Sometimes it’s the simplest of transactions that present some of the bigger challenges to the accounting and reporting for investment companies under ASC 946. In this blog we begin to tackle distributions made by investments in a fund and how they are accounted for – as dividend income or something else. This is a fundamental accounting question which we incorporate in our Investment Management Industry Fundamentals collection, but the nuances of this issue seem to always pop-up making some aspect of the issue a regular topic in our Update courses each year, whether the issue be one of U.S. GAAP or IFRS.

To put these issues in perspective, let’s look at our first simple example:

Omicron Fund holds an equity investment in Delta Ltd. On December 1, Omicron receives $10,000 cash from Delta. How should this $10,000 be accounted for?

At first glance, this question seems easy enough; it’s a dividend and accounted for as dividend income by Omicron Fund:

Dr. Cash   $10,000

   Cr. Dividend income (P&L)    $10,000

Dividends are a common way for investees to provide investors with a return “on” their investment. While this may be the most common conclusion, it is not the only possibility; the payment could be a return “of” the investment. In other words, a return of capital (ROC).

A ROC is when an investee begins to divest itself of its capital in a form of downsizing. If the cash received represents a ROC, there is no P&L impact, and the cash is simply offset against the cost basis of the investment:

Dr. Cash $10,000

   Cr.  Investment in Delta   $10,000

Big difference, right? But how is Omicron supposed to determine whether a distribution from its investee is a dividend or a ROC?

There is no explicit guidance in U.S. GAAP or IFRS on “how” to make this distinction and therefore judgment will need to be applied. Approaches to make this determination might include:

• Documented reason for distribution: In some instances, an investee might specify whether the distribution represents a dividend or ROC, but be careful as this is not always the best source of definitive proof, by itself, as it generally should be supported by more substantive information.
• Look-through the investment for the “reason” for the distribution: ROCs are often strategic in nature and the result of a significant change in business strategy. For example, a restructuring or major sale of part of the business might result in a decision to return capital to shareholders.
• Accumulated earnings: A more quantitative approach would be to consider the distribution in relation to the accumulated earnings of the investee. In other words, let’s assume over the period in which Omicron has owned Delta, accumulated earnings have been $200,000 and Omicron holds a 10% stake in Delta. In this scenario, Omicron’s proportionate shares of accumulated earnings for the period is $20,000. The fact that the distribution received was $10,000 indicates that it came from the entity’s accumulated earnings and therefore can be considered a dividend (return on its investment). If accumulated earnings had been less than $100,000, there would be significant cause to believe it was all (or most likely, partially) a ROC.

But the issues don’t stop there. Let’s assume the distribution was not made in cash, but instead by the transfer of stock in one of Delta’s investees, N95 Corp. And the fair value of stock received is, again, $10,000.

Normally, such a transaction is considered a non-cash dividend, fulfilled with the transfer of a financial asset. The transaction would simply be accounted for as follows:

Dr. Investment in N95 Corp.   $10,000

     Cr.  Dividend income (P&L)                     $10,000

Notice that the non-cash is measured at fair value at the time of the distribution with the offset to dividend income in the P&L.

But what else could this transaction represent? A spin-off! Sometimes, companies grow and as parts of its business become more independent and unique from its parent, it may make sense to break the entities up into two separate investments.

Spin-offs are addressed in U.S. GAAP in ASC 505-60 and defined as “the transfer of assets that constitute a business by an entity (the spinnor) into a new legal spun-off entity (the spinnee), followed by a distribution of the shares of the spinnee to its shareholders, without the surrender by the shareholders of any stock of the spinnor.” Accounting for spin-offs does NOT impact the P&L, but rather simply reallocates the cost of the original investee (i.e., Delta) into the two new investees (i.e., Delta and N95). In other words, the transaction would be accounted for as follows:

Dr. Investment in N95 Corp.  $X,XXX

    Cr.  Investment in Delta                  $X,XXX

Note that IFRS is silent with regards to accounting for spin-offs and therefore judgment will need to be applied to properly account for them (e.g., either no P&L impact similar to U.S. GAAP or as a non-cash dividend).

So how do we determine whether the distribution is a non-cash dividend or a spin-off? Once again, the guidance is non-existent, and judgment will need to be applied. Some factors that might want to be considered include:

• Was transaction part of a general reorganization – like our last analysis, if the transaction was part of larger reorganization or restructuring, a strategy may have been made to break the entity into parts alluding to a spin-off taking place.
• Significance of ownership distributed – Spin-offs generally only involve investees that are “controlled” by a parent. The higher the percentage of ownership, the more likely the parent can execute a spin-off as it has the ability to act unilaterally. If Delta only owned a relatively minor stake in N95, its unlikely to meet the definition of a spin-off.
• Consideration of the strategic nature of the transaction – Looking deeper into the “why” such a distribution was made and specifically the goals of the distributor (i.e., Delta) may lead to a determinative answer to what the distribution represents.

As you can see, a simple distribution can lead to several accounting and reporting issues. So before jumping to any conclusions, take a moment to consider the alternatives. While most distributions may be straightforward and obvious, occasionally you may run into a tricky one and this is when your judgment and documented support will be required to properly conclude on the transaction. Good luck out there!

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