Exposure draft on Investment Entities
Private Equity managers and certain Alternative Asset Managers have generally favoured the use of United States Generally Accepted Accounting Principles ("US GAAP") over International Financial Reporting Standards ("IFRS") as the reporting framework for their "Investment Entities" due to the consolidation requirements of the latter.
Under US GAAP an investment entity should only consolidate subsidiaries which are also investment entities or are operating companies that provide services to the investment entity itself. IFRS however requires investment entities to consolidate investments as subsidiaries if there is control, regardless of the prupose for acquiring the interest.
This has resulted in some users of investment entity accounts under IFRS questioning the usefulness of consolidating such "investments". The IASB has addressed this by publishing Exposure Draft ED/2011/4, Investment Entitites ("ED") issued on 25 August 2011. The fundamental proposal of the ED (amending the requirements of IFRS 10) is that investments that are deemed to be controlled by the investment entity can be held at fair value through the profit and loss. This will align IFRS with the treatment under US GAAP, instead of requiring consolidation.
Investment entities
The questions is what, under IFRS, would be considered an investment entity? Guidance on this has been issued as part of the ED, which provides the following definition:
- The entity's only substantive activities are investing in multiple investments for capital appreciation, investment income (such as dividends or interest), or both.
- The entity makes an explicit commitment to its investors that the purpose of the entity is investing to earn capital appreciation, investment income (such as dividends or interes), or both.
- Ownership in the entity is represented by the units of investments, such as shares or partnerhship interests, to which proportionate shares of net assets are attributed.
- The funds of the entity's investors are pooled so that the investors can benefit from professional investment management. The entity has investors that are unrelated to the paret (if any), and in aggregate hold a significant ownership interest in the entity.
- Substantially all of the investments of the entity are managed, and their performance is evaluated, on a fair value basis.
- The entity provides financial information about its investment activities to its investors. The entity can be, but does not need to be, a legal entity.
So are there any potential pitfalls if the ED is approved?
In practical terms the answer is yes for those entities that currently consolidate their controlled investments, but would fall under the criteria proposed for an investment entity. This would mean having to de-consolidate their controlled investments incurring additional cost in terms of time spent on disclosures within the financial statements. As with most changes in IFRS, the ED provides guidance for the transition.
Transitional arrangements
If an entity meets the definition of an investment entity, it shall report the effect of applying the proposed IFRS as an adjustment to retained earnings as of the beginning of the period for which the proposed IFRS is adopted for the first time. The adjustment to retained earnings would represent the difference between (a) the carrying amount of the net assets of the entity's controlled investment and (b) the fair value of the investment at the date of first applying the updated guidance, plus any changes in the fair value of net assets of the investment previously recognised, and remaining in, accumulated other comprehensive income.
Comments relating to the ED were due 5 January 2012 and are now being considered.
Our view
If approved, this ED will be welcomed by a number of asset managers and investors. Under the current regime applying IFRS results in the consolidation of controlled entities, even when the purpose of the investment is to gain a return through an increase in value and subsquent exit. For private equity houses in particular, reporting consolidated results does not always give the investor the information they want on the performance of the investments, instead showing an amalgamation of operating companies, possibly from different industries. Any new standard enabling investor friendly reporting under the now established IFRS framework would surely be welcomed.
We wait for the next phase in the process once the IASB has considered the submitted comments, and ultimately the issuing of new guidance
