Whether or not your entity is classified as an “investment company” can have a significant impact on its financial reporting. To establish a consistent approach for making this determination, the Financial Accounting Standards Board (“FASB”) recently issued Accounting Standards Update 2013- 08, Financial Services – Investment Companies (“Topic 946”): Amendments to the Scope, Measurement, and Disclosure Requirements (“the ASU”).
The ASU also provides measurement guidelines for certain types of investments and requires investment companies to disclose their investment company status as well as certain other information on their financial statements.
The new rules apply to interim and annual reporting periods in fiscal years beginning after December 15, 2013.
Determination of Investment Company Status
If your entity is regulated by the Investment Company Act of 1940 and required to register with the SEC, it continues its eligibility to be deemed an investment company. Otherwise, ASU 2013-08 requires a two-tiered analysis.
The initial step is to determine whether your entity possesses both of the following fundamental characteristics:
• Obtains funds from investors and provides investment management services, and
• Commits to investors that their business purpose and only substantive activities are investing funds solely for returns from capital appreciation, investment income, or both.
Also, the entities or their affiliates do not obtain or seek returns or benefits from an investee or its affiliates that are not normally attributable to ownership interests like capital appreciation or investment income.
Additional guidance for determining whether an entity has the fundamental characteristics of an investment company requires that it should have no substantive activities other than its investing activities and it should have no significant assets or liabilities other than those relating to its investments.
If investment company characteristics are present, the second step is to examine whether your entity possesses the typical characteristics of an investment company:
1. Multiple investments,
2. Multiple investors,
3. Investment by unrelated parties,
4. Ownership in the form of equity or partnership interests, and
5. Investments managed on a fair-value basis.
If your entity lacks one or more typical characteristics, you’ll need to make a judgment call as to whether your entity’s activities are consistent with those of an investment company. An entity might be an investment company even if it holds a single investment (for tax or other reasons), manages investments for a single investor (such as a pension plan), or holds interests other than equity or partnership interests (such as collateralized loan obligations).
Generally, investment companies measure their investments at fair value as opposed to the equity method, which is based on the original purchase price. As under current standards, ASU 2013-08 requires investment companies to measure investments in noninvestment companies at fair value. Even if they control noninvestment companies, they can’t consolidate them or apply the equity method unless the noninvestment companies provide them with services. As an example, a private equity fund that holds a controlling interest in one or more portfolio companies should report such investments at fair value.
The ASU also clarifies that a feeder fund is an investment company and should report its investment in the master fund at fair value.
Of significance to investment management firms, a noninvestment company parent retains the specialized accounting used by its investment company subsidiaries in consolidation. So, for example, a noninvestment company general partner that consolidates its investment funds would retain the funds’ specialized accounting as per current GAAP guidance.
Investment companies should report noncontrolling interests in other investment companies at fair value. The ASU doesn’t address controlling interests (although FASB may provide guidance on that issue in the near future). But under current practice, investment companies typically consolidate only wholly-owned investment companies.
An investment company must disclose in its financial statements that it is an investment company under ASU Topic 946 and also report any change in its status.
Evaluate Your Status
This article covers some of the highlights of the 78-page ASU. To assess its impact, ask your advisors to evaluate your firm’s investment company status and determine whether you’ll need to change your reporting practices.