The New Consolidation Standards Seminar Series: FRS 110 & FRS 112 How Does This Affect Your Investments in Funds and Trusts?

Transcription

1 The New Consolidation Standards Seminar Series: FRS 110 & FRS 112 How Does This Affect Your Investments in Funds and Trusts? Wednesday, 27 th March am

2 Introduction To FRS 110 Consolidated Financial Statements by Reinhard Klemmer Partner, Head of Department of Professional Practice and Accounting Advisory Services KPMG Singapore

3 Effective Date: 1 January 2014 Consolidation suite effective for years beginning on or after 1 January 2014 Issued by ASC in Singapore on 20 September 2011 Identical to IFRS, except that effective date in Singapore is deferred by one year If adoption results in change, generally retrospective application required Early adoption permitted provided that entire suite of consolidation standards adopted at the same time 3

4 The Sliding Scale More than 50% Subsidiary Consolidation with MI FVTPL if investment entity Investment More than 20% and less than 50% Joint Arrangement JV same as associate JO proportionate assets and liabilities Associate At-equity accounting Less than 20% Financial Instruments AFS FV thru equity Trading - FVTPL 4

5 A New Suite of Consolidation Standards ACCOUNTING SEPARATE FS DISCLOSURE SUBSIDIARIES FRS 110 Consolidated Financial Statements FRS 27 (2011) Separate Financial Statements ASSOCIATES JOINT VENTURES JOINT OPERATIONS FRS 28 (2011) Investments in Associates and Joint Ventures FRS 111 Joint Arrangements FRS 111 Joint Arrangements FRS 112 Disclosure of Interests in Other Entities UNCONSOLIDATED STRUCTURED ENTITIES FRS 112 Disclosure of Interests in Other Entities 5

6 Old vs New Requirements Extant standards FRS 110 Exemptions from preparing consolidated financial statements Similar requirements Determination of investees to be consolidated FRS 27 control model INT-FRS 12 risks & rewards model New single control model Consolidation procedures Similar requirements

7 Control Defined Power Exposure to variability in returns Link between power and returns Consolidation To have power, it is necessary for investor to have existing rights that give it the current ability to direct activities that significantly affect investee s returns (i.e. the relevant activities). Control assessed on continuous basis

8 The New Control Model At A Glance Identify the investee (legal entity or silo) Identify the relevant activities of the investee 1 2 Identify how decisions about the relevant activities are made 3 Assess whether the investor has power over the relevant activities Consider only substantive rights 4A 4 6 The diagram is a general presentation of the analysis to be performed in order to determine whether the rights held by the investor give it control over the investee. Majority of voting rights consider Rights held by others Voting rights are relevant Less than a majority of voting rights consider Agreements with other vote holders Other contractual agreements Potential voting rights De facto power 4B 4C Rights other than voting rights are relevant consider Purpose and design Evidence of practical ability to direct Special relationships Exposure to variability of returns 4D Assess whether there is a link between power and returns The logical flow presented here comprises a collection of indicators of control, but no hierarchy is provided by FRS 110. FRS 110 does not prescribe any order to be followed for the analysis and does not require an investor to go through all of the steps presented in the diagram. Assess whether the investor is exposed to variability in returns 5

9 Understanding FRS 110 Consolidated Financial Statements by Chan Yen San Senior Manager, Department of Professional Practice KPMG Singapore

10 Control Defined Power Exposure to variability in returns Link between power and returns Consolidation To have power, it is necessary for investor to have existing rights that give it the current ability to direct activities that significantly affect investee s returns (i.e. the relevant activities). Control assessed on continuous basis

11 Examples of Exposures To Variable Returns A broad definition Residual interests Dividends / changes in value Fixed interest payments from bond (exposes investor to credit/default risk of the issuer) Remuneration for servicing assets or liabilities Synergistic returns Tax benefits Access to future liquidity Fees and exposures to loss from providing credit / liquidity support

12 Pre-FRS 110 Control Definition Pre- FRS 110 control definition Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. What are the differences? Legal/contractual power versus defacto power; substantive versus protective rights Financial and operating policies versus relevant activities Ownership benefits versus variable returns Linkage test in FRS 110 includes specific guidance on how to apply this test (principal versus agent) Investee in FRS110 formalises the concept of silo

13 Potential Impacts De facto control model could lead to more investees being consolidated Change in control model may affect control conclusion for some investees, in particular SPEs Substantive rights are considered when assessing control while protective rights are not considered Investment and asset managers could be affected by agency relationship guidance 13

14 Step 2 Step 1 De Facto Power Over Investee Investor considers all facts and circumstances Size of investor s holding of voting rights relative to size and dispersion of holdings of other vote holders Potential voting rights Other contractual arrangements This is sufficient evidence that investor has power This is not conclusive This is sufficient evidence that investor does not have power Control analysis continued (returns ) Investor does not have control Investor considers additional facts and circumstances Pattern of participating in voting at previous shareholder meetings Evidence of power Additional factors Special relationships Level of investor s exposure to variability in returns If this is unclear Investor does not control investee

15 Step 2 Step 1 De Facto Power Over Investee Investor considers all facts and circumstances Size of investor s holding of voting rights relative to size and dispersion of holdings of other vote holders Potential voting rights Other contractual arrangements This is sufficient evidence that investor has power This is not conclusive This is sufficient evidence that investor does not have power Control analysis continued (returns ) Investor does not have control Investor considers additional facts and circumstances Pattern of participating in voting at previous shareholder meetings Evidence of power Additional factors Special relationships Level of investor s exposure to variability in returns If this is unclear Investor does not control investee

16 Size of Investor s Holding of Voting Rights Relative to Size and Dispersion of Holdings of Other Vote Holders Per FRS 110.B42, when evaluating the size of the investor s holding of voting rights relative to the size and dispersion of holdings of the other vote holders, the following three factors are considered: the more voting rights an investor holds, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities the more voting rights an investor holds relative to other vote holders, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities the more parties that would need to act together to outvote the investor, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities 16

17 De Facto Power Over Investee (FRS 110 Examples Step 1) No. Largest investor s holdings Holdings of next largest investors Holdings of remaining investors 1. 48% - Remaining voting rights held by thousands of shareholders, none > 1% 2. 45% Two other investors hold 26% of the voting rights Remaining voting rights held by three other shareholders each with <1% 3. 45% - Eleven other investors each hold 5% of voting rights 4. 40% - Twelve other investors each hold 5% of voting rights 5. 35% Three other investors each hold 5% of voting rights Remaining 50% held by thousands of shareholders, none > 1% Other facts and circumstances Step 1 is conclusive - Defacto control by largest shareholder? None of the shareholders has contractual arrangements to consult any of the others or make collective decisions. No other arrangements that affect decisionmaking None of the shareholders has contractual arrangements to consult any of the others or make collective decisions A shareholder agreement grants the largest investor the right to appoint, remove and set the remuneration of management responsible for directing the relevant activities. To change the agreement, a two-thirds majority vote of the shareholders is required. None of the shareholders has contractual arrangements to consult any of the others or make collective decisions Yes No Voting right alone - not conclusive. Step 2 analysis required Yes voting rights + contractual agreement Voting right alone - not conclusive. Voting right alone - not conclusive. Step 2 analysis required

18 De Facto Power Over Investee (FRS 110 Example Step 2) Step 1 not conclusive Investor holds 35% of investee Three other investors each hold 5% of voting rights Remaining 50% widely dispersed No other arrangements that affect decision-making Decisions about relevant activities require approval of majority of votes At recent shareholders meetings, 75% of voting rights cast That is, P holds only 47% (35/75) of active voting rights Learning points: If step 1 is not conclusive, the investor will need to proceed to step 2. Under step 2, the voting patterns at previous shareholders meetings does not refer how people had voted, but rather the pattern is how many people had voted (the active votes).

19 Example 1 - De Facto Control Company X Company Y Public (Many shareholders, each holding less than 1%) 10% 40% 50% Listed Company C Listed Company C is directed by voting rights and voting rights are equal to shareholdings. There are no contractual arrangements that exist between shareholders of the widely held interest (the 50%). Shareholder X has historically voted in line with Company Y. All substantive decisions need majority approval by the shareholders. Total shareholder meeting attendance is usually at 75%. Is Company Y likely to have control over C under FRS 110? 1. Yes 2. No

20 Example 2 - De Facto Control Nominee Company A Nominee Company B Nominee Company C Public (Many shareholders, each holding less than 1%) Company Y 15% 15% 15% 10% 45% 33% 33% 33% Listed company Listed company is directed by voting rights and voting rights are equal to shareholdings. All substantive decisions need majority approval by the shareholders. Is Company Y likely to have control over Listed company under FRS 110? 1. Yes 2. No 3. It depends 1 2 3

21 Nominee Companies in De Facto Control Assessment Nominee Company A Nominee Company B Nominee Company C Public (Many shareholders, each holding less than 1%) Company Y 15% 15% 15% 10% 45% Listed company 1. Does a nominee company represent one shareholder or many shareholders, in the absence of any known substantial shareholders among the beneficial owners? 2. Can the entire stake held by the nominee company be included in the total vote cast when evaluating the voting patterns at previous shareholders meetings?

22 Evidence of practical ability to direct (Evidence of power) The investor can, without having the contractual right to do so, appoint or approve the investee s key management personnel who have the ability to direct the relevant activities. direct the investee to enter into, or can veto any changes to, significant transactions for the benefit of the investor. The investor can dominate either the nominations process for electing members of the investee s governing body or the obtaining of proxies from other holders of voting rights. The investee s key management personnel are related parties of the investor (for example, the chief executive officer of the investee and the chief executive officer of the investor are the same person). The majority of the members of the investee s governing body are related parties of the investor. Special relationships Investee s KMP are current or previous employees. Investee s operations depend on investor The investee depends on the investor to fund a significant portion of its operations. The investor guarantees a significant portion of the investee s obligations. The investee depends on the investor for critical services, technology, supplies or raw materials. The investor controls assets such as licences or trademarks that are critical to the investee s operations. The investee depends on the investor for key management personnel, such as when the investor s personnel have specialised knowledge of the investee s operations. Significant portion of investee s activities either involve or conducted on behalf of investor Disproportionate exposure to returns compared to voting rights.

23 Key Takeaways 1. Voting pattern not about how they vote; it is about the usual quorum at the shareholder meetings 2. Historical attendance new investment versus investment acquired many years ago, changes to the composition of the remaining shareholdings (static versus high turnover) 3. Continuous assessment may lead to consolidation at a later date; may also lead to an investee falling in and out of consolidation 4. No bright lines

24 Potential Impacts De facto control model could lead to more investees being consolidated Change in control model may affect control conclusion for some investees, in particular SPEs Substantive rights are considered when assessing control while protective rights are not considered Investment and asset managers could be affected by agency relationship guidance 24

25 From INT-FRS to FRS 110 INT-FRS 12 tests FRS 110 factors Activities on behalf of the entity according to business needs. Entity has decision-making powers to obtain the majority of the benefits. Has rights to benefits and is exposed to risks. Retains majority of residual or ownership risks. Purpose and design (involvement, contract, decisions at inception; risks; commitment). Evidence of practical ability to direct. Special relationships. Exposure to variability in returns.

26 Example 3 Single Control Model Facts Investment vehicle V is created to purchase a portfolio of financial assets Loan Debt Investors Investment vehicle is funded by debt and equity instruments issued to a number of investors Investment vehicle V Equity Equity investors The Asset Manager, M, owns 30% of total equity Equity investors receive residual return and absorb losses M holds 30% and acts as Asset Manager The Asset Manager is responsible for selection, acquisition and disposal of assets in the portfolio within investment portfolio guidelines and the management upon default of any asset in the portfolio Asset Portfolio Management Investment vehicle V is an SPE within the scope of INT- FRS 12 Is M likely to have control over V under FRS 110? 1. Yes 2. No

27 Example 3 Analysis Analysis under INT FRS 12 Analysis under FRS 110 Under INT FRS 12, some would conclude that M does not consolidate V, based on the fact that M does not bear the majority of risks and rewards. The analysis provided under FRS 110 is that M controls V, since M has the ability to direct the relevant activities, has rights to variable returns from the performance of the vehicle and the ability to use its power to affect its own returns. 27

28 Potential Impacts De facto control model could lead to more investees being consolidated Change in control model may affect control conclusion for some investees, in particular SPEs Substantive rights are considered when assessing control while protective rights are not considered Investment and asset managers could be affected by agency relationship guidance 28

29 Example 4 Substantive versus Protective Rights Facts Investment vehicle V is created to purchase a portfolio of financial assets Loan Debt Investors Investment vehicle is funded by debt and equity instruments issued to a number of investors The Asset Manager, M, owns 30% of total equity Investment vehicle V Equity Equity investors The Asset Manager is responsible for selection, acquisition and disposal of assets in the portfolio within investment portfolio guidelines and the management upon default of any asset in the portfolio Asset Portfolio M holds 30% and acts as Asset Manager However, the debt investors have the ability to block decisions relating to the following activities: amendments to V s investment objective dividend payments to equity investors repurchases of equity instruments from equity investors issuance of debt instruments that could significantly change the credit risk of V Management Is M likely to have control over V under FRS 110? 1. Yes 2. No

30 Substantive versus Protective Rights Substantive rights (considered) Protective rights (not considered) Rights that are exercisable when decisions about the relevant activities need to be made and their holder has a practical ability to exercise them. Rights designed to protect the interest of the party holding those rights without giving that party power over the entity to which those rights relate. Consider... Are there barriers (economic, operational, legal or regulatory) that prevent the holder from exercising their right? Would the holder benefit from the exercise? Do several parties need to agree for the rights to become exercisable or operational? If yes, how many, and is there a mechanism in place to permit collective exercise? Consider... Are the rights relating to fundamental changes to the activities of the investee? Are the rights applicable only in exceptional circumstances? 30

31 Potential Impacts De facto control model could lead to more investees being consolidated Change in control model may affect control conclusion for some investees, in particular SPEs Substantive rights are considered when assessing control while protective rights are not considered Investment and asset managers could be affected by agency relationship guidance 31

32 Assess Whether There Is A Link Between Power and Returns Control = Assess whether the investor has power over the relevant activities + Assess whether the investor is exposed to variability in returns + Assess whether there is a link between power and returns OR Use of the delegated power primarily for the benefit of others Use of the power primarily to generate returns for itself The manager is an agent The manager is a principal 32 32

33 Example Fund manager makes all relevant decisions for Private equity fund A Investors Capital Returns Fund manager receives a market based fee 1% of assets under managed 20% of profits after a specified profit level achieved Private equity fund A Management Fee Capital Returns Fund Manager (M) Fund manager has X% pro rata investment in A Exit gains Equity Portfolio companies Power Variability Linkage? Consolidation? 33

34 Linkage: The Principal Agent Guidance Does a single party hold substantive rights to remove the decision maker without cause? n o Yes No Is the remuneration at market? y e s Consider the 4 indicator groups Scope of decisionmaking authority ( Economic interests aggregated) Remuneration Substantive rights held by other parties Other interests held Legend Key tests PRINCIPAL AGENT 34

35 Low Kick-out rights High Trade-off Between Kick-Out Rights & Aggregate Economic Interest The stronger the kick-out rights, the more aggregate economic interest can be accepted. To be an agent The weaker the kick-out rights, the less aggregate economic interest can be accepted. Agent Marginal zone Principal Low Aggregate economic interest High

36 Factors That Affect The Strength of Kick-Out Rights Few Key feature Strong Other features Number of investors Strength of kick-out rights Without / with cause Barriers to exercise the rights Many Weak There should be no other barriers to exercise. Factors to consider include: Operational and financial penalties Conditions narrowly limiting the timing for exercise Absence of mechanism allowing exercise Inability to obtain the information necessary for exercise 36

37 Kick-Out Rights Case 1 The fund has a board of directors, all of whose members are independent of the fund manager and are appointed by other investors. The board holds the right to remove the fund manager without cause. Case 2 The fund manager can be removed without cause by a simple majority decision of other investors. There are hundreds of widely dispersed unrelated third-party investors. Case 3 One investor could remove the fund manager, but only for breach of contract. Q: What strength would you assign to the kick-out rights (zero, weak, strong)?

38 1. What is the strength of the kick-out rights? Case 1 The fund has a board of directors, all of whose members are independent of the fund manager and are appointed by other investors. The board holds the right to remove the fund manager without cause. 1. Zero 2. Weak 3. Strong

39 2. What is the strength of the kick-out rights? Case 2 The fund manager can be removed without cause by a simple majority decision of other investors. There are hundreds of widely dispersed unrelated third-party investors. 1. Zero 2. Weak 3. Strong

40 3. What is the strength of the kick-out rights? Case 3 One investor could remove the fund manager, but only for breach of contract. 1. Zero 2. Weak 3. Strong

41 Low Kick-out rights High Solution: Kick-Out Rights Agent Held by the board of directors Marginal zone Held by large number of investors Principal With cause Low Aggregate economic interest High

42 Aggregate Economic Interest Remuneration Management fee Performance fee Other interest Equity investment At-market remuneration is not sufficient evidence to conclude that a decisionmaker is an agent. Aggregate economic interest

43 Measure of Aggregate Economic Interest Factors to consider Variability of returns Magnitude of aggregate economic interest Measured at expected level of performance Maximum exposure Assessing whether the aggregate economic interest is sufficiently high for the decision maker to have control is highly judgemental!

44 Variability Marginal increase in manager's returns in relation to performance of the fund - Variability 120% 100% 80% 60% 40% 20% 0% Fund profit 20% performance fee (10% hurdle rate ) + 1% management fee 10% pro-rata investment (investment at inception: 100)

45 Magnitude Manager's share of fund performance - % of return as a % of total fund's return - Magnitude 120.0% 100.0% 80.0% 60.0% 40.0% 20.0% 0.0% Fund profit

46 Combining The Two Indicators (IASB Examples) Example Fee Performance fee Interest held Removal right Variability of aggregate economic interest % - 10% None 1% + 10% x 99% = 11% Agent Agent/ Principal? 14A 1% 20% over unspecified hurdle 14B 1% 20% over unspecified hurdle 14C 1% 20% over unspecified hurdle 15 1% 10% over unspecified hurdle Effect analysis p.27 Immaterial (inferred) Immaterial (inferred) 2% None (with cause only) 20% None (with cause only) 20% Yes (Held by a Board) 35% Yes, but little weight as largely dispersed 1% + 20% x 99% + 2%x (80%x 99%) =22% Agent 1% + 20% x 99% + 20%x (80%x 99%) =37% Principal 1% + 20% x 99% + 20%x (80%x 99%) =37% Agent 1% + 10% x 99% + 35%x (90%x 99%) =42% Principal 45% None (inferred) 45% Principal 1 In FRS 110 (and the Effect Analysis), the examples do not quote figures for aggregate economic interest. The variability is calculated based on the approach discussed in the KPMG publication: Applying the consolidation model to fund managers. 46

47 Kick-out rights Matrix Approach To Assessment (Kick-Out Rights and Variability) IASB Example 14C (37%) Very strong Agent Strong Medium IASB Example 14A (22%) IASB Example 15 (42%) Zero IASB Example 14B (37%) Principal 0% Variability Aggregate of aggregate economic economic interest interest 100% 47

48 Marginal Zone Factors To Consider Factors De facto power Conclusion Indicates no control (Agent) Low percentage of voting interest Indicates control (Principal) High percentage of voting interest (if voting rights are relevant in the appointment of manager) Availability of replacement Other contractual or special relationships (e.g. master lease agreement, income support, trademark) Expected magnitude of aggregated economic interest Likelihood of the expected performance level applied in the variability calculation not being reached in all periods There are other managers willing and able to provide the services and take on other interests held by the incumbent manager. No other contractual or special relationships between the manager and the fund that would constrain the removal of manager or increase the manager s exposure to variability of returns. Lower Likely There is no other manager willing or able to provide the services or take on other interests held by the incumbent manager. Other contractual or special relationships between the manager and the fund that would significantly constrain the removal of manager or significantly increase the manager s exposure to variability of returns. Greater Unlikely Maximum exposure to variability of returns Lower Greater

49 Marginal Zone Factors To Consider Conclusion Indicates no control (Agent) Indicates control (Principal) Factors Alignment of manager s and investors interests - fees (e.g. Hurdle rate - manager more sensitive to changes in fund returns, Performance fees paid cannot be clawed back, Gross-basis management fee in a geared property fund) Strong alignment Weak alignment Alignment of manager s and investors interests - others (e.g. holds subordinated residual interest and provides credit enhancement) Strong alignment Weak alignment

50 Key Points To Remember! Two key factors in assessing the link between power and returns: kick-out rights and aggregate economic interest. Kick-out rights: Consider the number of investors who need to act together to exercise such a right. Aggregate economic interest: Both variability and magnitude must be sufficiently high to reach a conclusion of principal. Significant judgements/assumptions made in determining whether it is agent or principal need to be disclosed.

51 Illustrative Examples of Application of Control Over Common Funds or Trusts Structures Reinhard Klemmer Partner Head, Department of Professional Practice and Accounting Advisory Services KPMG Singapore Kok Moi Lre Partner PricewaterhouseCoopers LLP 51

52 Application of FRS Consolidated Financial Statements 1. Investments in Real Estate Investment Trusts (REITs) 2. Investments in Business Trusts (BTs) 3. Investments in private funds

53 Typical S-REIT Structure Sponsor Unitholders (likely to be widely dispersed) 100% 100% 100% - x% Board of directors Asset Manager* Asset Management Fees Asset management Services REIT Represents Unitholders Trustee s Fees Trustee Ownership Property Manager Real Properties Voting rights Contractual arrangement *The Asset Manager can be removed by a resolution passed by a simple majority of unitholders present and voting at a meeting of unitholders duly convened and held.

54 Powers of the Trustee Are the rights held by the Trustee substantive rights or protective rights? 50% 50% 1. Substantive 2. Protective 1 2

55 Asset Manager / Property Manager/ Trustee Principal or Agent? Does a single party hold substantive rights to remove the decision maker without cause? No Principal versus agent guidance Scope of decisionmaking authority n o Is the remuneration at market? y e s Consider the 4 indicator groups ( Economic interests aggregated) Remuneration Yes Questions to consider 1. Trustee What are the rights held by the trustee? Are the rights held by the Trustee substantive or protective? Who can remove/appoint the Trustee? Who appointed the Trustee at inception? 2. Board of directors of the Asset Manager Who can remove/appoint the directors? Is the Asset Manager controlled by the Sponsor? 3. Who can appoint/remove the Asset/Property Manager? Kick-out rights Voting of sponsor Substantive rights held by other parties Other interests held 4. Aggregate economic interest Unitholdings Fee structure PRINCIPAL AGENT

56 REIT Structure (variant) Sponsor Unitholders (likely to be widely dispersed) 13% 100% 100% 100% - x% Board of directors Asset Manager* Asset Management Fees Asset management Services REIT Represents Unit holders Trustee s Fees Trustee Ownership Property Manager Real Properties Voting rights Contractual arrangement *The Asset Manager can be removed by a resolution passed by a simple majority of unitholders present and voting at a meeting of unitholders duly convened and held.

57 Potential Impacts Restructuting required to maintain current accounting Financing arrangements may need to be adjusted Key ratios will change, for example leverage ratio, liquid asset ratio, equity ratios Stakeholder communication: communication of potential impact is critical to avoid surprises 57

58 Potential Impacts Banking sector: single borrower limits may be exceeded if entity is consolidated. Lending arrangements need to be restructured, debt covenants may need to be redefined. Funds sector: agent-principal guidance may require different governance structure or granting of kick-out rights Market opportunities for groups that have the ability to take exposure on-balance sheet 58

59 Typical Business Trust Structure Sponsor Unitholders 100% Board of directors Asset Manager/ Trustee Trustee & Management Fees Trustee & management Services Business Trust Ownership Voting rights Contractual arrangement

60 Private Fund Structure Sponsor 100% Investment committee Other investors (typically sophisticated investors) Fund Manager Management Fees Management Services Private Fund Voting rights Portfolio companies Contractual arrangement

61 Private Fund Structure Power? Identify relevant activities management of properties or acquisitions / divestments? Who makes decisions over relevant activities? Fund management company, Investment committee (IC) or investors? Identify the rights held by sponsor and other investors and how substantive they are Rights to appoint / remove IC members, kick out rights over FMC?

62 Private Fund Structure Identifying variable returns Returns that vary based on the performance of the investee: Base fee? performance fee? Exposure to variable returns? Exposure to include both direct interest and FMC fees No bright lines given by Standard Exposure with less than 50% can result in consolidation

63 Private Fund Structure 4 indicators to consider In practice rights held by others and exposure to variability of returns will be more critical How substantive are rights held by others e.g. rights to kick out FMC, rights to appoint / remove IC members. Any incentive or barriers to exercise? Principal or agent? Trade off between rights held by others and exposure to variable returns However consider all factors

64 Key Takeaways For Principal/Agent Assessment Over Funds 1. Who is the decision making body over the relevant activities? 2. Who can appoint/remove the members of the decision making body? 3. Are there kick-out rights over the Fund manager? 4. How substantive are the kick out rights? Are the remaining shareholdings widely dispersed? 5. Significant ownership of units by Fund manager or related party 6. Any special relationships?

65 The New Consolidation Standards Seminar Series: FRS 110 & FRS 112 How Does This Affect Your Investment in Funds and Trusts? Wednesday, 27 th March pm

66 Investment Entities by Kok Moi Lre Partner, Assurance PricewaterhouseCoopers LLP

67 Agenda Overview of key changes Definition of IE Accounting requirements Disclosures Effective date and transition

68 Overview of Key Changes Existing guidance (FRS 27/INT FRS 12) No exemption from consolidation FRS 110 IEs should generally measure subsidiaries at FVPL Question: What is an IE?

69 Definition of IE Business activities Business purpose Performance evaluation Obtain funds to provide investment management services Invest solely for returns from capital appreciation and investment income - Requires exit strategies Measures & evaluates performance of investments based on fair value

70 Typical Characteristics of IE Owns multiple investments Owned by multiple investors Investors are not related parties of IE Separate legal entity with ownership interests 70

71 Limited Partnership General partner GP (1%) Sub 1 (20X2) Limited Partnership ( LP ) formed 20X1 Sub 2 (20X3) 75 unrelated limited partners (99%) Sub 3 (20X3) LP formed 20X1; 10-year life. Stated purpose: invest for capital appreciation. No investments acquired in 20X1. Sub1 acquired in 20X2. Sub 2 & 3 in 20X3. Sub 1/2/3 assessed based on fair value. Exit strategy to IPO/sell each subsidiary within 10 yrs. Fund issues redeemable participating units. Is LP an investment entity in 20X1, 20X2 and 20X3?

72 Limited Partnership Business activities Business purpose Performance evaluation Provides mainly investment management services Specified exit strategies for each subsidiary. Evaluates performance based on fair value of each subsidiary.

73 Limited Partnership X Multiple investments No investments in 20X1 Only 1 investment in 20X2 Multiple investors Investors are not related parties Separate legal entity with ownership interests IE in 20X1/X2/X3; lack of multiple investments in 20X1/X2 due to startup period

74 Private Real Estate Fund Multiple unrelated investors Real Estate Fund ( REF ) Sub 1 Sub 2 Sub 3 Is REF an investment entity? REF set up to invest in real estate companies for investors. Each subsidiary actively managed by individual management; reports to REF on FV basis. REF assesses each subsidiary based on company FV. Exit strategy to IPO/sell each subsidiary within 10 yrs. Fund issues redeemable participating units. 74

75 Private Real Estate Fund Business activities Business purpose Performance evaluation Provides mainly investment management services Specified exit strategies for each subsidiary. Evaluates performance based on fair value of each subsidiary.

76 Private Real Estate Fund Owns multiple investments Owned by multiple investors Investors are not related parties of IE Separate legal entity with ownership interests REF is investment entity 76

77 Real Estate Investment Trust Multiple unrelated investors REIT formed to own and operate properties. Investment properties owned through 3 SPVs. No set time frame for disposing properties/spvs. Performance assessed mainly based on property yield and net property income. REIT engages asset manager to manage properties (e.g. negotiate leases, market properties, etc.) Is REIT an investment entity? REIT SPV 1 SPV 2 SPV 3

78 Real Estate Investment Trust X Business activities X Business purpose Substantial activities that are not merely investment management No specified exit strategies for SPVs X Performance evaluation Evaluates performance on property yield & net property income, not FV. REIT is not investment entity

79 Master-Feeder Fund Multiple GP 1% unrelated GP 1% investors 99% Multiple unrelated investors 99% FFD (Domestic feeder fund) FFO (Offshore feeder fund) MF1 (Master fund) Portfolio of investments Are FFD, FFO and MF1 investment entities? 79

80 Master-Feeder Fund MF1 formed in 20X1 with 10-year life. FFD & FFO formed to meet legal, regulatory and tax requirements. FFD & FFO held by numerous investors; no investor holds controlling interest. MF1 s sole purpose, as represented to investors, is capital appreciation and investment income. MF1 documented exit strategies for equity and nonfinancial investments. MF1 holds debt investments, some for trading, others to hold to maturity. All investments evaluated on FV basis. Investors receive regular FV information. Ownership in MF1, FFD, FFO represented via units. 80

81 FFD/FFO Business activities Business purpose Performance evaluation Provide investment management services through MF1 Solely capital appreciation and investment income Implicit exit strategy for MF1 via MF1 s exit strategies for MF1 s investments. Investments measured on fair value basis

82 FFD/FFO Multiple investments Multiple investors Holds multiple investments through MF1 Investors are not related parties Separate legal entity with ownership interests FFD/FFO is investment entity

83 MF1 Business activities Business purpose Performance evaluation Provide investment management services Exit strategies identified for equity/nonfinancial investments Debt investments either for trading, or held to maturity; exit strategy in either case Investments measured on fair value basis

84 Multiple investments Multiple investors Investors are not related parties Separate legal entity with ownership interests MF1 Has multiple investors via FFD and FFO Investors in FFD and FFO are not related. MF1 is investment entity

85 Accounting Requirements For IEs General Principle Measure subsidiaries at FVPL BUT Consolidate subsidiaries that provide services relating to investment activities of IE Parent of IE shall consolidate all subsidiaries unless Parent is also IE 85

86 Accounting By Non-IE Parent Non-IE parent (70%) IE Unrelated investors (30%) How does non-ie Parent account for Sub 1, Sub 2 and Sub 3 in group financial statements? 100% 100% 100% Sub 1 Sub 2 Sub 3 1. Consolidate 2. FVPL 86

87 Accounting By IE - Summary Consolidate! FV model Investment Entity FVPL under FRS 31 FVPL under FRS 28 Subsidiary 100% (only provides investment services to IE) Investment property Subsidiary 55% Joint Venture 50% FVPL under FRS 110 Associate 21% 87

88 Subsequent Changes in IE Status Prospective accounting Subsequent changes in IE status are accounted for prospectively at the date of change in status Ceasing to be an Investment Entity Apply acquisition method under FRS 103 Business Combinations Date of change in status is deemed acquisition date Fair value on deemed acquisition date is deemed purchase consideration Becoming an Investment Entity Change in status accounted for as deemed disposal Derecognise assets and liabilities of the subsidiaries Difference between previous carrying amounts and fair value of subsidiary recognised in profit or loss 88

89 Disclosures Significant judgements and assumptions When making the investment entity determination Reasons why it is an IE, when it doesn t have one or more of the typical characteristics Change in IE status, plus reasons and effects Information about unconsolidated subsidiaries Name, place of business, % ownership / voting rights Significant restrictions, financial and other support Financial instruments disclosures (FRS 107) 89

90 Effective Date and Transition Effective date Annual periods beginning on or after 1 January 2014 Early adoption permitted Transitional provisions: IE status based on circumstances at first day of annual period in which FRS 110 is adopted Retrospective application unless impracticable 90

91 Early Adoption Pros and Cons Pros More relevant information for certain entities (e.g. private equity funds) Eliminates efforts associated with full-scope consolidation processes Cons Careful assessment needed on whether entity is IE no market practice yet Brings forward new disclosure and restatement requirements. Greater alignment with USGAAP Decreases audited information relied upon by investors (e.g. leverage) 91

92 FRS 112 Disclosure of Interests in Other Entities by Ghamazy Rashid Director, National Professional Practice Deloitte & Touche LLP

93 In the nutshell Pull together disclosures related to: Subsidiaries Joint arrangements Associates Unconsolidated structured entities Objective Establish the information necessary to evaluate: Nature of, and risks associated with, interests in other entities Effects of those interests on the financial position, financial performance and cash flows Extensive disclosures on significant judgements 93

94 Effective Date Annual periods beginning before January 1, 2014 Early adoption permitted Encouraged to provide information required by FRS 112 earlier than mandatory effective date. This does not compel compliance with all the requirements of FRS 112 or to early apply the other FRSs in Package of Five Annual periods beginning from January 1, 2014 Mandatory effective date (IFRS equivalents January 1, 2013) Retrospective with the exception of disclosures for 94 unconsolidated SEs

95 Scope of FRS 112 Applies to entities that have an interest in a subsidiary, a joint arrangement, an associate or an unconsolidated structured entity. Does not apply to: Post-employment plans to which FRS 19 applies. Entities separate financial statements to which FRS 27 applies. A joint arrangement where joint control does not exist (unless significant influence exists). An interest in another entity accounted for in terms of FRS 39 (with exceptions). 95

96 Broad Categories of Disclosures 1. Significant judgements and assumptions made Information about interests in: 2. Subsidiaries 3. Joint arrangements and associates 4. Unconsolidated structured entities 5. Any additional information that is necessary to meet the disclosure objective 96

97 Meaning of Structured Entity [a]n entity that has been designed so that voting or similar rights are not the dominant factor in deciding who controls the entity, such as when any voting rights relate to administrative tasks only and the relevant activities are directed by means of contractual arrangements Examples - securitisation vehicles, asset-backed financings, certain investment funds 97

98 Meaning of Interest Contractual and non-contractual involvement. Exposes the reporting entity to variability of returns from the performance of the other entity. Can be evidenced by: the holding of debt or equity instruments; or other forms of involvement e.g. provision of funding, liquidity support, credit enhancement and guarantees. Encompasses the means by which an entity has control of, joint control of or significant influence over another entity. 98

99 Significant Judgements and Assumptions Disclose information about significant judgements and assumptions made in determining: control of another entity; joint control of an arrangement; type of joint arrangement when the arrangement has been structured through a separate vehicle; significant influence over an entity; and if it meets definition of an investment entity. 99

100 Disclosures for Subsidiaries Information to understand composition of the group Information to understand interest of NCI in the group s activities (including summarised financial information for each subsidiary with NCI that is material to reporting entity) Information to evaluate effects of significant restrictions on assets and liabilities Information to evaluate effects of changes in ownership interest and loss of control of subsidiaries Information on subsidiary with different reporting date or length of reporting period Information to evaluate effects of risks associated with consolidated structured entities 100

101 Disclosures for Unconsolidated Subsidiaries Apply to Investment Entity parent Details of each unconsolidated subsidiary (e.g. name, principal place of business, % of ownership interest and voting rights etc) Information to evaluate effects of significant restrictions on assets and liabilities Information on financial or other support to subsidiary No requirement to disclose certain detailed information applicable to non-investment Entity parents (previous slides) e.g. summarised financial information of investee 101

102 Disclosures for Associates Nature and effects of entity s contractual relationship with the other investors with significant influence. Each Associate material to reporting entity List and nature of interests (e.g. name, nature of relationship, principal place of business, % of ownership interest and voting rights etc) Each Associate material to reporting entity Summarised financial information (more detailed, and reflect amounts reported by Associate in FRS) When equity method used - reconciliation of carrying amount of investee to the summarised financial information Dividends received Fair value (if published quoted prices available) Associates NOT material to reporting entity Aggregated disclosures Carrying amount Share of profit/loss (continuing and discontinued operations), OCI and TCI 102

103 Disclosures for Associates - continued Associates Significant restrictions on ability of investee to transfer funds to reporting entity Financial statements to a different date or for a different period Unrecognised share of losses Risks associated with interests in investee Contingent liabilities relating to interests in investee 103

104 Disclosures for Unconsolidated Structured Entities Nature of, and changes in, the risks associated with an entity s interests Carrying amount of the assets and liabilities recognised (and which line items they are in the statement of financial position) Maximum exposure to loss and comparison to carrying amounts Non-contractual support provided 104

105 Disclosures for Unconsolidated Structured Entities - continued Nature and extent of interests in unconsolidated structured entities Quantitative and qualitative information E.g. nature, purpose, size, activities and financing Sponsor disclosures - for sponsors not providing other risk disclosures: how determined which entities it sponsored type of income earned (fees, interest, dividends, gains/losses from transfer of assets etc) carrying amount of all assets transferred 105

106 Sample Disclosures Refer to Hand-outs 106

107 Thinking Ahead Preparation for 2014 by Ghamazy Rashid Director, National Professional Practice Deloitte & Touche LLP

108 Impact of FRS 110 Why should you care? Financial Impacts Judgements made getting consensus Financial metrics - Potential changes or distortions of key performance indicators or operating metrics (leverage ratios; net interest margin for banks; performance fees for asset managers), Potential tax implications depending on how tax liabilities are computed. Operational Impacts Limited time to respond to the changes Future contracts - early consideration gives time to remedy undesirable consequences through documentation terms Systems and procedures will need to be updated to address the new requirements Educating key stakeholders Disclosures in 2013 financial statements impact of FRSs applicable in future periods 108