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Investment entities

Date recorded:

The IASB and the FASB (the Boards) discussed the following topics:

  • Asset-based versus entity-based guidance (IASB only consideration)
  • Approach to entity-based investment entity guidance
  • Definition of an investment entity and factors to consider
  • Application guidance

The FASB and the IASB staff (the staff) previously presented the Boards with a summary of the comments received on the proposals (EDs) at the April 17, 2012 joint meeting.  In their joint meeting on May 21, 2012, the Boards began redeliberations on the investment entities (investment companies) project.

 

Asset-based versus Entity-based Guidance (IASB only discussion

In responses to the IASB August 2011 ED on investment entities, some constituents suggested that the IASB should explore an asset-based  approach rather than an entity-based approach for fair value measurement of controlled entities.   Constituents noted that historically the IASB has avoided accounting guidance that is entity-specific and that the proposal should focus on transaction-based accounting.  The IASB staff recommended that the IASB continue to deliberate the proposed entity-based approach rather than an asset-based approach.   They indicated that an asset-based approach would allow more entities to measure their investments in controlled entities at fair value rather than consolidating these investments.  This would be inconsistent with the original objective of the project, which is to provide a limited number of types of entities with an exemption from consolidation.

The IASB agreed with the Staff recommendation and decided to continue with the entity-based approach as proposed in the IASB ED.

 

Approach to Entity-based Investment Entity Guidance

In responses to both the IASB and FASB EDs on investment entities/investment companies, many constituents expressed concerns that requiring an entity to meet all six criteria would be too onerous and would not allow entities to apply judgment.  Many stated that such requirement could potentially cause entities that should be accounted for as investment entities, or that currently apply investment entity accounting under U.S. GAAP from inappropriately being precluded from qualifying for such accounting.

In light of these comments, the FASB and IASB staff presented the following three alternatives to the Boards regarding the overall approach to assessing entity-based criteria:

  • Alternative 1:  All six criteria are required to be met. This is consistent with the requirements in the ED approach.
  • Alternative 2:  A qualitative assessment. Under this alternative an entity would apply a qualitative assessment (i.e., it could consider all evidence and indicators and apply judgment in determining whether it meets the criteria to be an investment entity).  The criteria would be treated as indicators and none of them would serve as a strict requirement
  • Alternative 3: A definition and factors to consider to qualify as an investment entity. Under this alternative, an entity would be required to meet a revised definition of an investment entity.  The revised definition would contain specific aspects from certain of the proposed criteria in the ED.  The remaining criteria would serve as factors that the entity must consider once the entity determines that it meets the definition.    If the entity does not meet the definition, it would not be permitted to assess the factors.  Many constituents also recommended this approach during the comment letter process.

The staff recommended alternative 3.  The staff believes that alternative 3 allows for an appropriate balance between creating a clear scope and allowing entities to perform the assessment based on relevant factors to determine whether they are investment entity. Accordingly, the Staff recommended that the revised definition incorporate the “nature of the investment activities” and the “business purpose” criteria proposed in the EDs. In addition, the entity would be required to obtain funds from an investor or investors and provides the investor(s) with professional management services. The staff proposed that entities would not be required to meet the other criteria in the EDs but could consider such criteria to be factors in the overall assessment.

The staff proposed the following definition:

 

“An investment entity is an entity that does both of the following:

a. Pools funds from an investor or investors and provides the investor(s) with professional investment management services

b. Commits to its investor(s) that its business purpose and only substantive activities are investing the funds for returns from capital appreciation, investment income, or both.

An investment entity and its affiliates do not obtain, or have the objective of obtaining returns or benefits from their investments that are either of the following:

a. Other than capital appreciation and investment income

b. Not available to other noninvestors or are not normallyattributable to ownership interests.”

The staff however was split on whether or not the fair value management criteria in the EDs should be included in the definition of an investment entity or as a factor.  The IASB staff felt that it is critical that an investment entity manages and evaluates performance of its investments on a fair value basis and therefore that fair value management should be a part of the definition. However, the FASB staff felt that fair value management should just be a factor due to concerns on how such criterion should be applied in practice (e.g. to structures like money market fund or short-term bond funds).

Although majority of the IASB and FASB members tentatively decided to proceed with alternative 3 and generally agreed with the concept of the definition as described above, there were differences in the views between the FASB and IASB on the definition and factors to consider:

  • The IASB has tentatively decided to incorporate the fair value management criterion as part of the definition.  Some of the IASB Board members also expressed the importance of having the exit strategy requirement be explicit in the definition.  The IASB believe that such exit strategy would help differentiate an investment entity from an operating entity and would substantiate the need to measure controlled investments at fair value through net income.   However, the Boards did not formally vote on having the notion of exit strategy as a part of the definition.
  • Under the FASB’s definition, neither fair value management nor the exit strategy requirement would be in the definition of an investment entity. The FASB believe that fair value management should just be a factor due to concerns on how such criterion should be applied in practice (e.g. to structures like money market fund or short-term bond funds).   The FASB also reconfirmed its view that an exit strategy would only be needed for investments held to earn capital appreciation.
  • Both Boards did not like the word “pool” to be in the staff’s proposed definition. They noted that the word “pool” indicates having multiple investors, which preclude situations where an investment entity has a single investor.  The Boards recommended the staff change the word “pool” to “obtain” or something of meaning.
  • The IASB also disagreed with the FASB that an investment entity can hold investments to earn investment income only (i.e. not capital appreciation or capital appreciation and investment income) and requested that such language to be removed from the definition.   The FASB believes that it is common for a fund to invest in assets to earn investment income only (e.g. debt securities that are held to maturity) and therefore these should not be precluded. The IASB noted that if such investments are substantive, the entity should not be permitted to measure its controlled investees at fair value.

Once the Boards decided on alternative 3 and the definition of an investment entity, the staff asked the Boards whether they agree with the staff recommendation for the factors to consider in addition to the definition of an investment entity. The staff had proposed that an entity would  consider its purpose and design when assessing the following factors in its assessment whether it is an investment entity:

  • Number of investments and investors
  • Related investors
  • Ownership interests.

The Boards however did not make any decisions regarding the factors presented and instead requested the staff bring back ideas/potential ways to deal with situations where it is unclear whether an entity is an investment entity (e.g., when an entity meets the definition of an investment entity but fails to meet some or all of the other factors) at a future meeting. The Boards were concerned on how this approach would be implemented in such grey areas.   Some Board members suggested that an entity with a single asset and a single investor should never qualify to be an investment entity in order to avoid abusive situations.

In addition, some of the Board members felt that the ownership interest (i.e. proposed in the EDs as unit of ownership) is not a relevant factor and therefore should be removed from the proposed factors to reduce complexity.

 

Application Guidance

The Boards also discussed various aspects of the application guidance and tentatively agreed with the following staff recommendations related to modifying the EDs:

  • The application should state that transactions between controlled investees would not be prohibited.
  • The reporting entity criterion as proposed in the EDs should not be a separate factor; however, the application guidance should clarify that an entity does not need to be a legal entity to be an investment entity.
  • The EDs allow for exceptions from the multiple investments/multiple investors requirement criterion to the extent that an investment company is set up in conjunction with another investment entity for tax, legal, or other business reasons (e.g., a blocker fund or a master feeder). The Board’s decided that the application guidance should clarify that the “in conjunction with” guidance applies even if the funds are not set up at the same time.

The IASB also tentatively decided that the application guidance should clearly state that:[1]

  • An investment entity would be allowed to provide investment-related services to third parties only if those services are not substantive.
  • An investment company’s day-to-day management of its investees should not disqualify it from investment entity status.
  • In a master-feeder structure when determining whether a feeder fund meets the exit strategy requirement, the feeder funds would not need an exit strategy. Rather only the master fund would be required to have an exit strategy for substantially all of its investments.
  • An entity is not required to measure its financial liabilities at fair value and manage those financial liabilities on a fair value basis in order to be considered to be managing its investments on a fair value basis and accordingly being able to be an investment entity.
  • The IASB decided that it would not amend its guidance on the fair value management criterion to be consistent with the FASB ED. That is, the IASB decided not to add consideration of how an entity transacts with its investors and how asset-based fees are calculated in determining whether the entity manages its investments on a fair value basis.
  • The IASB also tentative decided that an investment entity would be required to have an exit strategy for substantially all of its investments. The exit-strategy assessment would be performed at the portfolio level.



These tentative decisions apply to the IASB only; the FASB’s ED already contains such language.