Would the proposed definition of an investment entity affect you?

ey.com/IFRS
May 2012
IFRS Practical
Matters
The IASB’s proposal would
require investment entities,
as defined, to measure all
controlled investments at
fair value. This may mean
that some entities in a
group will no longer need
to be consolidated.
Would the proposed
definition of an investment
entity affect you?
How things stand now on the IASB’s investment entities project:
• Six requirements to qualify as an investment entity have been introduced. All six
criteria must be met in order for the entity to qualify as an investment entity
• Investment entities would have to measure all controlled investments at fair value
through profit or loss, and would be prohibited from consolidating those
investments
• An entity that holds a single investment or has a single investor generally would
not meet the definition of an investment entity
• A parent of an investment entity that is not an investment entity itself would be
required to consolidate controlled investees (this differs from the FASB’s proposal)
• Entities currently permitted to measure investments in joint ventures or
associates at fair value through profit and loss, but which do not meet the
definition of an investment entity, would no longer be able to use fair value
through profit and loss to account for such investments
Why propose an exception to consolidation for investment entities?
As part of the deliberations that ultimately led to the issue of IFRS 10 Consolidated
Financial Statements, the IASB received many letters noting that, in the case of investment
entities, rather than enhancing decision-useful information, consolidating controlled
investments actually obscures such information. Users of investment entity financial
statements stated that the practice by some funds to account for their underlying
investments at fair value provided them with the most decision-useful information.
This feedback was persuasive and the IASB and the FASB decided to begin a joint project
to deal with the issue, although they each had issued separate exposure drafts (EDs) — the
FASB issued Financial Services — Investment Companies, Amendments to the Scope,
Measurement, and Disclosure Requirements (Topic 946). The Boards’ aim was to work
towards a converged definition of an investment entity based on the definition in current
US GAAP and other non-authoritative guidance (the concept of an investment entity does
not exist under IFRS).
The IASB’s proposal, if finalised, would
amend IFRS 10 to require investment
entities to measure all controlled
investments at fair value. This proposal
helps address what many in the asset
management and private equity industries,
and users of their financial statements,
believe is a significant problem with the
current consolidation requirements in IFRS.
How would an investment entity
be defined?
Under the proposed guidance, there are
six criteria that would be assessed to
determine whether an entity is an
investment entity. These criteria are
discussed below:
• Nature of investment activity — The
entity’s only substantive activities are
investing in multiple investments for
capital appreciation, investment income
(e.g., dividends or interest) or both.
• Business purpose — The entity makes an
explicit commitment to a group of
investors that its purpose is investing to
provide returns from capital appreciation,
investment income or both. To meet this
requirement, the entity would need to
have an exit strategy for its investments.
• Unit ownership — Ownership in the
investment entity is represented by units
of investments, such as ordinary shares
or partnership interests, to which a
proportionate share of net assets are
attributed.
• Pooling of funds — There must be
substantive pooling of investors’ funds
in order for the investors to avail
themselves of professional investment
management services. Investors must
be unrelated to the investment entity’s
parent (if any), and must, in aggregate,
hold a significant ownership interest in
the entity.
2
• Fair value management — Substantially
all of the investment entity’s investments
are managed, and their performance
evaluated, on a fair value basis (IFRS 13
Fair Value Measurement defines ”fair
value” and describes how to measure it).
• Provides financial information — The
investment entity provides financial
information about its investment
activities to its investors. The entity can
be, but does not have to be, a legal entity.
The assessment of whether an entity
qualifies as an investment entity would need
to be performed at each reporting date.
Who would be affected by the
proposed definition?
Entities such as mutual funds, private
equity funds, hedge funds, venture capital
funds, sovereign wealth funds, pension
funds, endowment funds, and certain real
estate funds may meet the proposed
definition of an investment entity.
Entities that, by design, may have only one
single investor (such as those types of
entities mentioned above) may not qualify
as investment entities, because of the
criterion that requires them to have
multiple unrelated investors.
In addition, entities that, by design, hold
only one investment may not meet the
definition of an investment entity. There
would be an exception to the single
investment requirement for master-feeder
structures and blocker entities used to
facilitate investments. The IASB decided
that an investment entity may hold a single
investment in circumstances in which it
is formed in conjunction with another
investment entity that holds multiple
investments (directly or indirectly) and
meets all other criteria. Generally, these
are investment entities formed for legal,
regulatory, tax or other reasons.
IFRS Practical Matters — Would the proposed definition of an investment entity affect you?
Impact on joint ventures and associates
As a consequential amendment, the IASB
is proposing changes to the accounting
for joint ventures and associates.
Under current IFRS, venture capital
organisations, mutual funds, unit trusts,
investment-linked insurance funds and
similar entities have a choice as to
whether to use fair value through profit
or loss, or the equity method.
The IASB is proposing to remove this
choice. Investment entities (as defined) will
be required to measure investments in
associates and joint ventures at fair value
through profit and loss, because one of the
qualifying criteria for an investment entity
requires that substantially all of its
investments are managed on a fair value
basis. If an entity does not qualify as an
investment entity, it will no longer have the
option to use fair value through profit or
loss for its investments in joint ventures
and associates — it will have to account
for them using the equity method.
Disclosures
The proposal would require significant
disclosures, including the following:
• Information to enable users to evaluate
the nature and financial effects of the
entity’s investment activities
• Effect of any changes in status as an
investment entity
• Financial or other support provided to
controlled investments
• The nature and extent of any significant
restrictions on the ability of controlled
investees to transfer funds to the
investment entity.
An investment entity would still need to
apply the disclosure requirements of
other IFRSs where relevant. For example,
according to IFRS 13, an investment entity
would be required to disclose the fair value
for each material investment using the fair
value hierarchy.
The disclosures required by IFRS 12
(effective 1 January 2013) will also need
to be provided. However, consideration
should be given as to whether all of the
summarised financial information required
by IFRS 12 is necessary, especially since
the fair value of investments and the
inputs into those fair values are required
to be disclosed.
Transition
The proposals require that, if an entity
meets the definition of an investment
entity, it must recognise the effect of
adopting the measurement exception as
of the beginning of the period that it first
applies the proposed exception, as an
adjustment to retained earnings. This
adjustment would be for the difference
between: (1) the previous carrying amount
of the net assets of the investee; and (2)
the fair value of the investee as of the date
of first applying the IFRS, adjusted for any
changes in the fair value of investees that
still remain in accumulated other
comprehensive income.
How do the proposed changes
differ from US GAAP?
The Boards are proposing a largely
consistent definition for an investment
entity, although there would be accounting
and reporting differences. For example,
similar to the FASB’s proposal, the IASB’s
proposal would require an investment
entity to account for its investments at fair
value. However, unlike the FASB proposal,
the IASB would prohibit an investment
entity from consolidating its controlled
investees; i.e., fair value measurement of
controlled investments is not a choice.
Unlike the FASB’s proposal, the IASB’s
proposal would also prohibit the retention,
or roll-up, of fair value investment entity
accounting by a non-investment entity
parent. Instead, the IASB’s proposal would
require consolidation of all controlled
investees in accordance with relevant
accounting guidance. In its Basis for
Conclusions to the ED, the IASB raised a
concern that a parent may use the
exception to structure its group to achieve
a particular result. Therefore, to prevent
abuse, the IASB proposed that there should
be no fair value accounting roll-up for a
non-investment entity parent.
What are the IASB’s next steps?
The comment letter deadline for the ED
was 5 January 2012. In February and
March, the IASB and the FASB held four
round-table meetings around the world to
discuss the investment entities proposals
with interested parties. The Boards began
discussing the comments received in the
comment letters to the ED in April 2012.
IFRS Practical Matters — Would the proposed definition of an investment entity affect you?
3
What does the proposal mean for
your company now?
Management judgements
While the criteria included in the proposal
may, at first, appear relatively
straightforward, it is not entirely clear how
some of them should be interpreted, which
has led respondents to the exposure draft
to ask the IASB for clarification. How the
criteria are interpreted could change
whether an entity is or is not deemed an
investment entity.
For example, the proposed “fair value
management” criterion could be interpreted
in different ways. On one hand, fair value
management could be interpreted as
applying to an entity that is required to
measure its investments at fair value in
accordance with existing IFRS. On the other
hand, it could be interpreted as applying to
an entity that contemplates selling its
investments in the future.
Another area where entities are seeking
clarification is the “express business
purpose” criterion. The proposal, as written,
leaves open to interpretation whether an
exit strategy would be required for each
individual investment, or for most, but not
all, investments. In addition, interpretations
could differ as to whether funds that are
established with a plan to liquidate after a
finite life would satisfy the exit strategy
requirement.
Judgement also would be required to
determine whether pooling of funds is
“substantive”, and whether certain entities,
such as master-feeder structures, could
avail themselves of the exception to the
“pooling of funds” criterion.
4
If the entities that have been consolidated
by an investment entity parent change, the
parent’s auditors would need to reassess
whether they could rely on the work of
other auditors or whether they would need
to function as principal auditors. These
analyses would need to be re-performed
at each reporting period. The conclusions
reached may change as a parent investment
entity changes its portfolio.
Financial metrics
As a result of the proposals, key metrics
such as net asset value and assets under
management would be affected. These
metrics are used by financial analysts,
investors, and other users of investment
entity financial statements to track and
monitor investments.
Infrastructure, process and controls
The judgement and assessments required
under the proposal would demand indepth knowledge of the business and an
understanding of the intended purpose and
design of the entity being evaluated. Some
of these judgements will require knowledge
and expertise from beyond the accounting
department, such as legal and operational
personnel. Entities would need to establish
new accounting policies, processes and
internal controls to address the need for
continuous assessment of entities to be
evaluated as investment entities, to
establish whether they continue to meet
the definition over time.
Taxes
Adoption of the proposal could give rise to
tax-related considerations. As a result of
the consolidation or deconsolidation of
entities upon adoption, entities would need
to consider the accounting ramifications
on deferred taxes and the tracking of
book/tax differences related to assets
and liabilities consolidated for financial
reporting purposes. Entities would also
need to determine necessary changes to
administrative processes and controls for
identifying and tracking book to tax
adjustments and evaluating uncertain tax
positions. Early assessment of tax
implications early would help companies
reduce their tax exposures and develop
changes to financial systems to facilitate
tax processes.
What can you do now?
While the proposal is not yet final and
continues to be deliberated, we believe it
would be prudent for entities to begin
evaluating whether they would qualify as
investment entities under the proposed
criteria. Entities also should begin to
evaluate whether any entities they control
would qualify as investment entities. This
will require a thoughtful analysis of the
IASB’s proposed criteria, some of which are
subjective. Adopting the investment entities
exception (once finalised) would require
time, effort and judgement, and would
also involve obtaining a comprehensive
understanding of an entity’s business, its
operations, legal rights and obligations.
Early assessment will help enable a smooth
transition and avoid unwanted surprises.
A proposed effective date of the standard
will be determined after the IASB considers
all feedback from constituents.
IFRS Practical Matters — Would the proposed definition of an investment entity affect you?
Actions that entities should begin to
consider now:
• Identify potential issues related to the
proposal
• Monitor updates on the IASB’s
deliberations
For further information, please refer to the
following Ernst & Young publications:
• IFRS Developments — Proposal for
investment entities to measure
investments at fair value (Issue15,
August 2011)
• Understand whether any entities would
qualify as an investment entity
• Understand whether any entities would
no longer be consolidated and how key
metrics such as net asset value would
change.
• Consider the impact of no longer
consolidating entities that qualify as
investment entities on the balance
sheet, income statement, statement of
cash flows, and disclosures
• Understand the effects of the proposal
on performance indicators and
consider appropriate stakeholder
communications
• Determine training requirements for
individuals responsible for
consolidation and investment
accounting and related judgements
IFRS Practical Matters — Would the proposed definition of an investment entity affect you?
5
How Ernst & Young may be able to help
Ernst & Young can bring its multi-disciplinary team of accounting, tax, systems, and IT professionals to your company to assist in assessing
what the proposal means to you. In the chart below, we outline issues and steps you should consider concerning the proposal, and indicate
how Ernst & Young may be able to help you from initial assessment through adoption.
Issues and steps
How Ernst & Young may be able to help
Gain a general understanding of the investment
entities proposal
• Design and help deliver a training session for entity personnel
• Share insights of the views and latest deliberations of the IASB and the FASB
Perform a preliminary assessment of the impact of the
proposal on the entity’s financial statements
Advise and provide input into:
• Determining whether the entity meets the definition of an investment entity within
the scope of the proposal
• Determining whether the entity appropriately consolidates entities on its balance
sheet, including the impact on the income statement, statement of cash flows,
and disclosures under the proposed standard
• Assessing the impact of the proposal on key financial ratios and performance
measures such as net asset value, assets under management, and expense ratios
• Identifying shortfalls in available information to adopt the proposal
Assess the impact of the proposal on strategic
business decisions
Advise and provide input into:
• The impact on strategic business decisions and planned transactions (e.g.,
mergers, acquisitions, and new markets)
• The impact on existing loan covenants, borrowing arrangements, and
compensation plans, including the impact on arrangements currently being
negotiated
• Provide observations of how others are approaching the proposal, problems they
Benchmark the entity against peers and others in
the industry
anticipate and solutions proposed
• Assist in the evaluation of peers, competitors and industry disclosures and
expected impact on the financial statements
6
Assess processes for data collection, internal controls,
IT systems
• Provide observations and insights based on leading practices on ways the entity
Assess tax positions relating to proposal
• Advise on analysing tax positions arising from adopting the proposal, reducing tax
Plan for ultimate adoption of the proposed standard
• Advise regarding project management and planning, including timeline, tasks, and
Update accounting manuals and accounting policies
• Review and provide input into accounting manuals and policies selected by
Communicate the effect of adoption to stakeholders −
analysts, regulators, shareholders
• Advise on developing a communication plan so that the entity conveys the impact
could design its valuation processes, IT systems and internal controls
exposure, and determining tax effects
resource allocation
management
the proposal would have on the entity’s financial position and operating results
IFRS Practical Matters — Would the proposed definition of an investment entity affect you?
For more information, please contact:
Ken Marshall
Financial Accounting Advisory Services Leader — Americas
+1 212 773 2279
[email protected]
Mark Seddon
Financial Accounting Advisory Services Leader — Asia-Pacific
+852 2629 3138
[email protected]
Stephane Kherroubi
Financial Accounting Advisory Services Leader — Europe, Middle East,
India, and Africa (EMEIA)
+33 1 46 93 74 72
[email protected]
Tomohiro Miyagawa
Financial Accounting Advisory Services Leader — Japan
+81 3 3503 1191
[email protected]
Ernst & Young
Assurance | Tax | Transactions | Advisory
About Ernst & Young
Ernst & Young is a global leader in assurance,
tax, transaction and advisory services.
Worldwide, our 152,000 people are united
by our shared values and an unwavering
commitment to quality. We make a difference
by helping our people, our clients and our wider
communities achieve their potential.
Ernst & Young refers to the global organization
of member firms of Ernst & Young Global
Limited, each of which is a separate legal entity.
Ernst & Young Global Limited, a UK company
limited by guarantee, does not provide services
to clients. For more information about our
organization, please visit www.ey.com.
About Ernst & Young’s International Financial
Reporting Standards Group
The move to International Financial Reporting
Standards (IFRS) is the single most important
initiative in the financial reporting world, the
impact of which stretches far beyond accounting
to affect every key decision you make, not just
how you report it. We have developed the global
resources — people and knowledge — to support
our client teams. And we work to give you the
benefit of our broad sector experience, our deep
subject matter knowledge and the latest insights
from our work worldwide. It’s how Ernst & Young
makes a difference.
About Ernst & Young’s Financial Accounting
Advisory Services (FAAS) Group
Today’s global enterprises need help understanding
and addressing the effects of their business
decisions on complex accounting and financial
reporting requirements. Meeting this challenge
requires not only technical resources, but advisors
who understand the issues companies face in their
industries and who have the experience to provide
practical, effective services. Ernst & Young’s FAAS
professionals are deeply experienced in offering
up-to-date insight into standard setting and
regulatory developments, along with relevant
industry perspectives. And to help companies
receive the market, technical and regulatory
insights they need, we can coordinate global teams
of highly qualified resources in accounting, tax,
systems, IT, and transaction advisory. It’s how
Ernst & Young makes a difference.
© 2012 EYGM Limited.
All Rights Reserved.
EYG no. AU1187
www.ey.com
ED none.
In line with Ernst & Young’s commitment to minimise its
impact on the environment, this document has been printed
on paper with a high recycled content.
This publication contains information in summary form
and is therefore intended for general guidance only.
It is not intended to be a substitute for detailed research
or the exercise of professional judgment. Neither EYGM
Limited nor any other member of the global Ernst & Young
organization can accept any responsibility for loss
occasioned to any person acting or refraining from action as
a result of any material in this publication. On any specific
matter, reference should be made to the appropriate advisor.