Investment entities – Sweep issues
The Staff presented three issues that arose as a result of external reviewer comments on the pre-ballot draft of Investment Entities: Amendments to IFRS 10, IFRS 12, IAS 27 and IAS 28 (“the investment entities amendments”). The Staff asked the IASB Board members to discuss:
- whether an investment entity should be required to have an exit strategy for substantially all of its investments;
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- the interaction between the fair value management requirement in IFRS 9 Financial Instruments and the fair value management component of the investment entity definition;
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- whether an entity that provides investment-related services to external parties should qualify as an investment entity.
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Each of these issues was presented in turn by the Staff and the IASB Board members provided comments and voted on the Staff recommendations.
At the May 2012 board meeting, the IASB tentatively decided that an investment entity should have an exit strategy for substantially all of its investments. Consistent with this decision, paragraph B85G of the pre-ballot draft stated that:
A strategy to hold debt investments to maturity is not an exit strategy.
The Staff identified to the Board that this paragraph lead external reviewers to conclude that certain entities would be disqualified from investment entity status because they had substantial debt investments that were held to maturity. The external reviewers stated that in some jurisdictions the majority of investment funds would not qualify as investment entities because they hold a substantial amount of debt investments to maturity. A variety of reasons were put forward by these external reviewers as to why an investment fund could hold debt investments to maturity:
- Investment funds may make both debt and equity investments in their investees. The debt investments may have shorter maturities than the anticipated term of the fund’s equity.
- Investment funds may hold short-term debt investments to maturity to earn a return on funds temporarily while they identify suitable equity investment opportunities.
- Investment funds may hold debt investments to diversify their portfolio and/or to mitigate risk to investors.
- Investment funds may hold debt investments to manage liquidity risk and may hold those investments to maturity.
The Staff noted that they believe that an entity that holds its investments indefinitely should not qualify as an investment entity. They agreed with the external reviewer comments and emphasised that they too were concerned that an entity could be disqualified from investment entity status because it does not have an exit strategy for its debt investments even if it measures its debt investments at fair value through profit or loss (FVPL) using the requirements of IFRS 9 or IAS 39 Financial Instruments: Recognition and Measurement. The staff recommended changing the focus of the “exit strategy” requirements to the Board, replacing this with a requirement that investment entities do not hold their investments indefinitely – in this situation, with debt, as there are set maturity dates the entity cannot hold indefinitely. They explained that, under this approach, entities that measure their investments at FVPL would not be excluded from investment entity status merely because they do not have an exit strategy for some of their debt investments (assuming that the debt investments are measured at fair value). The Staff noted that one of the primary focus of the investment entity project was to determine when it is appropriate to measure interests in a subsidiary at fair value and the main focus on exit strategy should be on equity investments.
The staff did not think that changing the requirement for an exit strategy to a requirement that an investment entity should not hold investments indefinitely will weaken the guidance.
The staff recommended changing the definition of an investment entity in order to permit an investment entity to invest only for investment income rather than requiring some element of capital appreciation (as debt will only generate such income). This definition was changed by the IASB in the May Board meeting due to the decision to require an exit strategy for substantially all of an investment entity’s investments.
The staff asked the Board whether they agreed with their recommendation to replace the requirement for an investment entity to have exit strategies for substantially all of its investments with a requirement that an investment entity should not hold any of its investments indefinitely.
One of the IASB Board members sought clarification from the Staff as to the definition of “not holding indefinitely” was and questioned how these proposals would be applied to equity investments. The Staff mentioned that indefinitely meant that there was no set plans for exiting the investment as they acknowledged that eventually an equity investment would be exited. The Staff stated that when they were writing the Staff recommendation they did have holding companies in mind as entities that would be excluded from investment entity status as such exit plans would not ordinarily exist. The Staff noted that the amended paragraph B85F of the amendment noted that “an investment entity shall have an exit strategy documenting how the entity plans to realise capital appreciation of its equity investments and non-financial asset investments, because these investments have the potential to be held indefinitely”. The Board member noted that this addressed his concern regarding equity investments but this was not reflective in the Staff question to the Board.
Another Board member noted that it may have been a lot simpler to propose that a maturity of an instrument can in fact be considered a valid exit strategy. The Staff mentioned that they did consider this approach but decided against it in order to avoid potential tension with IFRS 9. The Board member responded that this could be avoided by defining that the exit strategy was the exit strategy as required by the amendment and only the considerations of the amendment.
Another IASB member noted that the pre-ballot draft did not address the timeframe for the exit strategy and questioned, therefore what the difference between a holding company and an investment company was as both could have the same exit strategies. However he noted that by moving to the notion that an investment entity cannot hold investments indefinitely (and hence introducing an element of time) it was moving closer to a business model concept of what an investment entity is. The staff noted that their recommended wording did include emphasis of time frame to strengthen this point.
11 of the 15 Board members tentatively agreed with the staff recommendation.
The pre-ballot draft required an investment entity to manage and evaluate the performance of substantially all of its investments on a fair value basis, consistent with the decisions made at the May 2012 board meeting.
The staff noted that some reviewers questioned this requirement and the interaction with the guidance in IFRS 9 especially whether the fair value management requirement in the amendments was different from the fair value management guidance in IFRS 9. The staff noted that the interaction between the fair value management guidance in IFRS 9 and the investment entities pre-ballot draft is confusing. They recommended that the “fair value management” component of the investment entity definition be reworded to “fair value measurement” to avoid a close link with the fair management guidance in IFRS 9. The staff noted that this approach would allow an entity to consider its relationship with its investors when determining whether it is an investment entity (for example if the entity’s investors focus on fair value information or interact with the investment entity on a fair value basis) and will allow an entity-wide assessment of fair value measurement and performance.
The Staff recommended that in order to be an investment entity, an entity must measure and evaluate the performance of substantially all of its subsidiaries on a fair value basis using the existing guidance in IFRSs.
The Staff also recommended that the investment entities amendments should include application guidance stating that in order to meet the “fair value measurement” component of the investment entity definition, an entity would have to elect the fair value option in IAS 28. The Staff noted that this could lead to “optional” accounting for investment entity status as an entity could avoid investment entity status by not making the IAS 28 fair value election.
The Staff recommended that the Basis for Conclusions also include clarification that, in accordance with IFRS 9 and IAS 39, some assets may be measured at fair value with fair value changes recognised in other comprehensive income (FVOCI) rather than profit or loss and that this measurement would be considered fair value measurement for the purposes of the definition of an investment entity. The staff did not think FVOCI would be prevalent in practice and that this should not disqualify an entity from investment entity status.
One Board member asked whether investment entities that are required, due to legal or contractual reasons, to hold debt (for instance government bonds) should be scoped out as qualifying as investment entities and accounting for their investments at fair value. The Board member was of the view that they should not be disqualified from being an investment entity because to do so would narrow the scope of the standard. He was of the view that these investment entities should be required to value investments at fair value but at the same time they would not be precluded from measuring some of their investments not at fair value.
Another Board member noted that he did not see that fair value accounting for investment entities was being mandated – as some members had expressed this view. However he noted that if entities wanted to get the exemption from consolidation of its investments it would have to apply fair value accounting. This view was shared by other Board members who noted that the exemption arose as many investors informed them that for certain entities fair value information was more relevant than consolidated information. Hence to get the exemption reporting fair value was required.
The Staff sought clarity with regards to question 2c that mentions that there should be an addition to the Basis of Conclusions language stating that an investment entity can measure financial assets at fair value through OCI (FVOCI) and still meet the “fair value measurement” component of the investment entity definition. The staff recommended that “financial assets” should be substituted with “investments” so an investment entity could measure investments at FVOCI. Amendments would also be made to 2b.
With the suggested modifications, 13 of the 15 Board members tentatively agreed with the staff recommendation.
The pre-ballot draft proposed that an entity could qualify as an investment entity even if it provided:
- substantive investment-related services if those services were provided only within the investment entity; and
- investment-related services to third parties only if those services were not substantive.
The Staff noted that external reviewers disagreed with the requirement in 31(b) and requested that the IASB allow an entity to qualify as an investment entity even if it provided investment-related services to third parties regardless of the substantive nature of those services. It was noted that external reviewers were of the view that many private equity companies would be excluded (in the pre-ballot draft) from investment entity status as they provide significant investment services to third parties. This was considered the case, even though the business model of these entities was investing and investors demanded fair value information for the investments held by these entities. The Staff noted that external reviewers requested that these companies should qualify for investment entity status but would be required to consolidate any subsidiary providing investment-related services.
The Staff agreed with these arguments and that an entity should not be disqualified from investment entity status only because it provides substantive investment-related services to third parties.
No significant Board comments were received in relation to this recommendation. All 15 of the Board members tentatively agreed with the Staff recommendation.