To Be or not To Be an Investment Company?

Background

In June 2013, the Financial Accounting Standards Board (“FASB” or the “Board”) issued Accounting Standards Update No. 2013-08, Financial Services-Investment Companies (Topic 946): Amendments to the Scope, Measurement and Disclosure Requirements (the “ASU”). The amendments in this ASU seek to clarify former inconsistencies as to what is considered to be an investment company and to provide extensive guidance in determining whether an entity is an investment company under United States generally accepted account principles (“U.S. GAAP”). Investment companies follow specialized accounting and reporting requirements that are unique and different than operating companies. In particular, they measure investments at fair value. The new guidance also requires an investment company to measure non-controlling ownership interests in other investment companies at fair value rather than the equity method. Finally, the amendments in this ASU require additional disclosures in regards to an entity’s status as an investment company, changes to that status and information about financial support provided or contractually required to be provided by an investment company to an investee.

The ASU is the result of a joint project with the International Accounting Standards Board (“IASB”) to combine guidance on investment companies and eliminate inconsistencies among the standards. Prior to this project, International Financial Reporting Standards had no reporting guidance specifically for investment companies and required reporting entities to consolidate controlled investees. The IASB issued its final standard in October 2012, Investment Entities (Amendments to IFRS 10, IFRS 12 and IAS 27).

The final ASU issued by the FASB modifies much of the criteria used to define an investment company which was suggested in the original proposed update that was issued in October 2011. The ASU is effective for an investment company’s (which includes investment partnerships and other entities) interim and annual reporting periods in fiscal years that begin after December 15, 2013 (2014 year-end financial statements). Unlike most other accounting guidance, early adoption is prohibited.

Primary Characteristics to Qualify as an Investment Company

In the original proposal, the FASB considered requiring an entity to meet six criteria to qualify as an investment company: (1) nature of investment activity, (2) express business purpose, (3) unit ownership, (4) pooling of funds, (5) fair value management and (6) reporting entity. However, significant issues were raised during the comment letter process in regards to this strict criteria. For instance, investment funds created for a specific investor, such as a pension fund or sovereign wealth fund would no longer qualify as an investment company under the proposed rules because there was no pooling of funds from several different investors. As a result, the FASB developed a new two-tiered approach for the assessment. This new approach requires an entity to possess certain fundamental characteristics while allowing judgment in assessing other typical characteristics.

The following fundamental characteristics are required to qualify as an investment company:

1. It is an entity that does both of the following:
   
   
1. Obtains funds from one or more investors and provides the investor(s) with investment management services. The Board concluded that this is a traditional function of an investment company and, therefore, an entity must possess this characteristic to be an investment company.
   
   
2. Commits to its investor(s) that its business purpose and only substantive activities are investing the funds solely for returns from capital appreciation, investment income, or both. The Board noted that an entity can assist with day to day management of the operations of an investee, which is what many private equity funds do, and provide other support, such as providing loans and guarantees to an entity; provided that the purpose is to maximize returns from capital appreciation or investment income and that it is not a substantial business activity for the investment company. In contrast, developing, producing or marketing products and services of an investee would be inconsistent with investment company activities. Furthermore, for investment companies whose business purpose includes realizing capital appreciation, there should be an exit strategy for how it plans to realize the capital appreciation of its investments. It need not be a specific exit strategy for each individual investment, but potential exit strategies should be identified.
   
   
2. The entity or its affiliates do not obtain or have the objective of obtaining returns or benefits from an investee or its affiliates that are not normally attributable to ownership interests or that are other than capital appreciation or investment income. The Board stated that if an entity obtains returns or benefits from an investee that are disproportionate or not attributable to ownership interests, then the entity holds that investment for operating or strategic benefits that are not consistent with the business purpose and activities of an investment company. An example would be holding an option to purchase an asset from an investee if the asset’s development is deemed successful. An entity structured as such would not be considered an investment company.

If an entity meets the requirements in the first tier described above, it would then consider the following typical characteristics while keeping in mind its purpose and design when making that assessment:

1. It has more than one investment. The Board noted that investing in multiple investments is an important characteristic of an investment company as a means of diversifying their portfolio and maximizing returns, however, during the comment process stakeholders provided examples of single investment funds (i.e. a fund that pools investors’ funds because the investment is unobtainable by individual investors), and therefore, the Board concluded that prohibiting an entity from being an investment company because it only holds one investment is too restrictive. In the proposal, the investment company would have been required to hold multiple investments either directly or indirectly through another investment company to qualify as an investment company. The final rules are not as restrictive and allow for exceptions such as the one described above.
   
   
2. It has more than one investor. The Board noted that, typically, investment companies have multiple investors, however, during the comment process stakeholders provided various examples of funds with one investor (i.e. government investment funds and investment funds wholly owned by pension plans); therefore, the Board concluded that prohibiting an entity from being an investment company because it only has one investor is too restrictive.
   
   
3. It has investors that are not related parties of the parent (if there is a parent) or the investment manager. The Board noted that, typically, investment companies have investors that are not related to the parent or to the investment manager and that these external investors collectively hold a significant ownership in the investment company, however, during the comment process stakeholders provided examples of entities with related investors that they noted should be considered investment companies (i.e. employee side-by-side funds); therefore, the Board concluded that prohibiting an entity from being an investment company because it has related investors is too restrictive. In the proposal, the investment company would have been required to have investors that were not related to the investment manager and whom held a significant ownership interest in the entity to qualify as an investment company.
   
   
4. It has ownership interests in the form of equity or partnership interests. The Board noted that, typically, investment companies have ownership interests in the form of equity or partnership interests that entitle investors to a portion of the investment companies net assets, however, during the comment process stakeholders provided examples of funds that entitle investors to a portion of the entities net assets but do not have units of ownership (i.e. pension plans); therefore, the Board concluded that the focus of determining ownership interests should be that investors are exposed to variable returns from changes in the fair value of underlying investments of an investment company. In the proposal, the investment company would have been required to have ownership units in the form of equity or partnership interests to qualify as an investment company.
   
   
5. It manages substantially all of its investments on a fair value basis. As stated in the proposal, the Board noted that the most useful information for users of investment company financial statements is the fair value of their investments and that an investment company must ensure that substantially all of its investments are fair valued. Fair value of investments must be considered when analyzing performance of investments and making investment decisions. Although in certain circumstances, financial statements may be prepared using other comprehensive basis of accounting, such as income tax basis, fair value information of investments should be provided internally to management for analysis.

Generally, an investment company has all of the typical characteristics mentioned above; however, if an entity lacks one or more of them, it will not preclude that entity from being an investment company. The entity will need to use judgment, after considering all the facts and circumstances, to determine if its activities are consistent (or not consistent) with those of an investment company.

Who is Affected by the Amendments in this ASU and What Does it Mean?

The ASU applies to both public and nonpublic entities. An entity registered as an investment company under the SEC’s Investment Company Act of 1940 (the “Act”), would be considered an investment company for purposes of applying the standard even if it doesn’t meet all the criteria. An entity that is not regulated under the Act shall assess all the characteristics of an investment company described above, to determine whether it is an investment company. All existing non-registered investment entities need to assess if they qualify as an investment company under the new guidelines. For entities formed after December 15, 2013, determination of whether an entity meets the definition of an investment company is made at the formation of the entity. An entities status as an investment company only needs to be reassessed if there is a subsequent change to the purpose and design of the entity or if the entity is no longer regulated under the Act.

Most entities that currently report as an investment company under U.S. GAAP will most likely continue to qualify under the new standards. However, if an entity no longer meets the requirements to be considered an investment company, the change in status should be applied prospectively from the date of determination along with the effect of the change from the fair value basis of accounting (accounting treatment used under the ASU) to another basis of accounting under U.S. GAAP (i.e. the equity method). The fair value of the investments on the date of determination would be adjusted from fair value to initial carrying amount under the other basis of accounting.

If an entity subsequently meets the criteria to qualify as an investment company under the ASU, the entity will account for the change in status from the date of determination as a cumulative-effect adjustment to beginning net assets and include the change in the beginning per share information in the financial highlights. Certain collateralized loan or debt obligations may potentially qualify under the new standards.

Real Estate Entities
In the final guidance, Real Estate Investment Trusts (“REITs”) are prohibited from qualifying as an investment company. During the proposal phase, the FASB considered removing the scope exception in ASC Topic 946 (“Topic 946”) for REITs. During the comment process, many stakeholders disagreed with the removal of the scope exception in Topic 946 stating that the business model of REITs is different from that of an investment company. Therefore, based on these comments and the complexities surrounding this issue, the Board determined to retain the existing scope exception in Topic 946 for REITs and to revisit this topic as a later project. The Board also noted they will address the applicability of investment company accounting for real estate entities at another time and that the update is not intended to change the current practice for certain real estate entities for which it is industry practice to issue financial statements using fair value measurement principles.

Consolidation Considerations

Investment Companies
In the proposal, an investment company would have been required to consolidate with another investment company or an investment property if it held a controlling financial interest in another investment company in the context of a master-feeder structure or fund-of-funds format. During the comment process stakeholders raised concerns about the usefulness of an investment company’s financial statements in which some investments were measured at fair value with other investments consolidated. In response to numerous amounts of comments received by the Board regarding this topic, the Board decided not to amend Topic 946 regarding an investment company’s application of consolidation guidance, as described in ASC Topic 810 – Consolidation, which currently allows (but does not require) an investment company to consolidate a controlling interest in another investment company and decided to revisit this as a later project. As part of the later project, the Board will look to require additional disclosures about an investment company’s investments in other investment companies and to address the concerns regarding the usefulness and transparency surrounding consolidation. The contemplated disclosures include the expense ratios, debt, total assets and net assets of significant investee funds. These requirements were not included in the final ASU.

Non-Investment Companies
Consistent with current U.S. GAAP, non-investment companies will retain the specialized accounting of a controlled investment in consolidation. In addition, the ASU clarified that an investment company is required to measure non-controlling interests in other investment companies at fair value, rather than using the equity method, unless that investee is an operating company that provides services to the investment company. The Board decided that this would reduce complexity because the reporting investment company could apply the net asset value per share practical expedient, as described in ASC Topic 820 – Fair Value Measurements, to measure the fair value of its interest.

Disclosure Requirements

Under the ASU, an investment company is required to disclose the following:

1. The entity is an investment company following the specialized accounting and reporting guidance of Topic 946.
2. Its status as an investment company and any change of status including reasons for the change.
3. Any financial support provided to any investees during the period, the type of support provided, the primary reasons for providing the support and any financial support that it is contractually required to provide to any investees but that has not yet been provided.

These first 2 disclosures should be included in the first footnote that describes the entity or in the significant accounting policies.

Conclusion

The final ASU clearly did not have the impact on private investment vehicles that the proposed update contemplated, which is good news for most. In general, most reporting entities that previously reported as an investment company will qualify under the new reporting standards. However, all entities must go through an assessment and consider the fundamental and typical characteristics of an investment company described above. If you have questions or concerns that your entity should or should not be following the specialized accounting guidance for investment companies (Topic 946), please consult your Marcum assurance professional for further guidance.