New technical practice aids for investment companies
The American Institute of Certified Public Accountants (AICPA) recently issued four new Technical Practice Aids (TPAs) impacting financial reporting issues for investment companies. TPAs 6910.25 - .28, which are separately discussed below, address cash flow presentation issues, presentation of deferred management and incentive fees, and the presentation of financial highlights for nonregistered unitized funds.
6910.25 Considerations in evaluating whether certain liabilities constitute "debt" for purposes of assessing whether an investment company must present a statement of cash flows
FASB Statement No. 102,
Statement of Cash Flows - Exemption of Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale, an amendment of FASB Statement No. 95, (FAS 102) provides for an exemption for investment companies from the requirement to include a statement of cash flows in their financial statements based on whether certain criteria are met. One of those criteria is that the fund must have had "little or no debt, based on the average debt outstanding during the period, in relation to average total assets."
FAS 102 generally excludes covered options written from classification as debt for purposes of meeting the criteria, but it did not address whether other transactions such as uncovered options, short sales, and reverse repurchase agreements should be treated as debt. The TPA provides some clarification to this debt classification issue, and states that classification depends on the nature of the transaction activity. Securities classified as fund liabilities which represent financing transactions, such as receipt of cash on margin, reverse repurchase agreements, securities lending, or other credit facilities would be considered debt for purposes of evaluating the criteria in FAS 102, unless the proceeds are invested in cash or cash equivalents. Other trades or transactions such as short sales of securities and other derivative transactions would not be considered debt so long as the form and intent of the transaction represents an investment and not a financing transaction.
6910.26 Additional guidance on determinants of net vs. gross presentation of securities purchases and sales/maturities in the statement of cash flows of a nonregistered investment company
This TPA addresses under what circumstances a nonregistered investment company can net purchases and sales/maturities of securities in the statement of cash flows. Registered investment companies are excluded from the provisions of this TPA.
The AICPA Audit and Accounting Guide
Investment Companies (the Guide) requires that cash flows from operations should separately include purchases of long-term investments, sales of long-term investments, and net purchases/sales of short-term investments. Technical Information Service 6910.20 added additional clarity by requiring nonregistered investment partnerships to present cash flows from purchases and sales of securities on a gross basis for investments with no stated maturity or with maturities greater than one year. The AICPA noted, however, that paragraph 8 of FAS 102 permits certain financial institutions such as banks, broker/dealers, and "other enterprises that carry trading securities" to net purchases and sales from such trading securities in the statement of cash flows.
In this TPA, the AICPA has concluded that if a nonregistered investment company is required to include a statement of cash flows under FAS 102, the trading style, investment objectives and portfolio turnover of the fund will be the primary determinants of net vs. gross reporting. If a nonregistered investment company's overall strategy and activity is consistent with trading, as discussed in FAS 102 and FASB Statement No. 115,
Accounting for Certain Investments in Debt and Equity Securities, then netting purchases and sales in the statement of cash flows would be permissible. However, it is important to note that nonregistered investment companies that qualify for and choose to net purchases and sales in the statement of cash flows should continue to segregate the net activity of transactions for long positions from transactions for short positions.
6910.27 Treatment of deferred fees
This TPA addresses the presentation in the financial statements, including related disclosures, of deferred management and incentive fees for investment companies domiciled in offshore jurisdictions.
The governing documents for offshore investment funds have often included provisions that permit the investment adviser to elect to defer payment of its management fee and/or incentive fees earned from the fund. Under a fee deferral arrangement, the fund retains the deferred fee balance and is obligated to pay the investment adviser the deferred fees in cash at a later date adjusted for the fund's appreciation or depreciation over the period, as provided for in the governing documents.
In this TPA, the AICPA has concluded that funds with such agreements should record the cumulative deferred fees and the associated unrealized appreciation or depreciation resulting from the return on the fund as a liability titled "Deferred incentive fees payable" on the statement of assets and liabilities.
The appreciation or depreciation related to the deferred fees should be recorded in the statement of operations as an expense (net appreciation on deferred fees) or, conversely, a negative expense (net depreciation on deferred fees) of the fund. The appreciation or depreciation on the deferred fees should be presented separately from the management fee or incentive fee incurred in the current period. Additionally, the fund should disclose the key terms of the deferred fee arrangement, including the priority of claim in the event of liquidation preferences, the current and cumulative amounts deferred, the cumulative net appreciation or depreciation on the deferred fees, the date that the deferred fees are required to be paid, and the allocation of net appreciation or depreciation on the cumulative deferred fees.
The AICPA also concluded that the financial highlights data, including the per share information, and the net investment income and net expense ratios should be presented including the impact of the deferred fee amount, and the related expense resulting from the net appreciation or depreciation on the deferred fees. However, in order to reflect the effect of the adjustment on the fund's expense ratio, the fund may also present an expense ratio that excludes the amount of deferred fee expense or negative expense.
6910.28 Reporting financial highlights, net asset value (NAV) per share, shares outstanding, and share transactions when investors in unitized nonregistered funds are issued individual classes or series of shares
This TPA addresses how a nonregistered investment fund with a unitized structure that issues a separate series of shares to each individual investor should present the financial highlights (per share data, ratios, and total return), and how share transactions for each series of shares should be disclosed in the financial statements.
A nonregistered investment fund organized in a unitized structure may issue, in accordance with governing documents, a separate series of shares unique to each individual investor, which are not periodically 'rolled up' into a single series or class of shares. In such cases, each investor's series of shares remains outstanding until that investor fully redeems those shares. As a result, each investor will have a NAV per share that may be different from other series in the same class, but each series of shares may have the same allocation and participation rights as other series in the same class. This method of recording share transactions is functionally similar to partnership accounting.
Presentation of the financial highlights
The issuance of a separate series of shares unique to each individual investor permits a nonregistered investment fund to allocate net investment income and realized and unrealized appreciation or depreciation to each investor similar to the allocation to an individual partner's capital account in a limited partnership.
Statement of Position (SOP) 03-4,
Reporting Financial Highlights and Schedules of Investments by Nonregistered Investment Partnerships: An Amendment to the Audit and Accounting Guide Audits of Investment Companies and AICPA Statement of Position 95-2, requires that each permanent series of a class of shares should be separately presented in the financial highlights. If each investor has a separate series of shares with a unique NAV, reporting the financial highlights for each outstanding series of shares could result in financial highlights being presented for every investor in the fund.
The staff concluded that the financial highlights should be presented in the aggregate for the entire permanent series of shares. Additionally, the financial highlights should be similar to the financial highlights applicable to a nonregistered investment partnership. As a result, the ratios to average net assets and total return would be presented, but per share data would not be included.
The TPA also states that it is acceptable for such a nonregistered unitized fund to present supplemental financial highlights for a single series of shares that management determines to be "representative" for its class. If a representative series of shares is used, management should select a series that has been outstanding the entire year, and that has a fee arrangement that is similar to the majority of the investors in that class of shares. The basis of calculation and presentation of the financial highlights, including the criteria used to select the representative series of shares, should be disclosed in the financial highlights.
Presentation of share transactions and total shares outstanding
The Guide requires disclosure of the type, par value, authorized shares, NAV per share and total shares outstanding for each class of shares. The Guide also requires disclosure for each permanent class of shares of the number and value of shares issued and redeemed, shares issued in reinvestment of distributions, shares reacquired by the fund, and the net change in shares outstanding. For funds which issue a separate series of shares to each individual investor, these share transactions and amounts should be disclosed on an aggregate level for each permanent class of shares from which the individual series of shares have been issued.
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Stay tuned for further guidance - PricewaterhouseCoopers is committed to helping our clients, including both investors in alternative products and fund managers, understand how this new guidance will be interpreted and applied in practice.
Specific advice and assistance may be sought from your PricewaterhouseCoopers engagement team or from any of the partners in our Alternative investment funds sroup.
To view AICPA TPA 6910.25 - .28 Investment Company TPAs,
click here.
