One of the interesting things about investment companies under ASC 946, and a focus in our Investment Management Industry Fundamentals baseline training program, is the unique financial reporting requirements that are unlike those of any other industry. Due to the obvious focus on investments, U.S. GAAP requires a Schedule of Investments (or SOI) to be presented. Specifically, for private funds (i.e. investment partnerships not registered with the SEC), investments must be categorized and presented by type of investment (e.g. common stocks, preferred stocks, convertible securities, fixed income securities, etc.), country or geographic region, industry, and derivatives (by broad category of underlying). Each investment that represents more than 5% of net assets must be presented separately within those categories.

A fund-of-funds (or FoF) is an investment company that invests primarily in investment companies. When preparing the SOI for a FoF, some interesting presentation issues arise. 

First of all, when a FoF, or any investment company for that matter, has an investment in another fund, for purposes of the SOI, that direct investment in the fund is considered the investment for purposes of complying with all the categorization and individual presentation requirements.

But does this requirement provide enough transparency to understanding the investments and exposure for a fund? Are the underlying investments held by the investee fund important information that should be disclosed? ASC 946 says…maybe!

As we’ve already noted, although the general principle is that the direct investment in the investee fund is considered “the investment” for purposes of preparing a SOI, a separate “look-through” consideration must be given for investments in other funds. ASC 946-210-50-9 requires that indirect investments (i.e. those investments held by the investee funds held by a FoF) whose proportional share ownership represent more than 5% of the reporting entity’s net assets be either included in the SOI or in a note to the schedule.

For example, let’s assume a FoF has net assets of $1 million. If they hold a 20% interest in Fund A and that fund holds an investment in a Company X common stock with a fair value of $300,000, the investment in Company X would be required to be presented/disclosed separately as a result of the “look through” requirement (i.e. $300,000 x 20% = 60,000, which is greater than $1 million (net assets) x 5% (or $50,000)).

This requirement seems reasonable, but often presents some interesting application issues.  Let’s take a look at just a couple quick ones:

1. The first issue is purely an administrative one. Let’s assume the FoF has a reporting date of December 31 and has an investment in an investee fund that also has a December 31. Do you see a problem? By the time audited financial information is available for the investee fund, it may be too late for the FoF to consider and prepare its own financial statements. When considering this issue, note that ASC 946 states that “if information about the investee’s portfolio is not available, that fact shall be disclosed”; however, this “out” should not be used without contemplation. The FoF may consider disclosing interim or unaudited information and note this in the disclosure as this may be more useful to the users of the financial statements. Obviously, judgment will need to be applied here largely based on the significance of the investment.
2. The next issue is a little more complicated. Consider this example from one of the courses in our Investment Management Industry Fundamentals series:

ASC 946 does not specifically address the issue highlighted in this example and only provides the principle already covered above. Therefore, judgment will need to be applied and an accounting policy will need to be developed by the fund. Two arguments that can be made to this scenario include:

• Kramerica should be viewed as one combined investment between the two funds for the purposes of presenting in the SOI. If the purpose of the “5%” rule is to highlight those indirect investments where the entity has a particularly large “exposure”, then aggregation would be appropriate to report this indirect exposure.
• Kramerica should not be aggregated into one combined exposure because the purpose of the “5%” rule is to highlight a fund’s “influence” over an investment through its indirect ownership. In this case, because the indirect interest in Kramerica is held more than one fund, there is no additional “influence” that Cosmo has over the investment, assuming both investments in Pennypacker and Van Nostrand are separately controlled entities.

A case could be made for both of these alternatives as ASC 946 does not specifically address this issue. Therefore, FoF’s (and similar funds) should make an accounting policy choice that is applied consistently, when addressing this issue. In my experiences working with various fund administrators and auditors in the industry, if the information is available, the aggregation argument seems to hold more water and is seen as a preferable policy. Generally speaking, users of a fund’s financial statements are interested in the value and diversification of the investments held by the fund and therefore, even though an exposure is aggregated through multiple investee funds, the exposure is still real.

So, that is a quick look at the “look-through” test for FoF’s. There are plenty of other strange issues that may arise when applying this requirement or others related to the SOI. But we will save that for another blog!

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.