Investment Entities: The Standards and their Challenges

By Ma. Emilita L. Villanueva

First Published in Business World (11/26/2012)

In May 2011, the International Accounting Standards Board (IASB) issued International Financial Reporting Standards (IFRS) 10, Consolidated Financial Statements, which revised the definition of “control” and provided for enhanced disclosures both for consolidated and unconsolidated entities. IFRS 10 requires the consolidation of all controlled entities, regardless of the nature of the reporting entities.

Before IFRS 10 was issued, the IASB had received comments from concerned parties that, for investment entities, the requirement of IFRS 10 to consolidate controlled investments will not enhance information useful for decision-making. Rather, such a requirement will obscure critical information needed by the various financial statement users to analyze these investment entities.

As a result, the IASB issued an amendment to IFRS 10 to exempt from the consolidation requirement entities that meet the definition of an investment entity. This exception requires investment entities to account for subsidiaries at fair value through profit or loss in accordance with IFRS 9, Financial Instruments.

Definition of an Investment Entity

An investment entity is one that:

a. Obtains funds from one or more investors for the purpose of providing those investor(s) with professional investment management services;

b. Commits to its investor(s) that its business purpose is to invest funds solely for returns from capital appreciation, investment income or both; and

c. Measures and evaluates the performance of substantially all of its investments on a fair value basis.

To be considered an investment entity, an entity must meet all three elements. It must also consider whether it has the following typical characteristics:

a. It has more than one investment to diversify the risk portfolio and maximize returns;

b. It has multiple investors who pool their funds to maximize investment opportunities;

c. It has investors that are not related parties of the entity; and

d. It has ownership interests in the form of equity or similar interests.

The absence of one or more of these typical characteristics means more evidence is needed, greater judgment is applied, and greater disclosure is required to conclude that the entity is an investment entity.

Measurement and consolidation

An investment entity does not consolidate its subsidiaries and does not apply IFRS 3, Business Combinations, when it obtains control of an entity. Instead, an investment entity is required to measure its subsidiaries at fair value through profit or loss. If, however, an investment entity has a subsidiary that provides investment-related services, such as investment management services, then the investment entity must consolidate its subsidiary.

On the other hand, the parent of the investment entity (unless the parent company itself is an investment entity) is still required to consolidate all entities that it controls, including the entities under an investment-based subsidiary.

Affected entities

The amendment to IFRS 10 may simplify the accounting in the case of mutual funds, private equity funds, hedge funds, venture capital funds, and similar entities. If these funds and similar entities qualify as investment entities, they will be exempted from consolidating their controlled investments, and will be required to carry such investments at fair value.

For banks, insurers and many other organizations involved in investment activities, the amendment may have little or no effect because the exemption can be applied only in the financial statements of the investment entities, and not in the consolidated financial statements of groups that control such an entity.

Challenges in the application of the amendment

The amended standard brings about the following concerns:

a. Management judgment – Judgment would be required to assess whether the activities of the entity are “substantive” enough to qualify it as an investment entity. A thorough knowledge of the entity’s business, its purpose and design would be critical in evaluating the entity’s classification. The assessment may involve not just the accounting personnel, but also other departments such as legal and personnel, and even the Board of Directors and top management.

b. Effect on financial information and key metrics – Adopting the provisions of the standards for investment entities may cause financial information to differ and may impact key metrics that are used by management, investors, financial analysts and other users of financial statements to track the performance of investment entities. Compliance with regulatory requirements and loan covenants should also be considered when assessing the impact of the adoption of these standards.

c. Processes and controls – Continuous reassessment would be required to evaluate whether an entity still meets the definition of an investment entity. Any changes in the purpose, design, investments and other factors would trigger a reassessment on the entity’s part. Thus, processes and controls to capture these changes should be established to ensure that all factors are considered, and that the reassessment is done quickly right after such changes have taken place.

d. Different effective dates – The amendment on investment entities will become effective on January 1, 2014 or one year after the effective date of IFRS 10. This may result in the investment entity having a different accounting policy (i.e., consolidation) on its controlled entities in 2013 and another accounting policy (i.e., fair value measurement) on these entities in 2014. Once it has been assessed that an entity qualifies as an investment entity, management would then need to decide if they will early adopt the standards for investment entities to coincide with the January 1, 2013 effective date of IFRS 10.

Ma. Emilita L. Villanueva is a Senior Director of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.