Fund Liquidations – Creating Financial Reporting Consistency and Comparability

Fund managers and their auditors would frequently grapple with the presentation of financial statements for liquidating funds. Because there was a lack of guidance on when it was appropriate to apply the liquidation basis of accounting for funds that were winding down or discontinuing operations, there was an inconsistency in practice. Typically, fund managers provided limited information as it related to their fund’s liquidation process. In a world where transparency is now 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 Accounting Standards Update (ASU) No. 2013-07: Liquidation Basis of Accounting. (“ASU 2013-07” or the “Amendment”), which amends the guidance in the FASB Accounting Standards Codification Topic 205: Presentation of Financial Statements.

The Amendment was issued in April 2013 to clarify when and how 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 and financial statement presentation. The FASB believes that the new guidance will improve the consistency and comparability of financial reporting. ASU 2013-07 applies to all entities that issue financial statements that are presented in conformity with U.S. Generally Accepted Accounting Principles (GAAP) with the exception of investment companies that are regulated under the 1940 Act (RICs). RICs are legally restricted under the 1940 Act from re-measuring their assets or modifying the calculation of net asset value.

Liquidation Considerations

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. The Amendment defines liquidation as imminent when the likelihood that the entity will return from liquidation is remote, and either of the following exists:

• A plan of liquidation has been approved and made effective by management (General Partner, Managing Member or Investment Manager) 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.

If a plan for liquidation was specified in the fund’s governing documents at inception (i.e. a private equity fund whose objective is to invest in companies, sell and dispose of assets after a specific and limited time frame, and then return funds to investors), then liquidation would already be considered imminent. However, a limited-life fund would not be required to adopt liquidation basis unless the fund deviates from the liquidation plan originally stipulated in the governing documents. Such deviations would include a change in the date that liquidation is expected to conclude (earlier or later than the contractually stated expiration date) due to the fund being 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.

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 upon date of adoption. This could possibly include brokerage fees or sales commissions which are typically not considered when valuing investments at fair value under GAAP. In addition, any other costs and income that a fund expects to incur or earn should be accrued for 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, as well as interest and dividend income. 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. On the income side, if a fund holds a performing, interest bearing note, the interest expected to be collected until the note is disposed of or matures should be accrued for as of the liquidation date.

Furthermore, 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. An example of this would be applying a blockage or other discount to the quoted price, which is normally not permitted under GAAP as this may be appropriate when valuing an investment under liquidation basis. That being said, in certain situations fair value may approximate the amount expected to be collected. At each 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 Amendment 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 distribution 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 estimated to be incurred as a result of the liquidation. It should not include the results of operations during the going concern period, but only changes to net assets that occurred during the period since liquidation became imminent. ASU 2013-07 does not require reporting on the stub period, which is the period of time from the last reporting date through the date of determination that liquidation became imminent. That being said, it would still be necessary to determine the initial net asset balance upon adoption of liquidation basis. FASB guides entities to consider the requirements of regulators (i.e. SEC Custody requirements for Registered Investment Advisors) and the needs of financial statement users (i.e. investors reporting requirements) when determining whether an entity should also report and present information for such stub period.

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

• The facts and circumstances surrounding the adoption of the liquidation basis of accounting and the determination that liquidation is imminent.
• 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.
• 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 fund’s governing documents. Verify that management or other fees are permitted to be charged to the fund during the liquidation period.
• 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 legal 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 of, an estimated time frame for the liquidation, as well as an estimate of recoverable cash that might be distributed to investors.
• Estimate all income to be earned and expenses that will be incurred during the liquidation period. These amounts must be included in the NAV calculation when calculating net assets in liquidation.
• Provide a final financial statement audit. The final audit is usually completed prior to the final 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 amended presentation of the financial statements, should alleviate investor concerns upon the liquidation of the fund. However, the major challenge a fund manager faces is estimating the time it will take and the costs that will be incurred to exit the investments. This could prove particularly difficult if the fund holds illiquid investments or is a fund of hedge funds whereby the underlying investment vehicles have suspended redemptions and the underlying fund managers are not providing sufficient information on their exit strategies. ASU 2013-07 is effective for entities that determine liquidation is imminent during annual reporting period beginning after December 15, 2013, with early adoption permitted. Fund managers considering liquidation need to be aware and evaluate the impact the guidance above would have on their funds.

Marni Pankin, CPA, Partner, Alternative Investment Industry Group, contributed to this article.