part of IFRS 10 Consolidated Financial Statements and IFRS 12 Disclosure of Interests in Other Entities. This is a joint project between IASB and FASB.
Why should not an investment company consolidate portfolio companies and measure them at fair value instead?
Consolidation, in the context of investment entities, is not considered, by industry experts, as well as by many of the constituents who responded to ED 10, to be meaningful, because investment entities invest only for the purposes of income and capital appreciation and they do not access the investees’ assets, nor have they any recourse for the investees’ debt, therefore a line-by-line consolidation, presenting the underlying assets and liabilities of their investments, would not be a true and fair presentation and consolidated financial statements of those investment entities would be misleading and uninformative, and would not be useful for assessing their performance and such presentation would make it difficult for investors to judge the value of their investments. Investments reported at fair value is what investors would expect and this is the information that they would require to be able to make judgements about the performance of their investments, because investors make their investment decisions based on the fair value of the investments held, and not based on how the individual assets and liabilities held by each entity are utilised. Thus this presentation will also better reflect the business model of the investment entities.
Highlights of ED/2011/4 Investment Entities
- Entities that would qualify as investment entities would be exempt from consolidating their financial statements with those of a subsidiary (i.e. a portfolio company) and instead they would be required to measure these investments at fair value through profit or loss in accordance with IFRS 9 Financial Instruments (as issued in October 2010).
- The ED proposes six qualifying criteria that an entity needs to meet to qualify as an investment entity and guidance for making such assessment.
- Additional disclosures (in addition to those in IFRS 7 Financial Instruments: Disclosures, IFRS 12 Disclosures of Interests in Other Entities and IFRS 13 Fair Value Measurement) are required to enable users of its financial statements to evaluate the nature and financial effects of its investment activities.
- The ED requires that entities applying this guidance early also apply all aspects of IFRS 10, IFRS 11 Joint Arrangements, IFRS 12 and IAS 28 (as amended in 2011) to ensure comparability among entities.
- It proposes for consolidated financial statements that, unless the parent qualifies as an investment entity itself, a parent of an investment entity should not retain the fair value accounting that is applied by its investment entity subsidiary to controlled entities. FASB though, reached a different preliminary conclusion on that point and the FASB proposal would extend the exemption to these cases.
The comment period will end on 5 January 2012 and the project is expected to be finalised in the second half of 2012 and since the IASB’s opinion was divided and three Board members dissented from the proposals, the project may need some extra support from constituents, therefore we would encourage you to send your comments to the IASB with regards to whether this accounting exemption would be beneficial and why, as well as with regards to the parent entity issue mentioned in the Highlights above (i.e. whether or not the exemption should be extended to a parent entity that is not an investment entity, or in other words if the parent entity should roll-up the fair value of the subsidiary to be included in its financial statements – FASB’s (but not IASB’s) preferred approach).