As noted above, the investment management industry is special. Therefore, the primary accounting issues impacting the industry are not necessarily those that a typical entity would identify. U.S. GAAP includes an entire topic dedicated to accounting principles for investment companies, ASC 946. However, absent specific principles in ASC 946, other U.S. GAAP topics must also be applied (e.g., ASC 820 (Fair Value Measurements) and ASC 740 (Income Taxes)), resulting in a challenge to navigate the principles of U.S. GAAP for the industry. However, many prefer this challenge to the challenge in IFRS that requires the application of largely general accounting principles being applied to an industry with unique transactions and reporting considerations.

Definition of investment company

Before we get too involved in the special aspects of accounting and reporting for funds, the first issue to address is whether or not a fund is “worthy” of receiving this special treatment.

ASC 946 not only provides industry-specific accounting and reporting requirements for funds, it also defines an investment company and the types of entities that are subject to these special principles.

Qualification as an investment company may be achieved either automatically, by being registered under the SEC’s Investment Company Act of 1940, or by meeting the definition of an investment company.

The definition of an investment company includes consideration of both fundamental and typical characteristics. The fundamental characteristics are mandatory and must be present in order for the entity to be considered an investment company.

Typical characteristics are those that are not mandatory  but would generally be expected. Typical characteristics of an investment company include:

• It has more than one investment, to diversify the risk portfolio and maximize returns;
• It has multiple investors, who pool their funds to maximize investment opportunities;
• It has investors that are not related parties of the entity;
• It has ownership interests in the form of equity or similar interests;
• Management of substantially all investments on a fair value basis

If the entity does not have all of the typical characteristics, it must apply judgment, using overall facts and circumstances, to determine if the entity meets the definition of an investment company.

While many funds will clearly meet the definition of an investment company, others may not meet the definition so clearly. Specifically, private equity funds and real estate funds, that are more actively involved in their investments through management, development, and operations, often require careful consideration of ASC 946 when making this determination.

Accounting for and measuring investments

Once it’s clear the fund is an investment company, the biggest issue, without question, will be how to account for and measure the investments held by the fund. And while the accounting principles are quite straight-forward, the application of these principles is a challenge.

ASC 946 requires that all investments be measured at fair value, with changes in fair value recognized through the income statement. “All” investments include those held in debt and equity instruments, as well as alternative investments, such as derivatives, investments in other funds (e.g., fund-of-funds), and non-financial investments (e.g., real estate, collectibles, cryptocurrencies, etc.). The extent of ownership also does not change this principle. For example, regardless of whether an investment company holds a 40% or 80% stake in an equity investment, ASC 946 requires the investment to be accounted for at fair value and NOT by using the equity method of accounting or consolidation. The reason for this principle has to do with the needs of the users of the financial statements (e.g., investors and future investors), where the fair value of the funds’ portfolio is the most useful information to present.

As a result, fair value becomes a very important measurement basis for an investment company. And while investment companies commonly use this measurement basis, they do so by applying ASC 820, not the industry-specific guidance in ASC 946.

While the determination of fair value may be easy for marketable investments in debt and equity securities, many funds may hold hard-to-value investments that do not have a readily determinable fair value. Investments in private equity, non-traditional debt, and alternative investments may require significant judgment when estimating fair value. Luckily, there is plenty of help to assist in these judgments, from online training to interpretive guides issued by the Big 4, which we cover in the resources section below.

One common issue faced by investment companies is how to measure investments in other investment companies, such as when the fund is a fund-of-funds. ASC 820 allows an entity to elect to measure fair value using net asset value (NAV) as a practical expedient to fair value, which greatly simplifies the measurement of these investments. However, it may only be elected if certain conditions are met.

There are many additional rules and disclosure considerations when electing this practical expedient. In addition, if an entity determines on any reporting date that it is probable that the investment will be sold at an amount other than NAV, the practical expedient is not allowed to be applied. However, if eligible, this measurement approach can save investment companies under U.S. GAAP the aggravation of estimating a true fair value (if only IFRS had a similar practical expedient in IFRS 13!)

Once fair value has been mastered, the challenges continue under ASC 946. Depending on the type of investment held, there are many other unique accounting requirements for investment companies, including:

• Accounting for transaction costs
• Distinguishing a distribution from an equity investment as a return “of” capital versus a return “on” capital
• Recognition of dividend income on the ex-dividend date
• Presentation of interest income on debt securities separately from other changes in fair value using the effective rate method
• Recognition and measurement of foreign currency movements in foreign investments
• Accounting for controlling interests in other investment companies

Service provider fees

From an operational perspective, investment companies are relatively lean and simple entities and therefore have very few, if any, employees. In fact, the everyday activities undertaken by the fund are generally provided by outside service providers, resulting in a number of service provider fees being charged to the fund and/or its investors. Typical service providers may include:

• Investment manager/ adviser/ general partner – manages investment portfolio
• Distributor – responsible for the selling of fund shares to investors
• Administrator – provides recordkeeping and accounting services
• Transfer Agent – tracks and manages investor shares (e.g., purchases and distributions)
• Custodian – holds investments held by the fund
• Legal Counsel – provides legal services
• Independent public accountant – audits fund’s financial statements

The investment manager is a critical service provider. Not only do they typically receive the largest fees from the fund, but they are most often the creator of the fund in the first place. Investment managers often establish funds in order to provide services to it!

Fees paid to service providers, particularly the investment manager, is an area where the investment management industry starts to really show its unique qualities. Fee structures often include a performance-based component and may require complex calculations to determine amounts owed, often resulting in material amounts. Terminology, such as hurdle rates, high-water marks, waterfalls, carried interest (or carry), and clawbacks, further add to the complexity of this area. ASC 946 requires both base and performance fees to be measured and accrued on interim dates by a fund based on the actual performance through the accrual date. As a result, it is important to understand the fee structures to ensure they are properly calculated each reporting period. 

Further complication may arise when dealing with funds structured as limited partnerships where the general partner is the investment manager. In these arrangements, management fees may be paid through a reallocation of capital rather than a cash payment. In these instances, judgment may need to be applied as to whether such reallocations are to be recognized in the income statement (as a non-owner-related service) or within shareholders’ equity (as an owner-related transaction).

Other arrangements commonly exist between a fund and its service providers that result in accounting and reporting consequences such as:

• Expense limitation arrangements
• Expense offset or reimbursement arrangements

Complex capital structures

Investment companies are often set up as limited partnerships but may also be established as corporations. This structure is often dictated by tax law and local regulations where the fund has been established.

Funds also have unique capital structures that are not typically seen in other industries. The structures vary widely and continue to evolve.  Some of the most common structures include:

The multi-class structure:

The multi-class structure is most commonly found in mutual funds and creates multiple classes of shares in which investors may invest. The different share classes allow for different types of investors (e.g., institutional versus individual) and provide flexibility with regards to how distribution fees will be assessed for each class (e.g., front-end load, back-end load, 12b-1/ level load, or no distribution fee at all). However, the multi-class structure may also be used for other purposes, such as providing classes for investment in different currencies or geographical locations.

The master-feeder structure:

In the master-feeder structure, investments are held in a separate master fund. Investors invest in various feeder funds, which use investor proceeds to invest in the master fund. While this structure may seem unnecessarily complicated, its primary purpose is tax optimization. By segregating investor groups and establishing funds in tax-exempt, off-shore locales, the fund manager is able to pool tax-exempt investors with investors that are subject to taxation to invest in the same investment portfolio, without disrupting the tax status of either group of investors.

The fund-of-funds (FoF) structure:

A fund-of-funds (FoF) is exactly what it sounds like...a fund that holds investments almost exclusively in other funds. The attraction to these types of investments is two-fold: diversification (even more than an individual fund can offer!) and accessibility of investments. FoFs are common with hedge funds as these mainly private funds require a rather large minimum investment for investors (which ensures the fund can maintain a minimum number of investors and maintain private fund status, while also maximizing its net assets under management). A FoF will pool investor funds to ensure that minimum investment can be made and allow investors to gain access to these types of investments.

Each of these structures, although unique, have a common purpose: to maximize the investment in a particular fund by providing investors with advantages and the accessibility they are seeking. Whether it is the cost structure, tax optimization, diversification, or access to investment, the capital structure of a fund can open the door to more investors!

However, with these complex structures come potential accounting and reporting issues. From an accounting perspective, the mix of “shared” fund activities and “isolated” capital pools result in the need to perform allocations of expenses, earnings, and distributions to each of the capital groups. This gets complicated, especially when units in a fund are regularly being bought and sold. For financial reporting, ASC 946 contains a number of specific presentation and disclosure requirements, some of which are unique to specific capital structures. Therefore, care must be given to comply with these requirements depending on the structure of the fund.

Financial statement presentation

The final, and perhaps most identifiable accounting issue for investment management is the financial statement presentation requirements for funds. The financial statements just plain look different!

Not only are the names different, with statements like the “Statement of Operations” or “Statement of Assets and Liabilities”, but there are also additional schedules and information not seen in typical industries. Also, a Statement of Cash Flows may or may not be presented depending on whether certain criteria are met.

Some of the most noticeable differences, other than nomenclature, is the inclusion of the following items and schedules:

• Net asset value (NAV) and NAV per share – This statistic represents the value of the fund for investors, and in the case of NAV per share, the value of each share at the reporting date. ASC 946 requires these amounts be included in the Statement of Assets and Liabilities or Statement of Net Asset (whichever is provided by the fund), and by class of investors.
• Schedule of Investments (SOI) – This is typically a separate schedule in the financial statements (although for registered funds, it may be included as part of the Statement of Net Assets) and reports the investment portfolio of the fund. ASC 946 contains specific rules, often complex, regarding its presentation and when investments must be reported separately from other investments. There are also unique reporting requirements for registered vs. unregistered/ private funds.
• Financial Highlights (FiHis) – The FiHis are either presented as a separate schedule in the financial statements or within the footnote disclosures and represent the key performance indicators (KPIs) of the fund. FiHis can be broken down into the following categories:
  • Per share data (e.g., investment income/loss, realized/unrealized gains or losses, distributions to shareholders, capital items, etc.)
  • Ratios (e.g., expenses to average net assets and investment income to average net assets)
  • Total return (or internal rate of return for certain funds)
  • Turnover (only applicable to registered funds)

ASC 946 has very prescriptive rules regarding the information to be presented and how it is to be calculated, therefore, care should be taken when preparing the FiHis.

The purpose and importance of these unique schedules and disclosures is quite obvious as this information is of utmost importance to an investor trying to determine whether they want to invest (or continue to invest) in a particular fund. Therefore, focus is often on these unique presentation items by auditors, regulators, and investors.

U.S. GAAP’s ASC 946 Financial Services – Investment Companies contains industry-specific accounting and reporting guidance for investment companies (the U.S. GAAP for funds), while IFRS has only limited industry-specific guidance in the form of a few scope exceptions. It should be noted that ASC 946 is to be used in conjunction with the other topic sections of U.S. GAAP. However, this leads to many potential differences between U.S. GAAP and IFRS, some more significant and common than others. Below we focus only on what we consider some of the most significant differences commonly encountered by funds.

For more comprehensive coverage of differences between the two, refer to the thought leadership provided by the Big 4 accounting firms. See the Accounting Resources section below for links. Additionally, GAAP Dynamics offers a “GAAP Differences” course that can be facilitated via webinar or in-person – contact us for details.

Join the Revolution with GAAP Dynamics!

Due to the specialized nature of the investment management industry, CPE eligible accounting training specific to investment companies and funds is practically non-existent! GAAP Dynamics recognized this void and designed a comprehensive training program, our Investment Management Industry Fundamentals Collection. This collection is in addition to our full library of U.S. GAAP and IFRS eLearning courses which can be found on our online eLearning platform, The Revolution. Our courses are continually updated and new courses are constantly being added, so check back often!

Investment Management Industry Fundamentals: Industry Overview - Part of the "Investment Management Industry Fundamentals" learning path, this CPE-eligible, eLearning course (1.0 CPE) provide you with an overview of the investment management industry and an introduction to the applicable accounting guidance for investment companies in accordance with U.S. GAAP (ASC 946). As you tour the investment company landscape, the following topics will be discussed: characteristics of an investment company, investment strategies, general categories, capital and legal structures, key players (service providers), definition of an investment company in U.S. GAAP, overview of applicable U.S. GAAP accounting guidance. This online course also explores the fundamental differences between U.S. GAAP and IFRS related to investment company accounting. This course is a must for anyone beginning to work in the investment management industry and serves as the starting point for our online Investment Management Industry Fundamentals course collection.
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Investment Management Industry Fundamentals: Investments - Part of the “Investment Management Industry Fundamentals” learning path, this CPE-eligible, eLearning course (2.0 CPE) begins with an overview of typical investments held by investment companies. This online course then takes a deeper dive into the accounting and reporting requirements for investments in equity securities, debt securities, and alternative investments. With the investments line item being so important to entities in the investment management industry, this course is a must for accountants in this industry!
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Fair Value: Overview of ASC 820 - Do you realize that fair value is one of the most widespread financial concepts in U.S. GAAP? As such, this course is a must for any accountant or auditor! After a review of the various balance sheet items which utilize fair value measurements, this CPE-eligible, eLearning course (1.5 CPE) explores key concepts of fair value including: Utilizing market participant assumptions, distinguishing between orderly transactions versus forced transactions, using exit prices and not entry prices, and determining the principal market. This online course then discusses the various approaches to determine fair value measurements, including the importance of inputs and their classification within the fair value hierarchy. The course concludes with a look at "real-life" fair value disclosures, highlighting the disclosure requirements within ASC 820.
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Fair value: Advanced Issues - Now that you have a good understanding of fair value accounting in accordance with ASC 820 Fair Value Measurements, it’s time to take you knowledge to the next level! The second course in our Fair Value Measurement series, this CPE-eligible, eLearning course (1.5 CPE) dives into advanced fair value measurement issues. Level up your fair value measurement accounting knowledge with advanced topics such as distinguishing, active, inactive and disorderly markets, using net asset value (NAV) as a practical expedient to fair value, and considerations when determining the fair value of liabilities. This online course is a must for any accounting, but especially those responsible for financial reporting or auditing financial institutions.
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Investment Management Industry Fundamentals: Transactions with Service Providers - Part of the "Investment Management Industry Fundamentals" learning path, this CPE-eligible, eLearning course (1.5 CPE) explains who the typical service providers of an investment company are and how they are compensated, highlighting the fact that most of the functions of an investment company are performed by these service providers. Typical fee arrangements are covered in this online course, with particular focus on the accounting for management fees and distribution fees. Fee waiver, reimbursement, and expense offset arrangements are also discussed along with their presentation in the U.S. GAAP financial statements.
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Investment Management Industry Fundamentals: Transactions with Unit Holders - Part of the "Investment Management Industry Fundamentals" learning path, this CPE-eligible, eLearning course (1.5 CPE) describes how capital share transactions are accounted for by an investment company in accordance with U.S. GAAP, along with the accounting for other fees incurred by unit holders related to capital share transactions. In addition, this online course explores the common capital structures utilized by investment companies, including the key impacts those structures have on the U.S. GAAP financial statements.
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Investment Management Industry Fundamentals: Financial Reporting - Part of the "Investment Management Industry Fundamentals" learning path, this CPE-eligible, eLearning course (1.0 CPE) explains the financial reporting requirements for investment companies under U.S. GAAP, for both registered and non-registered funds. It focuses the financial reporting requirements under U.S. GAAP that are unique to investment companies. This online course covers the following topics: statement of assets and liabilities, statement of net assets, schedule of investments, statement of operations, statement of changes in net assets, statement of cash flows, financial highlights, special considerations for different capital structures. A final case study provides you with an opportunity to apply what you’ve learned to identify errors in an example set of financial statements. This case study is a "choose your own adventure" where you can choose whether to identify errors in the financial statements of a registered investment company or a non-registered investment company. Differences in financial reporting requirements between U.S. GAAP and IFRS are also highlighted.
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We’ve bundled all these eLearning courses into a US GAAP investment management industry fundamental course collection for big savings! This post discusses each course in the collection.

U.S. GAAP Update: Investment Management (2021) - The investment management (IM) industry is unique. Therefore, your annual IM training should be too! In this CPE-eligible, eLearning course (2.0 CPE), we cover the latest developments in U.S. GAAP related to the various funds and other players that make up the IM industry, including hot topics in accounting and reporting related to the industry. If you're a financial preparer or an auditor of funds reporting under U.S. GAAP, this online course is for you!
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IFRS Update: Investment Management (2021) - The investment management (IM) industry is unique. Therefore, your annual IM training should be too! In this course (2.0 CPE), we'll cover the latest developments in IFRS related to the various funds and other players that make up the IM industry, including hot topics in accounting and reporting related to the industry. If you're a financial preparer or an auditor of funds reporting under IFRS, this course is for you!
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Fair Value Hierarchy Advanced Issues - One of the main disclosure requirements of ASC 820 Fair Value Measurements is the fair value hierarchy. Such disclosures help users of the financial statements understand the inputs used to measure the fair value of financial instruments. In this CPE-eligible, microlearning course (0.2 CPE), we discuss the fair value hierarchy implications of “off-the-run” U.S. Treasury bonds, bonds priced using matrix pricing, and centrally-cleared derivatives.
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Fair value: Restrictions on the Sale of Assets - How should fair value be applied to assets whose sale is restricted? After reviewing the definition of fair value and the requirement within ASC 820 to consider market participant assumptions, this CPE-eligible, microlearning course (0.2 CPE) presents a case study focused on determining whether a restriction is "entity-specific" or "security-specific."
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In addition to these courses specific to the investment management industry, we offer additional courses on various U.S. GAAP and IFRS topics, some of which may apply to funds from time to time.

There are numerous resources available when it comes to accounting for transactions encountered by the investment management industry. To save you time searching, we have compiled a list of resources below to assist you in your research.

Resources from GAAP Dynamics:

We have written several blogs on a variety of topics frequently encountered by the investment management industry, which are listed below. Click on the links to view the full blog post.

Accounting for Investment Companies under ASC 946: An Overview
This blog post provides an overview of our Investment Management Industry Fundamentals eLearning track, summarizing each of the courses and what is covered.

Impact of Underwriter Lock-Ups - Fair Value of Equity Securities
Private equity funds often hold investments in equity securities that have underwriter lock-ups for a period of time upon the investment going public. This post focuses on the evolving interpretations of how to determine fair value of these types of instruments.

It’s Not Always Easy to Look Through a Fund-of-Funds
Preparing a Schedule of Investments for a fund-of-funds requires extra considerations, including whether the fund-of-funds needs to “look-through” its investee funds at the individual investments they hold. This blog addresses this unique requirement under ASC 946.

Investment Companies are Special… So is their Accounting!
This post highlights the unique industry that is investment management and some of the key accounting and reporting differences from traditional companies.

Readily Determinable Fair Value: Updates and The Use of Net Asset Value
Using NAV as a practical expedient to fair value is common in the investment management industry, however, it is only allowed under U.S. GAAP if certain criteria are met. One of these criteria is that the investee fund does not have a readily determinable fair value. This post discusses exactly what that means.

Control Premiums – Do They Count?
Private equity and hedge funds may hold a controlling equity interest in an investee. We know that investment companies do not consolidate these investments, but should a control premium be considered when estimating fair value? This blog addresses this specific issue!

Cryptocurrency Accounting for Investment Funds: U.S. GAAP vs. IFRS
Cryptocurrencies are becoming more and more prevalent, particularly in the investment management industry. But how are they accounted for and is there a difference between U.S. GAAP and IFRS? The answer in this blog post may surprise you!

The FASB Doesn't Like Bad Surprises... So You'd Better Avoid Them!
ASU 2017-08 impacts the way callable debt securities acquired at a premium must be accounted for. Investment companies holding significant debt portfolios are likely to be impacted by this guidance. This blog tells you what you need to know to be ready.

Going Negative – Accounting for Investments with Negative Yields
In this extremely low interest rate environment, some funds are being faced with investments that hold negative interest rates! How are this accounted for? This blog post has got you covered.

Variation Margin: Accounting for Derivatives under ASC 815
Many derivatives are now required to be centrally-cleared through an organization that collects variation margin payments from the parties to the contract. This blog highlights the latest news on how these variation margin payments impact the recognition and measurement of derivative contracts.

COVID-19 & Investment Companies: New Virus, Same Old Accounting Issues
The pandemic has affected everybody in many different ways and the investment management industry is no exception. This blog highlights some of the accounting and reporting issues impacting the investment management industry.

Updates are Not One-Size-Fits-All – Investment Companies are Special!
This post highlights our approach to training for the investment management industry and our focus on industry-specific updates. What is new in the investment management industry and what does our update course cover? Check out our blog to find out.

We publish blog posts regularly on various accounting topics and issues relevant to the investment management industry. If you want to stay updated by receiving an email notification as new blog posts are published, you can subscribe to our blog here: Subscribe to GAAPology

Resources From the FASB and IASB:

• ASC 946 Financial Services – Investment Companies – This link will take you to the authoritative guidance.
• ASC 820 Fair Value Measurement – This link will take you to the authoritative guidance.
• IASB IFRS 9 Implementation Page – This link will take you to the landing page resources on the implementation of IFRS 9, Financial Instruments.

External Resources:

• AICPA Investment Companies Expert Panel – The Investment Companies Expert Panel protects the public interest by bringing together knowledgeable parties in the investment companies industry to deliberate and come to agreement on key investment companies issues.
• AICPA Audit and Accounting Guide – Investment Companies – This Guide issued by the AICPA represented industry guidance under U.S. GAAP prior to the codification in ASC 946. The Guide continues to be updated and issued, providing valuable insight into the investment management industry and the related accounting and audit issues.
• AICPA Accounting and Valuation Guide - Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies – Provides non-authoritative guidance and illustrations regarding the accounting for, and valuation of, portfolio company investments held by investment companies within the scope of FASB ASC 946, Financial Services-Investment Companies.

U.S. GAAP

• KPMG’s Alternative Investments Illustrative Financial Statements 2020
• CohnReznick’s Hedge funds: Illustrative Financial Statements
• CohnReznick’s Private Equity: Illustrative Financial Statements

IFRS

• KPMG’s Illustrative disclosures for investment funds
• PwC’s Illustrative IFRS financial statements 2019 – investment funds
• EY’s Investment fund illustrative financial statements