Authored by Matthew O’Rourke and Daniel Altschul
Fund managers are typically responsible for the preparation of financial statements of their underlying investment, in accordance with Accounting Standards Codification (ASC) 946 – Financial Services – Investment Companies, which requires the valuation of investments under ASC 820 – Fair Value Measurements.
Please note that this topic excludes interests that are required to be consolidated under ASC Topic 810 – Consolidation.
Accounting under ASC 820
Because it is common for fund managers to hold an interest in these funds, it is common for the manager to consider accounting for the interest by applying the proportional fair value method, which may be the equivalent of using net asset value as a practical expedient. This is a permissible valuation methodology, subject to certain requirements, under ASC 820.
However, ASC 820 is in scope only if another U.S. Generally Accepted Accounting Principles (GAAP) topic permits the use of fair value measurements (ASC 820-10-15-1). Unlike an investment company accounted for under ASC 946, ASC 820 is not the initial prescribed treatment for an operating business. Because of this, entities will account for interests under ASC 820 only if other guidance allows them this treatment.
Considering equity method and joint ventures
The topic that should first be considered is ASC 323 – Equity Method and Joint Ventures – Sub-topic 323-30 – Partnerships, Joint Ventures and Limited Liability Entities, which governs accounting for investments in partnerships and similar vehicles.
Under the equity method in accordance to GAAP, an investor recognizes its share of the earnings or losses on an investee in the periods for which they are reported in its financial statements. It is important to note that this method typically results in a value substantially consistent with use of the net asset value as a practical expedient. Consequently, this evaluation is not expected to have a material effect on reported results, but will effect an entity’s required disclosures.
Fund managers generally need to account for their investments using the equity method if the investor has the ability to exercise “significant influence.” Significant influence is defined under 323-10-15-6 as the ability to exercise significant influence over operating and financial policies of an investee, which may be indicated in several ways:
- Representation on the board of directors
- Participation in policy-making processes
- Material intra-entity transactions
- Interchange of managerial personnel
- Technological dependency
- Extent of ownership by an investor in relation to the concentration of other shareholdings (i.e., substantial or majority ownership of the voting stock of an investee by another investor does not necessarily preclude the ability to exercise significant influence by the investor)
Management must separately evaluate these criteria, but it is typically presumed they will have the ability to exert significant influence on funds they manage. As a result, they would likely apply the guidance in ASC 323-10. Under this standard, management must assess whether they have a variable interest entity in their partnership investment, which may trigger consolidation if they are deemed the primary beneficiary. If management is not deemed the primary beneficiary, they will typically apply the equity method of accounting.
Differences in disclosures
If there is no variable interest, assuming significant influence exists, then the fund manager will either apply the equity method of accounting or consolidate the vehicle if they own a majority interest. The disclosures under this circumstance will differ in nature than simply utilizing a fair value measurement and these steps must be considered.
Assuming a fund manager is not required to consolidate the fund vehicle and is required to account for its investment under the equity method of accounting, the manager may still elect the fair value option under ASC 825 – Financial Instruments to allow them to apply the guidance of ASC 820. Under this guidance, the manager would typically be permitted to use the proportional interest in the fund’s net assets as their fair value measurement, however, this would be an accounting election that shall be disclosed. While unlikely, if management does not have the ability to exercise significant influence, and the cost method of accounting is used, the fair value option can still be elected.
It is still possible to utilize net asset value as a practical expedient to arriving at fair value of a partnership interest in a managed investment fund, however, there are several steps that must be considered beforehand to arrive at this conclusion. This may result in additional disclosure in the fund manager’s financial statements and adoption of the fair value option.
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