New guidance proposed by the Financial Accounting Standards Board (FASB) will apply to fund advisers as they determine whether to consolidate another entity, such as a mutual fund or other investment vehicle, in their financial reporting process. A comment period on the proposed rules ended in February 2012, and while FASB has not issued final guidance or set an effective date, the direction of upcoming changes is becoming clear.
Baker Tilly Audit Senior Manager Amar Kothapalli, CPA, recently explained what is proposed and why fund advisers should take time to become familiar with the proposed rules now.
Kothapalli: The proposed rules would require a decision maker to evaluate several factors in determining whether it is acting in a principal or agency capacity to the variable interest entity. The outcome of this evaluation will determine if you need to continue with other aspects of consolidation.
For advisers who expect to begin new advisory/service relationships, understanding the direction the FASB is taking could save time and effort later. Applying the proposed consolidation rules after you begin a relationship is likely to be more difficult than if you consider them at the onset. We are advising our clients to consider the proposed rules to the extent possible before entering into agreements.
Kothapalli: Ultimately, consolidation aims to provide a full picture of the activities of reporting entities, including the resources, obligations, risks, and opportunities.
Kothapalli: The focus is on determining the capacity in which the decision maker is using its power, whether as principal or agent, based on three specific criteria. Under current consolidation rules, a decision maker is determined based on the use of its power to control the entity. The proposed guidance would change the way reporting entities evaluate whether they should consolidate another entity.
Kothapalli: For the first time, criteria would need to be applied to assess whether the decision maker is using its power as a principal or an agent. If the decision maker acts as a principal, the general rule is to continue with other aspects of consolidation. If the decision maker acts as an agent on behalf of others, consolidation would not be required.
Kothapalli: There are three: the decision maker’s compensation, its interests in the fund, and its rights versus the rights of others to control the fund. Each of the three is to be evaluated first on its own to determine if the decision maker is acting as a principal or agent. Then they are to be weighed in aggregate.
Kothapalli: Are the fees that are generated by the decision maker considered to be market rate? Are they reasonable in light of the services provided? If a decision maker is earning market-rate fees, it would be acting as an agent. However, if the fee is market rate, but services provided are over and above those typically offered at that rate, the adviser would be acting as a principal.
Kothapalli: The type of interests or relationships the decision maker has with the fund are the basis for this criterion. Specifically, is the adviser exposed to positive returns only, or to both positive and negative returns through its investment in the fund? If the exposure is to positive returns only, such as when a reasonable, market-based fee is generated, then the decision maker is acting as an agent. If beyond earning a market-rate fee, the decision maker invests in the fund, we must assess its exposure to gain and loss relative to the fund and other members in the fund.
If exposure is high, the decision maker is likely using its power as a principal. For example, if the decision maker invests $100,000 in a $100 million fund, exposure to gains or losses is not high, indicating an agency relationship. If the investment is $500,000 in a $1 million fund, exposure is very high and the decision maker would be acting in the capacity of a principal.
Kothapalli: The essential question is how easy is it for others to remove the decision maker from power? If he can be kicked out fairly easily, then he is acting as an agent on behalf of others. If the decision maker cannot be removed easily, the relationship is that of a principal. Consider, for example, a fund with 100 partners that requires a majority to remove a decision maker. The effort to gather the necessary votes would be considerably greater than if only two individuals were involved and one vote was needed. The greater the effort required for removal, the stronger the indication that the decision maker acts as a principal.
Kothapalli: Evaluating the criteria in aggregate will require looking at each relative to the other two and using significant judgment to make the determination. For example:
If in the above example it was a $1 million fund and you had $500,000 invested, you would be acting in the capacity of a principal and would need to continue with other aspects of the consolidation rules.
As you can see, significant judgment will be required in each case
Kothapalli: Advisers will need to prepare a memorandum or other analysis detailing the evaluation. If they provide advisory services to multiple funds, they will need to evaluate and document each one. Final guidance from the FASB is expected in 2013.