The Financial Accounting Standards Board’s (FASB’s) longstanding guidance on investment company accounting has acknowledged that investment companies are “special” in that investors in these entities bear all the upside and downside risk of the underlying investments made by the investment company and therefore such investors need to directly see the change in fair value of their underlying investments. The FASB guidance set forth certain criteria that needed to be met to qualify as an investment company. If an entity met such criteria, it was exempt from consolidating its controlled investments. Instead the entity reported its investments at fair value through the income statement.
The International Accounting Standards Board (IASB), meanwhile, has not historically had any such guidance in place. However, the IASB recently issued an Exposure Draft that proposes to exempt “investment entities” (note the difference in FASB and IASB parlance) from consolidating their investments.
Why? Because the IASB received complaints from its constituents that consolidating controlled investees by investment entities obscured decision-useful information for investors, and made it impossible for investors to evaluate the performance of the underlying investment portfolios of the investment entities they invest in.
Positive Step Forward
Wanting to seek a converged solution to this issue, the FASB also issued a Proposed Update that attempts — emphasis on attempts — to align the FASB guidance with the new IASB proposal on certain dimensions.
Generally speaking, CFA Institute believes the proposals are a step in the right direction in developing investment entity specific guidance. Although we generally favor consolidation, given the “special” nature of investment entities we believe that “specialized accounting” should apply where investments are carried at fair value and not consolidated.
Here comes the “but.” And it is a big BUT. As the saying goes, the devil lies in the details, and it is when we dig into the details of the proposed changes that we see some problematic issues with the proposals. We expound upon these in our recent comment letter to the standard setters.
What’s New about These Revised Proposals? Why Should You Care?
There are three key changes or elements to the IASB and FASB proposals:
1) Changes in the Criteria to Qualify for Investment Company Accounting – The IASB proposal sets forth criteria (based upon, but different from, the original FASB criteria) on what constitutes an investment company and the FASB’s Proposed Update adopts these revised criteria.
2) Changes in How Underlying Investments Will Be Measured and Presented – The proposals seek to define how the underlying investments will be measured and presented.
3) Disclosures – The proposals also include disclosure principles/requirements.
Investment Company Classification Criteria Based on Arbitrary Accounting Rules
The change in the qualification criteria should be of interest to investors as some entities that, until now, qualified as investment companies may no longer do so under the new FASB guidance. And a change in the classification of these entities will have a huge impact because it will effect a change in the underlying measurement basis. To give you some examples, collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), and some private equity funds may no longer qualify for investment company status. The crux of the issue is this: if the criteria are not scoping the right entities into the purview of the investment company guidance, we have a pretty fundamental problem.
The problems with the criteria do not end here. The IASB and FASB have incorporated exceptions within the qualification criteria to obtain desired outcomes. For example, the FASB proposal states that an investment company that is regulated under the Investment Company Act of 1940 would be subject to the investment company guidance regardless of whether the entity meets the proposed definition of an investment company. With the need for this caveat, can we really consider these criteria comprehensive and take them seriously?
To make matters worse, the proposed criteria contain implicit options which may lead to structuring opportunities — allowing entities to opt in or out of the guidance’s scope. Take the “express business purpose criterion” as an example. The guidance may cause entities to believe they can present themselves to investors as an investment entity based upon the mere “expression” of their business purpose — which can change over time and may not actually follow their actual business practices — thereby creating an implicit option to fall within or outside this guidance.
Measurement and Presentation
1) Too Many Approaches and Way Too Complex – The IASB and FASB proposals contain a multitude of measurement and presentation approaches for the same types of underlying entities. In fact, the proposals are so confusing that, in order to comprehend all of the approaches, we had to diagrammatically depict them to capture the accounting for the following factors:
- All the possible types of entities (e.g. investment companies, investment property entities, service providers, other investees, etc.)
- The levels of influence that the parent company has over its investee (e.g. control, significant influence, less than significant influence)
- The nature of the parent company’s operations (e.g. investment company parent, non-investment company parent)
- The importance of the investment entities’ structure (e.g. fund-of-funds structure)
The visual depictions of the proposals, which can be found in our comment letter, illustrate their complexity. We are not ashamed to admit we found this exercise pretty taxing. And we believe that ascertaining the net result of these various approaches would be very difficult for investors and result in economically similar items being accounted for differently under U.S. GAAP and IFRS.
2) Accounting for Non-Economic Distinctions – These illustrations demonstrate that accounting distinctions have been made where economic distinctions do not necessarily exist. For example, the IASB proposal requires a non-investment entity parent to consolidate and, upon consolidation, change the measurement of the investment entity subsidiary. This is counter to the principles of consolidation which only require changes in presentation, not measurement of underlying investments. Consolidation will obscure information needed by investors and the nature of the parent’s operations does NOT change the value of its investments. While we appreciate the IASB’s desire to prohibit the manipulation of leverage ratios by including debt in unconsolidated subsidiaries, we believe the greater good is served by developing disclosures regarding such leverage ratios and, if significant, referencing those disclosures on the face of the financial statements.
More broadly speaking, we find that these proposals and the FASB proposal on Investment Property Entities include accounting rules that create artificial distinctions among investment entities, investment property entities, and operating entities, and the underlying measurement and presentation of their results may lead to unnecessary complexities and reduced comparability across types of entities.
3) Way Too Much Divergence Between the IASB and FASB Proposals – The complexity created by the numerous measurement and presentation approaches within the separate IASB and FASB proposals is only compounded by the differences between the proposals. So, not only will it be difficult for investors to evaluate the performance of the underlying investment portfolios or to evaluate performance across investment entities, it will be even more difficult to do so across jurisdictions. As we know, capital allocation and investment decision making is a global process, and we believe this will hinder investors in making appropriate investment allocation decisions. If this is the result of the proposals, it is diametrically opposed to the very objective of financial reporting.
We did not undertake a review of the proposed disclosure requirements or changes in the proposals explicitly, as we believe that the Boards should first address the measurement and presentation matters. We do, however, believe the disclosures should be consistent between the FASB and IASB guidance. And we disagree with the IASB Exposure Draft’s notion of simply articulating a disclosure principle — do we really believe investors will get the information they need with a mere disclosure principle?
On an Ironic Note, Fair Value Gains Fans
CFA Institute has long been the most vocal and ardent supporter of fair value accounting — something we’ve been widely criticized for. Going back 30+ years, you can evidence CFA Institute advocating for increased use of fair value for bonds, equities, and derivatives. At each turn we have faced critics explaining how wrong we were to support fair value for things like derivatives — sounds funny today, doesn’t it?
At the recent FASB-IASB roundtable on investment entities it was ironic to hear participants professing the benefits of fair value. Their profession of love for fair value was based upon their belief that holders of interests in investment companies are interested in the performance of the underlying assets. Hmmmm … isn’t that true in any stock, bond, or investment you hold, whether or not you own it through an entity classified as an investment company? Our view has consistently been that the underlying measurement of performance being at fair value is relevant despite the nature of the entity holding the asset. Amazingly, some don’t see how the logic translates. Maybe someday.
So What Should the Boards Do?
We have simple a request for the Boards: Could you look to simplify the proposals? Instead of complex qualification criteria, the Boards should consider formulating a general principle that defines an investment company and an accompanying set of indicators to be used for determining whether an entity is an investment entity or not.
The Boards should also seek to simplify the measurement and presentation of the underlying investments of such entities, consider the lack of convergence between the IASB and FASB proposals, and develop robust disclosure requirements. How else will investors be assured of receiving the most decision-useful information?