Many investment vehicles exist that pool funds and make investments and participants in these might expect to receive regular accounting and audited financial statements.
To determine what statements to deliver, one of the first decisions that needs to be made is whether the entity should follow accounting rules found in Accounting Standards Codification (ASC) 946, Financial Services – Investment Companies.
Scope and scope exceptions
In determining if an entity should follow the accounting rules for investment companies, there is some black and white and of course plenty of gray. For example, an entity regulated under the Investment Company Act of 1940 would always follow ASC 946. On the other hand, a real estate investment trust (REIT) is excluded from ASC 946 as it must follow ASC 974, Real Estate – Real Estate Investment Trusts.
Fundamental and typical characteristics
Investment companies must have all fundamental characteristics and may or may not have typical characteristics. These are evaluated by management considering how the entity was formed and for what purpose. Oftentimes reviewing information outlined in an entity’s organizational documents, such as a private placement memorandum or limited partnership agreement, is helpful to utilize in this assessment.
Fundamental characteristics include both:
- Obtaining funds from one or more investor and providing the investor(s) with investment management services.
- Committing to its investor(s) that its business purpose and only substantive activities are investing funds solely for returns from capital appreciation, investment income, or both.
Also, the entity or its affiliates shouldn’t obtain benefits from an investee that are not normally attributable to ownership interests.
Typical characteristics may include having:
- More than one investment
- More than one investor
- Investors that are not related parties to the investment manager
- Ownership interests in the form of equity or partnership interests
- Substantially all of its investments managed on a fair value basis
If an entity does not possess one or more of the typical characteristics, it is required to apply judgment and determine, considering all facts and circumstances, how its activities continue to be consistent (or not consistent) with those of an investment company.
Fair value basis
Especially for certain real estate focused entities, the question of managing investments on a fair value basis may be a sticking point. Fair value for these purposes is defined by ASC 820, Fair Value Measurement, which defines fair value as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.
Another sticking point can be how substantive activities are defined. The AICPA published Technical Questions and Answers (Q&A Section 6910 – Investment Companies) to provide additional guidance on this topic. This guidance is also a helpful tool to apply the assessment of facts and circumstances to any judgmental area of the ASC 946 framework.
The question posed considered if loan origination activities would represent a substantive activity precluding an entity from qualifying as an investment company under ASC 946.
The first step outlined is performing an assessment that considers:
- The entities design and business purpose
- The reason for performing the activities
- How the entity is marketed and presented to current and potential investors
If an entity believes it is an investment company, it should consistently be demonstrated in its design, purpose and how it holds itself to investors.
Since loan origination would not generally be consistent with the business purpose of capital appreciation, investment income, or both, to qualify as an investment company it would require more judgment and evidence. Consequently, the Q&A also provides some quantitative considerations.
In this example, the entity may calculate the percentage of income generated from the entity’s origination activities compared to income generated through capital appreciation, investment income, or both. This quantitative measure in addition to the qualitative measure of the entity’s investment strategy should be helpful in determining if the entity has any substantive activities that would preclude it from being treated as an investment company.
In determining if your entity should follow ASC 946, it’s important to understand the fundamental and typical characteristics outlined above. Additionally, it may be necessary to assess your particular facts and circumstances. For more information or assistance visit our web page for investment companies.