Defining Issues June 2013, No. 13-31 FASB Amends Investment Company Criteria, Measurement, and Disclosure Requirements The FASB recently issued an Accounting Standards Update (ASU) that amends the criteria that define an investment company, clarifies the measurement guidance, and requires new disclosures. 1 The changes to the definition criteria for an investment company likely will not cause most entities that are considered investment companies under current U.S. GAAP to become ineligible for investment company accounting and financial reporting. However, the ASU also requires new disclosures about an entity s status as an investment company, changes to that status, and information about financial support provided by an investment company to an investee. Contents Investment Company Criteria 1 Measurement and Presentation 5 Disclosures 6 Application to Real Estate Entities 6 Effective Date and Transition 7 Differences with IFRS 7 The guidance previously developed by the AICPA (and indefinitely deferred by the FASB) to clarify investment company accounting and financial reporting has been superseded by the ASU. 2 Entities that adopted that guidance prior to the FASB s indefinite deferral must assess whether they continue to meet the definition and new criteria of an investment company. The ASU is the result of joint FASB and IASB efforts to develop a consistent approach for determining whether an entity is an investment company. It is effective for interim and annual reporting periods in fiscal years that begin after December 15, 2013 (2014 for entities with a calendar year-end). Early application is prohibited. Investment Company Criteria An entity regulated under the Investment Company Act of 1940 (1940 Act) is automatically an investment company under the ASU s provisions. For all other entities, the Board decided that to be an investment company an entity must possess certain fundamental characteristics. The ASU states that some other characteristics, while present in typical investment companies, may not be 1 FASB Accounting Standards Update No. 2013-08, Financial Services Investment Companies (Topic 946): Amendments to the Scope, Measurement, and Disclosure Requirements, June 2013, and FASB ASC Topic 946, Financial Services Investment Companies, both available at www.fasb.org. 2 AICPA Statement of Position 07-1, Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies. (This guidance is included in FASB ASC Topic 946, Financial Services Investment Companies, available at www.fasb.org, as pending content.)
present in all investment companies. An entity s purpose and design must be evaluated to determine whether it is an investment company. Assessment of Investment Company Status Fundamental (Required) Characteristics Provides Investment Management Services Business Purpose Investing No Operating/Strategic Benefits Consistent with current U.S. GAAP, the ASU requires an investment company to have all of the following fundamental characteristics: Obtains funds from, and provides investment management services to, one or more investors. 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. It is consistent with the attributes of investment companies in current GAAP where funds of an investment company s investors are typically pooled to provide investors with professional investment management. Commits to its investor(s) that its business purpose and only substantive activities are investing solely for returns from capital appreciation, investment income, or both. Current GAAP includes the attribute that an investment company s primary business activities involve investing its assets for current income, capital appreciation, or both. The Board noted that primary has been interpreted inconsistently with respect to the amount of noninvestment activities that can be conducted by an investment company. The Board decided that an investment company s only substantive activities should be its investing activities because having other substantive activities calls into question whether the entity exists for reasons other than investing for capital appreciation or investment income. The Board decided that an exit strategy is not essential for investments that are held for returns from investment income only (e.g., some investments in municipal bonds) because the entity does not plan to realize changes in the price of the investments through disposal. However, an exit strategy is essential to an investment company whose investment objectives include realizing returns from capital appreciation because the investment company must have a plan to dispose of its investments to realize capital appreciation. Does 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. This characteristic differentiates an investment company from an operating conglomerate or holding company. It is to be evaluated by considering the objectives of both the entity and its affiliates. The Board decided that investments made for operating or strategic benefits 2 / Defining Issues / June 2013 / No. 13-31
are not consistent with the business purpose and substantive activities of an investment company. However, an investment company may have a strategy to invest in more than one investee in the same industry, market, or geographical area. In addition, synergies that arise between the investees of an investment company are not prohibited because their existence does not necessarily mean that the investment company is obtaining returns or benefits that are other than capital appreciation or investment income. An investment company may be involved in the day-to-day management activities of its investees and may provide financial support to its investees if those services are provided to maximize the overall value of the investment, rather than to obtain other benefits and do not represent a separate substantial business activity or separate substantial source of income for the investment company. Other Typical Characteristics Multiple Investments Multiple Investors External (Unrelated) Investors Ownership Interests Fair Value Management The ASU states that an investment company typically also has the following characteristics, but the absence of one or more of the typical characteristics does not preclude an entity from being an investment company. Rather, not having one or more of the typical characteristics indicates that additional judgment is required to determine whether the entity s activities are consistent (or inconsistent) with those of an investment company: More Than One Investment. An investment company typically holds multiple investments to diversify its risk and maximize its returns from capital appreciation, investment income, or both. Although not required, the Board considers investing in multiple investments an important typical characteristic of an investment company. More Than One Investor. An investment company typically pools funds from multiple external investors and provides them with investment management services, including access to investment opportunities unobtainable by individual investors. Although not required, the Board considers this is an important typical characteristic of an investment company because it makes it less likely that the entity or its affiliates obtain or have the objective of obtaining returns or benefits from an investee that are not normally attributable to ownership interests or that are other than capital appreciation or investment income. 3 / Defining Issues / June 2013 / No. 13-31
Investors That Are Not Related Parties of the Parent (if Any) or the Investment Manager. An investment company is expected typically to have significant external equity investors or partners that are not related to the entity s parent (if there is a parent) or investment manager. The Board included this characteristic because having external investors is one way to ensure that an investment company is not inserted into a larger corporate structure to achieve a particular accounting outcome or obtain returns or benefits from investing that are other than capital appreciation or investment income. Ownership Interests in the Form of Equity or Partnership Interests. Ownership interests in an investment company are typically in the form of equity or partnership interests, to which a portion of the net assets are attributed. The Board considers this an important typical characteristic because it explains in part why fair value measurement of investments is more relevant to investors of an investment company. KPMG Observations Some collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs) structures may not have been considered investment companies based on the unit ownership attribute in current GAAP. However, because this is not a required characteristic under the ASU, certain securitization entities may meet the ASU s revised investment company criteria. For example, some CDO and CLO entities may have the fundamental characteristics of an investment company along with most of the typical characteristics. Other important characteristics would need to be considered, including the purpose and design of the entity (how the entity portrays itself to investors) and whether the entity manages substantially all of its assets on a fair value basis. Management of Substantially All Investments on a Fair Value Basis. An investment company typically manages substantially all of its investments on a fair value basis. The Board recognized that fair value information is critical for analyzing the performance of investments made by investment companies and that fair value management can be performed in a number of ways. For example, an entity may use fair value as the primary measurement attribute to evaluate the financial performance of, and to make investment decisions for, substantially all of its investments. In that case, information about the entity s investments would be provided internally on a fair value basis to key management personnel. Alternatively, an entity may transact with its investors on the basis of net asset value per share, which is calculated using the fair value of the entity s investments. 4 / Defining Issues / June 2013 / No. 13-31
Measurement and Presentation The ASU does not change the requirement for investment companies to measure their investments in investees at fair value with changes in fair value recognized in the statement of operations. The ASU requires an initial determination at formation about whether an entity is an investment company. If there is a subsequent change in the purpose and design of the entity (or if the entity is no longer regulated under the 1940 Act), the entity is required to reassess whether it meets (or does not meet) the criteria to be an investment company. Noncontrolling Ownership Interest. The ASU clarifies that an investment company is required to measure noncontrolling interests in other investment companies at fair value rather than using the equity method of accounting. The reporting investment company may apply the net asset value per share practical expedient in ASC Topic 820 on fair value measurement to measure the fair value of its interest. 3 Controlling Financial Interests. Current GAAP prohibits an investment company from consolidating a noninvestment company subsidiary, unless that subsidiary is an operating entity that provides services to the investment company. There is diversity in practice about whether an investment company should consolidate another investment company in which it holds a controlling financial interest. The Board decided not to address that diversity in practice but to develop at a later date additional disclosures about investments held by an investment company in other investment companies to address concerns about transparency into the risks, obligations, and expenses of an investee fund. KPMG Observations The issue of whether an investment company should consolidate another investment company in which it holds a controlling financial interest may arise in the context of a master-feeder structure or a fund-of-funds structure. The Board originally had proposed that an investment company that holds a controlling financial interest in another investment company in a fund-of-funds structure should consolidate the investment company in which it holds a controlling financial interest. However, in response to constituent concerns about the conceptual and operational considerations relating to the proposed requirement, the Board decided not to address whether an investment company should consolidate another investment company in this project. 3 FASB ASC Topic 820, Fair Value Measurement, available at www.fasb.org. 5 / Defining Issues / June 2013 / No. 13-31
Disclosures The ASU requires an investment company to disclose that it is an investment company and, therefore, is applying the specialized accounting and reporting guidance in ASC Topic 946. Change in Status. An entity with a change in status is required to disclose that a change in status occurred and the reasons for that change. An entity that was not an investment company and becomes an investment company is required to disclose the effect of the change in status on the reported amounts of investments as of the date of the change in status. Financial Support. An investment company is required to disclose information about the: (1) Type and amount of financial support provided, including situations in which the investment company assisted the investee in obtaining financial support; and (2) Primary reasons for providing the financial support, disaggregated by financial support that it is contractually required to provide and financial support that it was not previously required to provide to any of its investees during the periods presented. An investment company is also required to separately disclose information about financial support including the: (1) Type and amount of financial support to be provided, including situations in which the investment company must assist the investee in obtaining financial support; and (2) Primary reasons for the contractual requirement to provide the financial support. The Board concluded that this would provide information about the investment company s potential future obligations without being forward looking in nature. Application to Real Estate Entities The Board is aware that some real estate entities currently measure their real estate investments at fair value because (a) they have determined that they are investment companies, or (b) based on industry practice (e.g., because they are controlled by pension plans that are required to measure their investments at fair value). The Board decided to retain the current U.S. GAAP scope exception from investment company accounting and financial reporting for real estate investment trusts and otherwise not to address issues related to the applicability of investment company accounting for real estate entities and the measurement of real estate investments at this time. The Board indicated that it does not intend for the ASU s requirements to change practice for real estate investment 6 / Defining Issues / June 2013 / No. 13-31
entities for which it is industry practice to issue financial statements consistent with the measurement principles applicable to investment companies. KPMG Observations All entities, except for real estate investment trusts, must assess whether they meet the ASU s criteria to be an investment company. However, it is likely that the changes to the criteria that define an investment company would not cause a change in practice for most real estate investment entities currently considered investment companies or for which it is industry practice to issue financial statements consistent with the measurement principles applicable to investment companies. Effective Date and Transition The ASU s requirements are effective for interim and annual reporting periods in fiscal years that begin after December 15, 2013. Earlier application is prohibited. An entity must discontinue application of the guidance in ASC Topic 946 if it no longer qualifies as an investment company upon the effective date. The entity is required to present the change in its status as a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption. A currently non-investment company entity that is an investment company under the new guidance upon the effective date is required to apply the investment company accounting and financial reporting guidance by recording the effect of applying the amendments as an adjustment to opening net assets as of the effective date. The cumulative-effect adjustment is included in the net asset value at the beginning of the period. The adjustment to net assets represents both the difference between the fair value and the carrying amount of the entity s investments and any amount previously recognized in accumulated other comprehensive income. Differences with IFRS The characteristics to be evaluated to determine whether an entity is an investment company under the ASU are similar to the characteristics under IFRS. 4 However, there are some key differences, including the following: Exit Strategy Requirement. Under IFRS, an investment entity must have an exit strategy for investments without stated maturity dates, such as equity securities and nonfinancial assets. IFRS does not require an investment entity to have an exit strategy for investments that have stated maturity dates. 4 Investment Entities (Amendments to IFRS 10, IFRS 12 and IAS 27), October 2012. 7 / Defining Issues / June 2013 / No. 13-31
Managing on a Fair Value Basis. Under IFRS, an entity must measure (rather than manage) and evaluate the performance of substantially all of its investments on a fair value basis to be an investment entity. An entity could satisfy the fair value measurement requirement if investments are measured at fair value with fair value changes recognized in other comprehensive income. Investing-related Services. IFRS permits an investment company to provide investing-related services to third parties whereas the ASU precludes an entity that provides substantive investing-related services to third parties from being an investment company. The following key differences exist between the stand-alone financial statements of an investment company reporting under U.S. GAAP and IFRS. U.S. GAAP IFRS Initial Measurement Requires an investment company to initially measure its investments at their transaction price, which includes commissions and other charges that were part of the purchase transaction. Requires investments (other than investment property) that are subsequently measured at fair value to be initially measured at fair value (excluding transaction costs). 5 Requires investment property to be initially measured at cost, including transaction costs. Subsequent Measurement Generally requires an investment company to measure all investments at fair value with changes in fair value recognized in the statement of operations. Requires an investment entity to measure substantially all of its investments at fair value whenever fair value is required or permitted in accordance with relevant IFRS. As a result, an investment entity could have a limited number of investments measured at amounts other than fair value. An investment entity could also have investments measured at fair value with 5 IAS 40, Investment Property. 8 / Defining Issues / June 2013 / No. 13-31
U.S. GAAP IFRS changes recognized in other comprehensive income as discussed in the section on Managing on a Fair Value Basis. Accounting for Controlling Interests in Another Investment Company Prohibits an investment company from consolidating an investee that is not an investment company, unless that investee provides services to the investment company. Does not specifically address whether an investment company is required to consolidate another investment company in which it holds a controlling financial interest. Requires an investment entity to measure all subsidiaries at fair value, except those that provide services to the investment entity. Disposal of Securities Requires an investment company to determine the cost of disposed securities using the average cost of the securities or specifically identifying the cost of each security sold. Does not prescribe how to calculate the cost of disposed securities. Required Financial Statements and Schedules Does not require an investment company to present comparative financial statements and only requires a statement of cash flows in certain circumstances. An investment company is required to provide a statement of changes in net assets, a schedule of investments, and financial highlights in all circumstances. Requires an investment entity to present comparative financial statements (including a statement of cash flows) and related footnotes. Does not require a statement of changes in net assets or a schedule of investments. Rather, it requires additional information only for controlled investees. 9 / Defining Issues / June 2013 / No. 13-31
U.S. GAAP IFRS Financial Statement Line Items Specific financial statement presentation requirements exist for an investment company, including guidance on realized and unrealized gains and losses. Does not include specific financial statement presentation requirements for an investment entity. Disclosure Requirements Specific disclosure requirements exist for an investment company, such as the information to include in an investment company s financial highlights and directions on how to calculate the highlights. Does not include specific disclosure requirements for an investment entity. There are disclosure requirements in other areas of IFRS that are not required by U.S. GAAP. 6 Accounting by a Noninvestment Company Parent for an Investment Company Subsidiary Requires a noninvestment company parent to retain the specialized accounting applied by an investment company subsidiary in consolidation. Requires a noninvestment entity parent to consolidate controlled investees of an investment entity subsidiary, which could result in significant differences in the financial statements of a noninvestment company parent under U.S. GAAP and IFRS. Net Asset Value per Share Practical Expedient ASC Topic 820 provides a practical expedient that allows an investor in an investment company to measure the fair value of its interest using net asset value per share, if certain conditions are met. Does not include the concept of net asset value for an investment entity and, therefore, does not provide a similar practical expedient to fair value measurement for an investment in an investment entity. 6 IFRS 7, Financial Instruments: Disclosures. See the guidance on sensitivity analysis. 10 / Defining Issues / June 2013 / No. 13-31
U.S. GAAP IFRS Investment Companies under Regulatory or Legal Rules An entity that is regulated under the 1940 Act would qualify as an investment company under U.S. GAAP. Because the regulatory requirements may differ depending on a particular jurisdiction, the IASB decided not to base its definition of an investment entity on local regulations. Therefore, some investment companies regulated under the 1940 Act or other regulatory rules and laws may not be investment entities under IFRS. Other GAAP Differences* Requires equity issued by an open-end fund to be reflected as a shareholder transaction. Open-end multiple class funds generally classify investor ownership interests as liabilities, with distributions paid to investors reflected as a finance cost. 7 *Other differences also may arise as a result of references to other U.S. GAAP and IFRS requirements. 7 IAS 32, Financial Instruments Presentation. Contact us: This is a publication of KPMG s Department of Professional Practice 212-909-5600 Contributing authors: John V. Russo Shirley Choy Earlier editions are available at: http://www.kpmginstitutes.com/financial-reporting-network The descriptive and summary statements in this newsletter are not intended to be a substitute for the potential requirements of the standard or any other potential or applicable requirements of the accounting literature or SEC regulations. Companies applying U.S. GAAP or filing with the SEC should apply the texts of the relevant laws, regulations, and accounting requirements, consider their particular circumstances, and consult their accounting and legal advisors. Defining Issues is a registered trademark of KPMG LLP. 2001 2013 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative ( KPMG International ), a Swiss entity.