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Q2 2012 update: IFRS investment entity exemption from consolidation

Q2 2012 update: IFRS investment entity exemption  from consolidation
17/07/2012

It would appear that the International Accounting Standards Board is finally engaged in understanding the investment management industry, alternative investment asset classes and private equity in particular. Despite the Board’s earlier refusal to provide a carve-out to private equity with regards to the consolidation exemption for investment companies/entities, similar to what a private equity fund reporting under US GAAP enjoys, there has been real progress this quarter. The Board is even trying to find solutions to more specific problems such as treatment of master-feeder structures, blocker funds and funds of funds. Credit for encouraging progress goes to the Financial Accounting Standards Board through its IFRS/US GAAP convergence process and its better understanding of the private equity asset class.
 

Despite the Q1 2012 comment period closing and seemingly little resulting from the following opinion-gathering meetings held by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) on Investment Entities (IE) Exposure Drafts (ED), momentum is building once again. Both Boards held joint meetings in May and June, raising confidence levels that the long-awaited (and much needed) change may still take place in 2012 (effective from January 1, 2013). And what is more, they are now really talking the talk and sounding more like they understand the asset class better.

Summary of the tentative decisions made in May and June 2012

In summary, as a result of the joint meetings the following tentative decisions have been made:

1. May tentative decisions: Instead of meeting the six criteria suggested originally in the EDs, a definition is now to apply to the entity with some additional factors/indicators to be considered in determining whether the entity qualifies as an investment entity.

2. June tentative decision No.1:  An investment entity should be required to measure all controlling financial interests in another investment entity at fair value (including in both master-feeder and fund of funds structures), rather than consolidating those subsidiaries. However, some exceptions apply. This was the fourth out of four different alternatives suggested by the staff in their staff paper prepared for the meetings. However, the FASB will discuss at a future FASB meeting whether an investment company parent entity that is regulated under the US Securities and Exchange Commission’s Investment Company Act of 1940 should be required to consolidate its wholly owned investment company subsidiaries.

3. June tentative decision No.2: The IASB tentatively decided not to require an investment entity to attach the FSs of its investees in any circumstances. The FASB tentatively decided to require a feeder fund in a master-feeder structure to attach its master fund's FSs along with its FSs. All FASB members agreed. The FASB will discuss at a future FASB meeting whether a master-feeder structure should be defined.

4. June tentative decision No.3: The IASB tentatively decided that a non-investment entity parent should not retain (or roll up) the exception from consolidation that is used for the controlled investees of an investment entity subsidiary while the FASB tentatively decided to retain the requirement in current US GAAP that a non-investment company parent should retain the specialised fair value accounting used by an investment company subsidiary.

The fact that these discussions have actually taken place instils a degree of confidence that progress is being made. Results from the June discussions and their published staff papers would seem to suggest that the IASB now reasonably understand and recognise the nature and the purpose of the master-feeder structure, blocker structures and funds of funds.

Accounting by an investment entity parent for an investment entity subsidiary

There are two main types of structures involving investment entity parents and investment entity subsidiaries: master-feeder structures and funds of funds. The IASB and the FASB recognise the fundamental differences between the two structures and understand that investors in a fund of funds structure do not require the same information as investors in a master-feeder structure.

  • Master-feeder structures

The IASB and the FASB recognise that master-feeder fund managers focus on providing trading and tax benefits by separating investment-related activities in the master fund from investor-servicing activities in the feeder fund; they also recognise that the master fund and the feeder funds together could be viewed economically as one investment company. They also recognise that in a master-feeder structure investors invest in the feeder funds, which in turn invest in the master fund. The master fund performs all the investment-related activities, while subscription/redemption activity and management/performance fees are handled at the feeder fund level.
 

Presently, under US GAAP, a feeder fund is required to separately present its allocated share of the master fund’s net investment income, and realised and unrealised gains and losses in its FSs. In addition, for investment companies regulated under the 1940 Act, each feeder fund is required to present a complete set of the master fund’s FSs along with its FSs. Presenting a complete set of the master fund’s FSs is optional for unregulated investment companies.

  • Funds of funds

Funds of funds also invest in another investment entity. The IASB and the FASB recognise that, unlike the master-feeder structures which are predominantly tax-driven, the purpose and the focus of fund of funds managers is commercial, namely to provide investors with greater diversification of assets. Unlike the master fund and its feeder-fund, a fund of funds and the investee funds are completely separate economic entities.

Differing opinions between the IASB and the FASB

Initially, the FASB and IASB agreed that an investment company would measure all controlled investees at fair value, unless the investee is an operating entity that provides services to the investment company. Later, however, the FASB decided (and reflected this in its ED) that an investment company should consolidate controlling financial interests in another investment company in a fund of funds structure because of concerns raised that an investment company should consolidate wholly owned investment company subsidiaries that are set up for specific tax, legal, or regulatory purposes, such as blocker entities. Even some constituents stated during the consultation process that consolidation of a blocker fund should be required because this type of fund is not a passive investment, but rather its activities are an extension of the activities of the investment company parent. However, conceptually, a distinction could not be made between a wholly owned and a majority-owned subsidiary and the FASB decided that all controlling financial interests in another investment company should be consolidated in a fund of funds structure. The FASB considered whether the proposed consolidation requirements for fund of funds structures should also apply to master-feeder structures, but they decided that consolidation was not required in a master-feeder structure because the current presentation and disclosure requirements for master-feeder structures, such as including the master fund’s FSs as part of the feeder fund’s FSs provide transparency into the underlying investments and obligations of the master fund.

Constituent input

Most non-user constituents, however, stated that controlling financial interests in another investment company should be measured at fair value and did not support consolidation of controlling financial interests in a fund of funds structure as proposed in the FASB ED. In addition, all users generally disagreed with consolidation of controlling financial interests in a fund of funds structure. Those users stated that consolidation would clutter and distort the FSs. They also stated that they are most interested in fair value information in the FSs, including liquidity and valuation information provided through fair value disclosures, and financial highlights information that provides details about changes to net asset value. Some users stated that they use fair value information in the FSs, particularly in the schedule of investments, to perform trend analysis and consolidation would actually complicate such analysis. Constituents have also raised both conceptual and operational concerns with the proposed consolidation requirement in a fund of funds structure. Some constituents suggested that, in lieu of consolidation, an investment company parent’s FSs should be required to present the FSs of an investment company subsidiary along with its FSs. Other respondents suggested some additional disclosures in the notes to the FSs (disclosures in lieu of consolidation).

Proportionate consolidation

In the published staff paper, there is mention of a proportionate consolidation which would be consistent with the staff’s understanding that investors in investment companies are most interested in the changes to the value of their unit ownership (or net asset value per share). However, the staff did not present proportionate consolidation as an alternative in their staff paper. Proportionate consolidation would have been a solution, but current US GAAP does not allow it except in some industries; and IFRS no longer allows proportionate consolidation. Investors in an investment company are primarily concerned about total return and changes to their net asset value per share. The staff members agree with user feedback that consolidation of investment company subsidiaries could clutter the financial statements and confuse that primary analysis. The staff also believes that consolidation in a fund of funds structure would give undue prominence to investment company subsidiaries when those subsidiaries may not be significant to the net assets of the investment company parent and therefore not significant to the net asset value per share of an interest held by an investor. The staff also acknowledges the operational concerns raised by non-user constituents and the staff believes those operational concerns would be increased if there are multiple layers in a fund of fund structure.

Accounting by a non-investment entity parent for an investment entity subsidiary

One of the questions is whether there is a need to roll up or not to roll up. Once again, the IASB and the FASB have different views on this subject and as a result their tentative decisions diverge:
 

IASB decisions: The IASB tentatively decided that a non-investment entity parent should not retain (or roll up) the exception from consolidation that is used for the controlled investees of an investment entity subsidiary. In total, 12 of the IASB members agreed. The staff noted in their agenda paper for this meeting that there was broad support in the comment letters to roll up, but despite this, the IASB continues to have concerns around abuse, mainly with regards to structuring transactions in such a way that to achieve certain accounting outcomes by transferring controlled investments into an investment entity subsidiary, if it allows a roll-up.
 

FASB decisions: The FASB tentatively decided to retain the requirement in current US GAAP that a non-investment company parent should retain the specialised fair value accounting used by an investment company subsidiary. All FASB members agreed.
 

Both of these decisions are consistent with the proposals in the respective EDs.
 

Definition of an investment entity
 

In May, the IASB and the FASB made some important tentative decisions based on the comments received by constituents on both of their EDs.

  • An entity is no longer required to meet the six criteria originally suggested in the EDs in order to qualify as an investment entity.
     
  • An entity must now meet a definition instead using some of the originally proposed criteria and consider the remaining originally proposed criteria as factors or indicators in its assessment of whether it qualifies as an investment entity.

What will happen next?

Over the next few months, the IASB and the FASB will continue their deliberations on the investment entity proposals and once all of the details have been finalised they will effect an amendment to IFRS 10 which should be effective from January 1, 2013. There is really very little time left and the latest work plan on the IASB’s website indicates that the target IFRS is expected in the second half of 2012, so hopefully we will soon see the final amendments and the industry will be able to enjoy that long-awaited and very much needed amendment to the existing IFRS framework for investment entities.

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