At their joint board meeting on May 21, 2012, the FASB and IASB began redeliberations on their investment companies project. The boards reached tentative decisions regarding alternatives presented by the staff related to the overall approach to assessing whether an entity is an investment company. The alternatives were based on comments received on the boards’ respective exposure drafts (EDs).¹ In addition, the boards reached tentative decisions regarding changes proposed by the staff to certain of the EDs’ criteria and application guidance.

Alternatives to the Assessment Approach

In their comment letters on the EDs, many constituents expressed concerns that requiring an entity to meet all six criteria to qualify as an investment company was onerous and that certain entities that should be accounted for as investment companies, or that currently apply investment company accounting, may be inappropriately precluded from qualifying for such accounting. In response to these comments, the staff presented three alternative approaches to assessing whether an entity is an investment company.

Under the first alternative, the boards would retain the EDs’ approach. Under the second alternative, an entity would apply a qualitative assessment (i.e., it could consider all evidence and indicators and apply judgment in determining whether it meets the criteria to be an investment company). Under the third alternative, which the staff recommended, an entity would first assess whether it meets the definition of an investment company and, if so, would then qualitatively assess whether it meets certain additional factors.

The staff recommended that the definition of an investment company incorporate the “nature of the investment activities” and the “express business purpose” criteria proposed in the EDs. In addition, the entity would be required to obtain funds from an investor or investors and to provide the investor(s) with professional investment management services. The staff proposed that entities would not be required to meet the other criteria in the EDs but could consider such criteria to be factors in the overall assessment.

The boards agreed with the staff’s proposed approach but asked the staff to explore potential ways to address situations in which it is unclear whether an entity is an investment company (e.g., when an entity meets the definition of an investment company but fails to meet some or all of the other factors). In addition, the IASB agreed that the fair value management criterion in the EDs should be incorporated into the definition of an investment company. However, the FASB decided that this criterion should instead be a factor.

The FASB decided that the definition of an investment company would be as follows:

1.   An investment company is an entity that does both of the following:

a.   Obtains funds from an investor or investors and provides the investor(s) with professional investment management services

b.   Commits to its investor(s) that its business purpose and only substantive activities are investing the funds for returns from capital appreciation, investment income, or both.

2.   An investment company and its affiliates do not obtain, or have the objective of obtaining, returns or benefits from their investments that are either of the following:

a.   Other than capital appreciation or investment income

b.   Not available to other noninvestors or are not normally attributable to ownership interests.

The boards also discussed the factors an entity should consider in determining whether it qualifies as an investment company. Specifically, if an entity meets the definition of an investment company, the entity would then consider its purpose and design and evaluate the following factors:

• Number of investments.
• Number of investors.
• Related parties.
• Ownership interests.

The boards asked the staff to explore further the interrelationship of these factors and how each would apply to the definitions of an investment company. The boards were especially concerned about situations in which an entity had a single investor and a single investment.

Application Guidance

The boards also discussed various aspects of the application guidance and tentatively agreed with the following staff recommendations related to modifying the EDs:

• The application should state that transactions between controlled investees would not be prohibited.
• The reporting entity criterion proposed in the EDs should not be a separate factor or indicator; however, the application guidance should clarify that an entity does not need to be a legal entity to be an investment company.
• The EDs allow for exceptions from the multiple investments/multiple investors requirement criterion to the extent that a fund is set up in conjunction with a main fund for tax, legal, or other business reasons (e.g., a blocker fund or a master feeder). The application guidance should clarify that the “in conjunction with” guidance applies even if the funds are not set up at the same time.

The IASB also tentatively decided that the application guidance should clearly state that:²

•     An investment entity would be allowed to provide investment-related services to third parties only if those services are not substantive.

•     Day-to-day management of investees should not disqualify an entity from investment company status.

Further, the IASB tentatively decided that an investment company would be required to have an exit strategy for substantially all of its investments. The exit-strategy assessment would be performed at the portfolio level.

[1] The investment companies project is a joint effort between the FASB and the IASB to develop converged criteria for determining whether an entity is an investment company. In August 2011, the IASB published an ED, Investment Entities, which provides an exception to the consolidation principle in IFRS 10, Consolidated Financial Statements, for entities that qualify as investment entities. In October 2011, the FASB issued a proposed Accounting Standards Update, Financial Services — Investment Companies (Topic 946): Amendments to the Scope, Measurement, and Disclosure Requirements, which proposes amendments to the existing guidance in U.S. GAAP on investment companies. The comment period for both EDs ended in the first quarter of 2012.

[2] These tentative decisions apply to the IASB only; the FASB’s ED already contains such language.