Investment companies, whether under ASC 946 (U.S. GAAP) or IFRS 10, generally account for their investments at fair value through earnings. As you can imagine, fair value measurement, and particularly its nuances when applied to the funds industry, is a focus in our Investment Companies baseline training program. Investments held by private funds, such as private equity or venture capital funds, are faced with particularly challenging issues given the types of investments they hold. 

One unique issue involves investments where the fund holds a controlling financial interest in its investee.  Consider the following scenario:

Let’s analyze this example. First, why might the size of Padre’s holding alter the market price on the measurement date? What we are getting at here is whether it makes sense that a “control premium” should be included in the valuation of the investment. In other words, not only does Padre hold the rights to 75% of the risks and rewards of the investee, but they also have the right to control the investee (i.e. ability to single-handedly make decisions that significantly impact the economic performance of the investee). While this is clearly an added benefit for Padre Fund, it is not necessarily clear whether a control premium should impact the ultimate fair value measurement of the investment under U.S. GAAP or IFRS.

Remember, both ASC 820 and IFRS 13 require us to consider a “market participant’s perspective” when assessing fair value. So, we must consider the value of an equity interest in Niña from a typical market participant’s perspective. We also must make this determination at the proper “unit of account”.

Unit of account is defined by ASC 820 as the level at which an asset or a liability is aggregated or disaggregated for recognition purposes. Although the concept is explicitly introduced in these standards, the actual unit of account is determined in accordance with the relevant standard that requires or permits the fair value measurement. In many cases, the unit of account can be inferred. However, for a financial asset that is an investment in a subsidiary, JV, or associate, it is not clear. In this case, the unit of account could be identified as an “individual share” or could be considered the entire 75% (block) holding.

Neither U.S. GAAP nor IFRS are clear as to how this investment should be recognized, but it’s not for lack of trying! 

The IASB got closest to addressing the issue in 2014 when the IASB issued an exposure draft that concluded that the unit of account for these types of holdings is the entire investment; however, they also decided that fair value for subsidiaries, JVs, and associates actively traded should be the product of the quoted price multiplied by the quantity of financial instruments. Since the exposure draft, a diversity of feedback was received and in January 2016, the IASB decided to await the results of the IFRS 13 Post-Implementation Review before moving forward with any decisions on this issue. There has been no guidance since.

U.S. GAAP remains silent on this issue, although the SEC has stated that they believe that in certain situations, the unit of account could be considered the entire holding and therefore a control premium may be appropriate when determining fair value. The AICPA’s Audit Risk Alert (2013/2014): Investment Companies Industry Developments also discusses this issue and concludes that “all available evidence about how a market participant would exit the investment” shall be considered given the lack of clear guidance, but that in certain instances the entire holding may be considered the unit of account.

At the heart of this issue is identification of the typical unit of account a market participant would be expected to deal in when transacting in the particular security. In the case of an exchange-traded share, it would be hard to argue that a typical market participant would transact in any unit of account other than the individual share level. However, in the case of a private investment that is not exchange traded, the unit-of-account may be broader, including the entire holding. This might be the case if Padre determines that the prospective buyers of its investment in Niña would be interested in acquiring a controlling financial interest.

This analysis will obviously require judgement and careful analysis. While we don’t have definitive guidance yet, the AICPA may add to the guidance with the release of its forthcoming accounting and valuation guide, Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. While this guide is still only in draft form, a final version is expected later this year where more guidance is expected to address this issue.

Keep your eyes out for this guidance or check back again to see if we can uncover more guidance on this issue.

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.