Investment companies are special… So is their accounting!
Investment companies are special… So is their accounting!

Investment companies are special… So is their accounting!

Hedge funds, private equity, mutual funds… all of these types of entities fall under the “accounting umbrella” we call investment companies. And due to the unique needs of the users of the financial statements of these entities, U.S. GAAP and IFRS provide special rules and accounting and reporting exceptions. In U.S. GAAP, ASC 946 covers a variety of special rules for both recognition and measurement of typical transactions entered into by these entities, as well as very unique financial reporting requirements.

Some of my favorite training sessions I’ve given have been the first time I’ve run an investment company-specific training in a location known for investment companies, such as Ireland or the Cayman Islands. Participants have grown accustomed to taking generic training courses which provide only a fraction of relevant content to this industry. The accounting and reporting issues are so unique and widespread that only investment company-specific training will be worth the time spent. That’s why over the years we have developed both a baseline training program for investment companies, as well as annual updates covering the latest accounting developments and hot topics in the industry. And we've just released an online, comprehensive eLearning program - Investment Management Industry Fundamentals!

The unique accounting rules for investment companies can be major changes from typical accounting or more subtle ones.  Let’s take a look at example of both:

  • Consolidation accounting for investment companies is largely non-existent - Assume a private equity fund holds a 75% interest in a start-up organic farming operation. Rather than consolidating this investment, a fund instead measures the investment at fair value with changes in fair value through earnings.  Why?  Well, think about this from the perspective of an investor in the fund. Do they really want to see tractors, fertilizer, and produce consolidated in the fund’s financial statements or do investors just want to know the best estimate of the fair value of this fund’s investment?  Probably the latter!  As a result, both U.S. GAAP and IFRS exclude investment companies from applying the consolidation guidance for their investments held.  The only possible exception to this rule relates to investment companies’ interests in other investment companies where, under U.S. GAAP, consolidation may be appropriate in limited circumstances.
  • Transaction costs on purchases of investments – ASC 820 specifically states that transaction costs are to be excluded from fair value measurements. Therefore, any investment measured at fair value would recognize the costs of transacting as a separate charge in the P&L.  Investment companies under U.S. GAAP, however, treat transaction costs a little differently. Although investments are required to be measured at fair value, with changes in fair value through the income statement, ASC 946 also states that initial recognition of an investment should be at the transaction price (which includes transaction costs). The result is that these transaction costs are captured as a “day 1” unrealized loss in the income statement! Note also that this represents a difference with IFRS which treats transaction costs in a manner similar to ASC 820 (i.e. expense separately when incurred).

 

Speaking of U.S. GAAP and IFRS differences, there are many when it comes to accounting and reporting for investment companies. The reason stems from the fundamental difference that U.S. GAAP has historically been willing to provide industry-specific accounting guidance, where IFRS has always prided itself as being a principle-based set of accounting standards and have shied away from offering industry-specific alternatives.  While over the years certain scope exceptions have appeared in IFRS for investment companies, it has mostly held true to this consistent approach.

 As a result of this fundamental difference between GAAPs, when it comes to financial statement presentation, U.S. GAAP financial statements for investment companies look very different, while IFRS financials look more like  traditional financial statements.

 For instance, the names alone of an investment company’s primary financial statements are unique:

  • An investment company’s balance sheet is called the “Statement of Assets and Liabilities”
  • An investment company’s income statement is called the “Statement of Operations”
  • The statement of cash flows is called the “Statement of Cash Flows”, but an investment company may be exempt from including this statement if certain conditions are present
  • Finally, the statement of changes shareholders’ equity is called the “Statement of Changes in Net Assets” which also serves the function of providing a rollforward of the equity accounts

In addition to these primary financial statements, there are additional schedules required to be presented including:

  • The Schedule of Investments – this statement provides a listing of a fund’s investment portfolio, divided up by type of investment, industry, and geography. Certain investments meeting minimum size thresholds in relation to the fund’s total net assets must be presented separately. Rules regarding separate presentation and format are quite specific and special care should be given to this schedule given its obvious importance to investors
  • Financial highlights – This schedule provides a number of key performance indicators of a fund, including per share data, key ratios, and other pertinent information. “FiHi’s” are presented for each class of shares covered by the financial statements and have specific rules on how amounts are to be calculated
  • Attached financial statements – Some investment companies may incorporate unique capital structures. One common structure is the master-feeder, in which “feeder” funds offer shares to investors and hold only one investment in a “master” fund. This structure is commonly used to achieve desired tax outcomes, allowing investment by both onshore and offshore investors. Financial statements for these structures are often required to include both the complete financial statements for the feeder fund, as well as attached financial statements of the master fund.

And these unique issues are just scratching the surface. Investment companies are unique entities and carry a number of accounting and reporting considerations specific to only these types of entities. If you are an administrator, auditor, or user of these financial statements, it is important to know the special accounting and reporting requirements under ASC 946 for U.S. GAAP and the scope exceptions and industry practices under IFRS. 

Morale of the story: You need to know where to find this industry-specific guidance and don’t accept generic training… you’re too special for that!

Disclaimer

This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.

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Comments (2)

  1. Erich:
    Sep 23, 2019 at 06:30 PM

    Regarding private equity funds, if you are a RIA, is there a requirement to consolidate blocker activity on the fund financial statements? Is there any GAAP or SEC requirement for that?

  2. Mike Walworth, CPA:
    Oct 22, 2019 at 10:06 AM

    In short, there is no specific guidance in GAAP for non-registered funds, except that in general investment companies do not consolidate direct investments or investments in other investment companies. SEC has clarified that the best presentation for a master-feeder or a fund-of-funds is to not consolidate the funds that they are invested in. This would include blockers. Since this guidance is specifically from the SEC, while generally most funds follow this guidance, since this guidance does not extend to non-registered funds, from time-to-time we do consolidation of funds by these entities. It's not common, but you do see it. Hope it helps!


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