Would the proposed definition of an investment entity affect you?

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1 ey.com/ifrs May 2012 IFRS Practical Matters Would the proposed definition of an investment entity affect you? 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. 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).

2 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. 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. 2 IFRS Practical Matters Would the proposed definition of an investment entity affect you?

3 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 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 IFRS Practical Matters Would the proposed definition of an investment entity affect you? 3

4 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. 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. 4 IFRS Practical Matters Would the proposed definition of an investment entity affect you?

5 Actions that entities should begin to consider now: Identify potential issues related to the proposal Monitor updates on the IASB s deliberations 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 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) IFRS Practical Matters Would the proposed definition of an investment entity affect you? 5

6 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 Gain a general understanding of the investment entities proposal Perform a preliminary assessment of the impact of the proposal on the entity s financial statements Assess the impact of the proposal on strategic business decisions Benchmark the entity against peers and others in the industry Assess processes for data collection, internal controls, IT systems Assess tax positions relating to proposal Plan for ultimate adoption of the proposed standard Update accounting manuals and accounting policies Communicate the effect of adoption to stakeholders analysts, regulators, shareholders How Ernst & Young may be able to help Design and help deliver a training session for entity personnel Share insights of the views and latest deliberations of the IASB and the FASB 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 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 anticipate and solutions proposed Assist in the evaluation of peers, competitors and industry disclosures and expected impact on the financial statements Provide observations and insights based on leading practices on ways the entity could design its valuation processes, IT systems and internal controls Advise on analysing tax positions arising from adopting the proposal, reducing tax exposure, and determining tax effects Advise regarding project management and planning, including timeline, tasks, and resource allocation Review and provide input into accounting manuals and policies selected by management Advise on developing a communication plan so that the entity conveys the impact the proposal would have on the entity s financial position and operating results 6 IFRS Practical Matters Would the proposed definition of an investment entity affect you?

7 For more information, please contact: Ken Marshall Financial Accounting Advisory Services Leader Americas Mark Seddon Financial Accounting Advisory Services Leader Asia-Pacific Stephane Kherroubi Financial Accounting Advisory Services Leader Europe, Middle East, India, and Africa (EMEIA) Tomohiro Miyagawa Financial Accounting Advisory Services Leader Japan

8 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 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 EYGM Limited. All Rights Reserved. EYG no. AU1187 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.

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