Description
Asset management, broadly defined, refers to any system that monitors and maintains things of value to an entity or group. It may apply to both tangible assets such as buildings and to intangible concepts such as intellectual property and goodwill.
Asset Management Accounting and Financial Reporting Update
December 2011
Financial Services Industry
Contents
Foreword Introduction Updates to Guidance
Reconsidering Effective Control for Repurchase Agreements (ASU 2011-03) Achieving Common Fair Value Measurement and Disclosure Requirements Under U.S. GAAP and IFRSs (ASU 2011-04) 2 3 iii iv
On the Horizon
Convergence Update and Areas of SEC Regulatory Focus Financial Instruments Project — Classification and Measurement Financial Instruments Project — Offsetting Revenue Recognition Exposure Draft Investment Companies Exposure Draft Investment Property Entities Exposure Draft Consolidation Exposure Draft 7 11 12 14 14 18 21
Other Related Developments
Dodd Frank Act Updates Registration of Fund Advisers Form PF Pay to Play Net Worth Standard Compensation Rules Regulation of OTC Derivatives Other Developments Custody Rule Updates RIC Modernization Act 24 24 24 25 25 26 26 26 26 27
Appendixes
Appendix A — Links to Titles of Standards and Other Literature Appendix B — Abbreviations Appendix C — Deloitte Specialists and Acknowledgments Appendix D — Other Resources 30 31 32 33
Foreword
December 2011 We are pleased to announce our fourth annual accounting and financial reporting update — presented for the first time by sector. This publication covers the asset management sector and is divided into three sections. The first, “Updates to Guidance,” summarizes accounting and reporting updates that asset management entities need to start preparing for now. The second, “On the Horizon,” consists of standard-setting topics that asset management entities should consider as they plan for the future. The third includes a discussion of other hot topics related to asset management. The following are links to the publications for each of the other financial services sectors: • • • Banking & Securities Insurance Real Estate
We hope you find this more condensed and focused publication a useful resource as you begin to prepare your annual reports and plan for the upcoming year. Please visit us as www.deloitte.com for more information. In addition, watch for our Heads Up newsletter covering highlights from the 2011 AICPA National Conference on Current SEC and PCAOB Developments. As always, we encourage you to contact your Deloitte team for additional information and assistance, and we welcome your feedback.
Bob Contri Vice Chairman, U.S. Financial Services Leader Deloitte LLP
Susan L. Freshour Financial Services Industry Professional Practice Director Deloitte & Touche LLP
Asset Management: Accounting and Financial Reporting Update Foreword
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Introduction
In the wake of the financial crisis, the financial services industry has operated in a much more challenging business environment. This year, the industry continues to confront difficult domestic and international economic issues and to face overall public scrutiny and dissatisfaction. In response, regulators and standard setters have established new accounting and reporting rules for financial service companies, many of which have or will become effective in the near future.
Economic Challenges
The state of the global economy continues to have a significant impact on all sectors of the financial services industry. The U.S. economy still struggles with high unemployment rates, a weak housing market, low interest rates, ongoing worries about the debt situation, the downgrade of the U.S. credit rating, and government spending. Other countries in the global markets, particularly in the eurozone, have also continued to struggle with their own debt issues and have seen a rise in political uncertainty and unrest. The public continues to blame financial institutions for many of the hardships that the global economy is facing. Many of the criticisms have fallen upon the ears of legislators, who continue to look for ways to improve the situation. In an effort to win back public confidence, regulators have sought ways to increase investor protection and to make the financial positions of public financial institutions more transparent. As a result, financial services firms are making significant changes to their compliance functions and are rethinking the strategies that they have in place for the future.
Regulatory Reform
This year marked the one-year anniversary of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which mandated extensive rulemaking in response to the financial crisis. Although only a quarter of the proposed regulations have been written, some significant changes have already been made. In addition to the increased scrutiny by regulators, additional capital requirements, and customer protection rules, the financial services industry most recently has been faced with new regulations on derivatives and the Volcker Rule. Companies must make strategic decisions to navigate this new, more strictly regulated business environment.
Convergence and Accounting Changes
This year, standard setters are still busy updating and writing guidance that will affect the financial services industry as a whole. The FASB and IASB (the “boards”) continue to work together on converging their guidance into a single, comprehensive set of global accounting standards. In addition, standard setters have placed greater emphasis on improving the transparency of accounting and the related disclosures for financial statement users. Amid all the turmoil and change, it appears certain that change and volatility are here to stay for the foreseeable future. Companies in the financial services industry will have to respond and adapt. This publication describes accounting developments over the past year that may be relevant to financial services companies. Some of these developments apply to the 2011 fiscal year, while others are on the horizon. Companies should consider formulating a plan to prepare for the changes that lie ahead.
Asset Management: Accounting and Financial Reporting Update Introduction
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Updates to Guidance
Asset Management: Accounting and Financial Reporting Update Updates to Guidance: Updates to Guidance?
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Reconsidering Effective Control for Repurchase Agreements (ASU 2011-03)
Introduction
On April 29, the FASB issued ASU 2011-03, which eliminates from U.S. GAAP the requirement for entities to consider whether a transferor (i.e., seller) has the ability to repurchase the financial assets in a repurchase agreement (“repo”). Such requirement was one of the criteria under ASC 860 that entities used to determine whether the transferor maintained effective control. Although entities must consider all the effective-control criteria under ASC 860, the elimination of this requirement may lead to more conclusions that a repo arrangement should be accounted for as a secured borrowing rather than as a sale.
Background
Repos can take different forms. In one type, the entity (1) transfers financial assets to a purchaser and receives cash and (2) promises to repurchase the same (or substantially the same) financial assets on a future date and at a specified price. In essence, the entity “borrows” cash equal to the sales price of the financial assets and has the obligation to return that cash (i.e., repurchase the financial asset) on a future date. In these transactions, the financial assets held by the purchaser effectively “collateralize” the entity’s debt (i.e., the obligation to repurchase the financial assets in the future). Whether to account for such a transaction as a sale or a secured borrowing depends on whether the entity meets certain criteria in ASC 860. Under ASC 860, an entity that maintains effective control over transferred financial assets must account for the transfer as a secured borrowing rather than as a sale. Further, ASC 860 states that an entity maintains effective control in a repo if certain criteria are met. One of these criteria indicates that an entity maintains effective control over a financial asset when the transferor “is able to repurchase or redeem [the financial asset] on substantially the agreed terms, even in the event of default by the transferee.” To comply with this criterion, the entity must maintain cash or sufficient collateral “to fund substantially all of the cost of purchasing replacement financial assets from others.” An entity that meets this criterion (and other criteria discussed in ASC 860-10-40-24) maintains effective control over the transferred financial assets and must account for the transfer as a secured borrowing. An entity that does not meet this criterion would need to account for the transfer of financial assets as a sale if it meets other criteria in ASC 860.
Overview of the Changes
The ASU removes from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee. The ASU does not change the other criteria in ASC 860 used in the assessment of effective control. Accordingly, upon the adoption of the ASU’s guidance, a transferor in a repo transaction is deemed to have effective control (i.e., account for the repo as a secured borrowing) if the following three conditions in ASC 860-10-40-24 are met: • • • “The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred.” “The agreement is to repurchase or redeem them before maturity, at a fixed or determinable price.” “The agreement is entered into contemporaneously with, or in contemplation of, the transfer.”
Asset Management: Accounting and Financial Reporting Update Updates to Guidance: Reconsidering Effective Control for Repurchase Agreements (ASU 2011-03)
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Implementation of the guidance above is not without its challenges or complexities, especially for investment companies that enter into treasury roll and certain mortgage dollar roll transactions. One of the complicated accounting issues in certain dollar roll transactions is determining whether the security to be repurchased from the counterparties is substantially the same as the security transferred to the counterparty. Preparers, therefore, should carefully consider the fundamental characteristics of the transferred and reacquired securities to determine the appropriate accounting treatment of the transaction. If the transaction is accounted for as a secured borrowing, there will be an additional complexity related to considerations in connection with the financing cost accrual and the impact on investment company expense ratios.
Effective Date
The guidance in the ASU is effective prospectively for transactions, or modifications of existing transactions, that occur on or after the first interim or annual period beginning on or after December 15, 2011. For example, a calendar-year-end entity will be required to apply the new guidance as of January 1, 2012. Early adoption is not permitted.
Achieving Common Fair Value Measurement and Disclosure Requirements Under U.S. GAAP and IFRSs (ASU 2011-04)
Overview
On May 12, 2011, the FASB issued ASU 2011-04 to conform (1) the definition of fair value and (2) common requirements for measurement and disclosure of fair value under U.S. GAAP and IFRSs. While the ASU largely retains the fair value measurement principles under ASC 820, it expands current disclosure requirements and changes how fair value measurement guidance is applied in certain circumstances. The ASU affects all entities with assets, liabilities, or equity instruments measured or disclosed at fair value. The resources and time commitment needed for implementation will most likely vary by entity but could be significant for those that would also have to implement controls that comply with the Sarbanes-Oxley Act of 2002.
Significant Amendments and Potential Implementation Challenges
Disclosures
Additional Disclosures Required by the ASU For fair value measurements categorized in Level 3 of the fair value hierarchy: • Description of the valuation processes used by the entity. • Development of descriptions of valuation processes to be included in the financial statements, including policies, procedures, and related analysis. • Judgments about whether a change would result in a significantly different fair value measurement and whether there is an interrelationship among the unobservable inputs. • Yes. Potential Implementation Challenge Applicable to Nonpublic1 Entities?
• Qualitative description of sensitivity of fair value to changes in unobservable inputs and their interrelationships if a change would result in a significantly different fair value measurement.
• No.
1
As defined in the FASB Accounting Standards Codification.
Asset Management: Accounting and Financial Reporting Update Updates to Guidance: Achieving Common Fair Value Measurement and Disclosure Requirements Under U.S. GAAP and IFRSs (ASU 2011-04)
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Additional Disclosures Required by the ASU • Quantitative disclosures about unobservable inputs. This is not required if the entity does not develop quantitative unobservable inputs when measuring fair value (e.g., when using prices from prior transactions or third-party pricing information without adjustment). However, the entity is not allowed to ignore reasonably available quantifiable unobservable inputs that are significant to the fair value measurement. Further, goodwill fair value measurements categorized as Level 3 are exempted from this requirement. Any transfers between fair value measurements classified as Level 1 and Level 2 resulting in the disclosure of all transfers between levels. For those assets and liabilities not measured at fair value in the statement of position for which fair value is disclosed (e.g., loans receivable or own debt measured at amortized cost as required by ASC 825), the level within the fair value hierarchy. This is in addition to the existing requirement to disclose the fair value and to describe the method and significant assumptions used to estimate fair value for certain financial instruments (see ASC 825).
Potential Implementation Challenge • Gathering data, depending on the number and complexity of unobservable inputs involved (e.g., illiquid options), establishing whether the data is reasonably available, and building processes to gather information from third parties if it is reasonably available.
Applicable to Nonpublic Entities? • Yes.
Systems may not have such tracking capabilities and therefore may require an adjustment or manual tracking, which may increase the risk of error. Assessment of the level in the fair value hierarchy for these fair value measurements disclosed may be subjective and may require entities to implement additional processes and controls in making the disclosure.
No, only transfers from Level 3 are required.
Yes.
Many of the potential implementation challenges outlined above will be especially burdensome to investment companies with significant Level 3 investments. The removal of the word “significant” from the requirement under ASC 820 to disclose transfers between Levels 1 and 2 will affect entities that had previously only disclosed such transfers on the basis of significance.
Highest and Best Use and Valuation Premise
The ASU specifies that the highest and best use and valuation premise concepts only apply in the measurement of the fair value of nonfinancial assets, thus potentially prohibiting the grouping of financial instruments in the determination of their fair values. One exception to this principle is discussed below. Investment companies that use an enterprise value approach when valuing controlling debt and equity interests in an investee should focus on this portion of the ASU because the accounting treatment may be affected by this new guidance.
Offsetting Positions in Market Risks or Counterparty Credit Risk
The ASU permits an entity to measure a group of financial instruments with offsetting market or counterparty credit risk on a net risk exposure basis if the reporting entity does all of the following: • Manages the group of financial assets and financial liabilities on the basis of the reporting entity’s net exposure to a particular market risk (or risks) or to the credit risk of a particular counterparty in accordance with the reporting entity’s documented risk management or investment strategy. Provides information on that basis about the group of financial assets and financial liabilities to the reporting entity’s management. Is required or has elected to measure those financial assets and financial liabilities at fair value in the statement of financial position at the end of each reporting period.
• •
A reporting entity should consistently apply its accounting policy decision to measure the group of financial assets and financial liabilities on the basis of its net long- or short-risk position (the unit of measurement). The ASU’s guidance applies
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to the fair value measurement of financial instruments and not to financial statement presentation. Entities may be required to allocate the fair value of a net risk position to specific assets or liabilities (in a manner similar to the unit of account allocation specified in other ASC topics).
Premiums or Discounts in Fair Value Measurement
Blockage factors (i.e., a premium or discount that reflects size as a characteristic of the holding, as opposed to a characteristic of the asset or liability, because the market’s normal daily trading volume is insufficient to absorb the quantity held by the entity) are generally not allowed in a fair value measurement. Entities are exempt from this principle when the unit of measurement is specified to be the entire holding (e.g., when entities apply the guidance discussed in the Offsetting Positions in Market Risks or Counterparty Credit Risk section above). To remove blockage factors previously included in a fair value measurement, entities may need to reassess the manner in which fair value is determined.
Instruments Classified as Shareholders’ Equity of the Reporting Entity
The ASU aligns the fair value measurement of instruments classified as shareholders’ equity of the reporting entity with the guidance on measuring the fair value of liabilities. If there is no observable transaction (quoted price) for the transfer of the equity classified instrument, the entity would measure the fair value of the instrument from the perspective of a market participant holding the identical instrument as an asset. An entity may therefore have to review its existing policy for measuring the fair value of instruments classified as shareholders’ equity of the reporting entity.
Convergence
The ASU’s primary goal was to converge guidance with IFRSs on (1) how to measure fair value and (2) what to disclose about fair value measurements within the financial statements. Although the ASU was principally successful, the following differences remain: • • Under IFRSs, a fair value measurement must be based on observable inputs for a day-one gain or loss to be recognized in earnings. There is no such requirement under U.S. GAAP. There is no practical expedient exception to a fair value measurement of certain investments (e.g., hedge funds) under IFRSs. Under U.S. GAAP, net asset value may be used for a fair value measurement for certain investments as a practical expedient. A quantitative measurement uncertainty analysis is required under IFRSs for financial instruments. There is no such requirement under U.S. GAAP. Under IFRSs, nonpublic entities are not exempt from certain fair value measurement disclosure requirements. However, guidance in U.S. GAAP contains such an exemption. Under IFRSs, fair value cannot be less than the present value of the amount payable on demand. Under U.S. GAAP, the fair value of a deposit liability is the amount payable on demand at the reporting date.
• • •
Effective Date and Transition
The ASU’s measurement and disclosure requirements are effective for public entities for reporting periods (including interim periods) beginning after December 15, 2011 (i.e., for calendar-year entities, the beginning of first quarter ended March 31, 2012), and for nonpublic entities for annual periods beginning after December 15, 2011. Nonpublic entities may early adopt the amendments for interim periods beginning after December 15, 2011. The amendments in the ASU should be applied prospectively (i.e., no cumulative adjustment to opening retained earnings). Entities should disclose the change, if any, in valuation technique and related inputs resulting from application of the amendments and should quantify and disclose the total effect of the change, if practicable.
Asset Management: Accounting and Financial Reporting Update Updates to Guidance: Achieving Common Fair Value Measurement and Disclosure Requirements Under U.S. GAAP and IFRSs (ASU 2011-04)
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On the Horizon
Asset Management: Accounting and Financial Reporting Update On the Horizon: Achieving Common Fair Value Measurement and Disclosure Requirements Under U.S. GAAP and IFRSs (ASU 2011-04)
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Convergence Update and Areas of SEC Regulatory Focus
Development of IFRS Adoption in the United States
November 2008 Roadmap
In November 2008, the SEC issued and sought comments on a proposal, Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers, for evaluating the future role of IFRSs in the U.S. capital markets. After consideration of comment letters on the proposed roadmap, the SEC determined that before a decision about a transition to IFRSs from the current financial reporting system could be made, a more comprehensive work plan was needed, including details of the scope, timeframe, and method for any such transition.
February 2010 Work Plan
In February 2010, the SEC issued a statement of continued support for a single set of high-quality, globally accepted accounting standards. At that time, the statement also included a work plan that identified six areas of particular importance that needed further analysis by the SEC staff in determining whether, when, and how to incorporate IFRSs into the U.S. financial reporting system for U.S. issuers. The six areas of concern were: 1. Sufficient development and application of IFRSs for the U.S. domestic reporting system. 2. The independence of standard setting for the benefit of investors. 3. Investor understanding and education regarding IFRSs. 4. Examination of the U.S. regulatory environment that would be affected by a change in accounting standards. 5. The impact on issuers, both large and small, including changes to accounting systems, changes to contractual arrangements, corporate governance considerations, and litigation contingencies. 6. Human capital readiness. At that time, the statement indicated that a determination about the use of IFRSs in the United States would be made in 2011. The SEC staff committed to providing public progress reports on the work plan.
October 2010 Progress Report on Work Plan
In October of 2010, the SEC staff issued its first progress report on the work plan, in which it clarified that it would be in a better position to determine whether to incorporate IFRSs into the U.S. domestic financial reporting system after successful completion of the work plan and existing FASB and IASB convergence projects. Although many countries that have previously adopted IFRSs have done so at a single point in time by using a “first-time adoption” or “switch-over” conversion approach, such methods have been criticized by some U.S. constituents. Other constituents, especially large issuers, have indicated their preference for a so-called “big-bang” transition.
2011 SEC Staff Papers
In May 2011, the SEC’s Office of the Chief Accountant issued a staff paper pursuant to the work plan that outlined a new possible framework for incorporation of IFRSs into the U.S. financial reporting system. The SEC staff paper approach combined elements of convergence and endorsement (dubbed “condorsement” by a member of the SEC staff at the 2010 AICPA National Conference on Current SEC and PCAOB Developments).
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Under an endorsement approach, jurisdictions would incorporate individual IFRSs into their local financial reporting systems in accordance with specified endorsement processes and usually by using specified endorsement criteria. The European Union and Australia have followed such an approach. The staff paper notes that the United States would follow similar processes and that the FASB and SEC would have specific responsibilities. In particular, the FASB would incorporate newly issued IFRSs into U.S. GAAP, and the SEC and the FASB would retain the ability to modify or supplement IFRSs when doing so would be in the public interest or necessary for the protection of U.S. investors. During a transition phase, the framework would follow a convergence approach under which the FASB would bring U.S. GAAP closer to IFRSs by addressing and evaluating differences between the sets of standards and incorporating IFRSs into U.S. GAAP, with a focus on minimizing transition costs. While the term “U.S. GAAP” would be retained, the ultimate goal of the framework is that at the end of the transition period, a “U.S. issuer compliant with U.S. GAAP should also be able to represent that it is compliant with IFRS as issued by the IASB.” The SEC has not committed to a method of adoption and no timeline has been specified, but the staff paper mentions a transition period of five to seven years. On July 31, 2011, the comment period closed for constituents to submit responses to the SEC. The SEC is currently analyzing more than 140 comment letters received in response to the proposed framework outlined in the staff paper. Concerns included the following: •
Timing of decision — Many respondents encouraged the SEC to make a final decision and establish a comprehensive implementation plan with a definitive timeline before the end of 2011 to help facilitate a timely and cost effective transition. Conversely, other respondents encouraged the SEC to make a decision on incorporation of IFRSs only when the boards have completed MoU projects and established a clear plan to address the remaining substantive differences between IFRSs and U.S. GAAP. IASB’s due process and quality of IFRSs — Some respondents suggested that the SEC critically evaluate the IASB’s standard-setting process, including the robustness of its due process and the quality of its standards relative to U.S. GAAP. Respondents also expressed concerns regarding the uniform application of principles-based accounting standards given the (1) diverse legal and cultural environments of the countries applying IFRSs and (2) significant judgments needed in their application. Transition:
o
•
•
Phased versus single effective date for U.S. issuers — Constituents expressed mixed views about whether a phased approach should be used to incorporate IFRSs into the U.S. financial reporting system or whether IFRSs should be incorporated all at once on a single effective date. Prospective versus retrospective application — Most preparers suggested that, whenever possible, IFRSs incorporated into U.S. GAAP be applied prospectively because a retrospective application would be costly and burdensome. Some users of financial statements indicated a preference for retrospective application because such a transition would allow them to compare a preparer’s financial results for the periods presented in its financial statements. Early adoption — Most preparers preferred an option to adopt IFRSs voluntarily during the transition period. Users of financial statements had mixed views on this topic. Although some noted that early adoption might be advantageous for certain companies, others indicated that it could result in the presentation of information that was not comparable for certain periods.
o
o
•
Role of the FASB — Most respondents agreed that the FASB should play a strong role in the IASB’s standardsetting process and serve as the voice of the United States in the development of IFRSs. Many agreed with the staff paper’s proposal to give the FASB authority to modify IFRSs incorporated into U.S. GAAP because they believed that such an “endorsement” approach would offer greater protection to U.S. investors than would direct incorporation of IFRSs. However, respondents had mixed views on the circumstances in which the FASB should
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be able to modify IFRSs. Some believed that modifications of IFRSs should not be limited to rare circumstances but rather should be made whenever the FASB determines that they are needed to protect the interests of U.S. investors. Others were concerned that such modifications would lead to a U.S. flavor of IFRSs and preferred that the FASB establish specific criteria that it would have to apply to determine whether modifications of IFRSs would be in the best interest of U.S. investors. On November 16, 2011, as part of its work plan, the SEC staff published two papers with information relevant to the SEC’s assessment of the sufficient development and application of IFRSs for the U.S. domestic financial reporting system. One paper, A Comparison of U.S. GAAP and IFRS, focuses on the more significant differences between the two sets of standards. The other, An Analysis of IFRS in Practice, reviews a selection of annual consolidated financial statements of both SEC registrants and nonregistrants that prepare their financial statements in accordance with IFRSs and discusses the comments they receive from the SEC. In a speech at the December 2011 AICPA National Conference on Current SEC and PCAOB developments, the SEC staff commented that it expects to complete a final comprehensive report on its work plan in the next several months.
The Road Ahead for the SEC, FASB, and IASB
Irrespective of the SEC’s decisions on the timing and method of incorporation of IFRSs into the U.S. financial reporting system, the FASB and IASB continue to make progress on the convergence of U.S. GAAP and IFRSs in “high-priority” accounting areas, including revenue recognition, leases, insurance contracts, financial instruments, and consolidation. Such progress is highlighted in the table below.2
Financial Crisis–Related Projects IFRS 9: Financial instruments (replacement of IAS 39) Deferral of mandatory effective date of IFRS 9 Impairment Hedge accounting General hedge accounting Macro hedge accounting Asset and liability offsetting (amendments to IFRS 7 and IAS 32) Memorandum of Understanding Projects Leases Revenue recognition (revised ED, comments due by March 13, 2012) Other Projects Insurance contracts Consolidation — investment entities (ED, comments due by February 15, 2012) Consolidation — policy and procedures (ED, comments due by February 15, 2012) Comment period Comment period 2011 Q4 Target IFRS 2011 Q4 2012 H1 Target ED (reexpose) Comment period 2012 H1 Review draft or revised ED 2012 H2 Target IFRS Target IFRS 2012 H2 Review draft Target IFRS Target ED X X X MoU X X MoU X Joint X X Joint X X Target completion Reexposure X X 2011 Q4 2012 H1 2012 H2 MoU Joint
Deferred and Proposed Projects
Projects relevant to the financial services industry that were previously added to the IASB’s agenda but later deferred include those on financial instruments with characteristics of equity, financial statement presentation, liabilities, income taxes, and EPS.
2
As reprinted from the IASB’s Web site. See the FASB’s Web site and the IASB’s Web site for a full list of projects.
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Areas of SEC Regulatory Focus
Increased Scrutiny of Accounting and Reporting by Financial Institutions
In 2011, the SEC established two specialized teams of financial services disclosure experts to (1) review disclosure statements filed by large financial institutions and (2) review disclosure statements filed by approximately 700 mid-tier and smaller community banks. The teams will focus on disclosure trends particular to these two industry segments and ensure that clear comprehensive information is provided in accordance with SEC requirements.3 Although the teams are not specifically focusing on investment companies, the themes of their review may be helpful for investment managers to understand. As discussed further below, companies in the financial services sector can expect increased scrutiny from regulators.
Potential Litigation Loss Contingencies
SEC disclosure teams want financial institutions to clarify their exposure to potential losses due to litigation and other contingencies. Previously, the inability to accurately make any estimate of the risk that disclosure could prejudice ongoing legal proceedings was acceptable to limit disclosure. While there are no new requirements, the SEC expects companies to provide clearer information regarding the nature of the loss contingency and a possible loss or range of loss. The SEC also expects that a registrant would continually evaluate and refine estimates over time as events and circumstances change, especially since, in theory, the ability to estimate should increase as the registrant gets closer to settling the matter. Registrants are permitted to aggregate the disclosures so as not to prejudice their position in legal proceedings. In particular, the SEC would like improvement in the area of surprise disclosures when a large charge was recorded with no previous disclosure (i.e., from immaterial to large settlement).
Sovereign Debt Exposures
The SEC wants clarity in disclosures regarding the level of exposure and how sovereign debt exposure is monitored. Currently, there is no staff view on the specific changes to the application of U.S. GAAP or impairments under U.S. GAAP for registrants holding U.S. government obligations. However, on the basis of informal discussions, the conclusion that U.S. treasuries are not other-than-temporarily impaired (except in limited circumstances) is consistent with the expectations of both the FASB and the SEC staff.
Performance-Based Compensation
The SEC wants investors to understand how executives at financial institutions are compensated and why a particular compensation strategy is selected (i.e., prioritizing short-term over long-term).
Overall Quality of MD&A
Expectations related to the quality of MD&A include: • • Management’s expectations of the impact of the external economic environment on the company. Transparent qualitative discussions to help investors understand the trends and qualitative factors that affect loss allowances and expectations going forward of the impact that trends and the external economic environment will have on allowance levels. Directional consistency between underlying credit trends and how the allowance is changing as expected (e.g., “If 10 percent of our loans were downgraded by one loan class, our allowance would change by x amount”).
•
3
For additional information, see the SEC’s Division of Corporation Finance Filing Review Process.
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Financial Instruments Project — Classification and Measurement
Background
In May 2010, the FASB issued a proposed ASU that outlines a comprehensive new model of accounting for financial assets and financial liabilities related to (1) classification and measurement, (2) impairment, and (3) hedge accounting. The FASB elicited extensive feedback from various constituents by organizing a series of roundtables in October 2010, and it received more than 2,800 comment letters on the proposal. Redeliberations have been in progress since December 2010 and are expected to continue. While the ASU covers many topics, several of which are still being deliberated, the discussion below highlights those that most significantly affect the investment management industry.
Fair Value Option for Financial Instruments
An unconditional fair value option would not be provided for either financial assets or financial liabilities. A conditional fair value option would permit measurement of a group of financial assets and financial liabilities at fair value if the entity manages the net exposure related to those financial assets and liabilities and it provides information on that basis to its management. In addition, there is a conditional fair value option for hybrid instruments to avoid bifurcation of an embedded derivative after an entity has determined that the embedded derivative feature would otherwise have required separate accounting.
Financial Liabilities
Financial liabilities that meet the criteria for amortized cost are classified and measured at amortized cost unless they are (1) a financial liability for which the entity’s business strategy is to subsequently transact at fair value or (2) a short sale.
Financial Assets Held to Settle Nonrecourse Liabilities
In circumstances in which financial assets will be used to settle nonrecourse financial liabilities, an entity should measure the financial liabilities consistently with the measure of the related financial assets. In other words, a write-down on the financial asset would entail a symmetrical write down of the nonrecourse financial liability.
Loan Commitments, Revolving Lines of Credit, and Standby Letters of Credit
In accordance with the current tentative decisions, loan commitments, revolving lines of credit, and standby letters of credit would be carried at fair value through net income (FV-NI) if the entity’s business strategy for the underlying loans is to hold them for sale.
Initial Measurement Principle and Accounting for Transaction Fees and Costs
As clarified in the FASB’s June 8, 2011, summary of meeting decisions, entities that follow the specialized industry guidance in ASC 946 will initially measure financial instruments at the transaction price. The Board voted by a wide 6 to 1 majority to retain this specialized industry guidance. Under the Board’s tentative decision, investment companies subsequently measure a financial instrument at fair value, with transaction fees and costs recorded in unrealized gains/losses until the instrument is sold, at which time such amounts are reclassified to realized gains/losses. This represents an exception to the initial measurement principle tentatively selected for financial instruments subsequently measured at FV-NI and initially measured at fair value. While most entities will expense transaction costs incurred for the acquisition or issuance of a financial instrument that is initially and subsequently measured at fair value, investment companies will be permitted to report transaction costs in unrealized gains/losses until the instrument is sold.
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Deferral of IFRS 9
In November, the IASB tentatively decided to consider changes to the classification and measurement requirements in IFRS 9 and delayed the mandatory effective date from January 1, 2013, to January 1, 2015. The decision to reopen and defer IFRS 9 will enable the boards to address potential application issues in IFRS 9, consider the interaction between IFRS 9 and tentative decisions made as part of the IASB’s insurance contracts project, and to consider potential convergence with the FASB’s model on the classification and measurement of financial instruments. However, because significant changes would be disruptive for companies that early adopt IFRS 9 or for those that have made significant implementation efforts, the Board decided that these changes should be made as soon as possible and that the scope of changes should be limited. Some IASB members expressed concern that reconciling IFRS 9 with the FASB’s model might lead to “scope creep” because some of the differences are significant. For example, the FASB’s model prohibits the reclassification of all financial instruments, while IFRS 9 permits an entity to reclassify financial assets when an entity’s business strategy changes. Furthermore, the FASB’s tentative model retains the requirement to bifurcate certain embedded derivatives from hybrid financial assets, while IFRS 9 requires an entity to classify and measure hybrid financial assets in their entirety (i.e., without bifurcating embedded derivatives). Addressing these and other differences between IFRS 9 and the FASB’s tentative model on the classification and measurement of financial instruments may require significant changes to IFRS 9.
Financial Instruments Project — Offsetting
Background
In January 2011, the boards issued a joint ED outlining a proposed revision to the model for determining when a reporting entity should offset (i.e., present net) financial assets and financial liabilities on the face of the statement of financial position. The boards issued the ED in hopes of harmonizing the significant presentation differences between financial statements prepared under U.S. GAAP and those prepared under IFRSs, particularly for financial institutions. Under the ED’s proposed model, reporting entities would have been required to present all recognized financial assets and financial liabilities, including derivative instruments (financial and nonfinancial), “collectively eligible assets and eligible liabilities,” net on the face of the statement of financial position when the entities (1) had an unconditional and legally enforceable right to set off the eligible asset and eligible liability and (2) intended either: • • To settle the eligible asset and eligible liability net. To realize the eligible asset and settle the eligible liability simultaneously.
In all other circumstances, netting of financial assets and financial liabilities would have been precluded. Feedback received on the ED was mixed. Some commenters agreed with the proposed criteria because they believed that a gross presentation on the statement of financial position generally provides better information about an entity’s future cash flows. Others believed that a net presentation of instruments subject to master netting arrangements better reflects an entity’s credit exposures and provides more useful information to financial statement readers. There was general consensus, however, that both gross and net information was useful and should be included in the financial statements, either on the face of the statement of financial position or in the notes to the financial statements. Had the proposed model been adopted, the amounts of total assets and liabilities reported in statements of financial position of certain U.S. GAAP filers with large derivative portfolios would have significantly increased because the right to offset derivative instruments and related cash collateral receivables and payables under a master netting arrangement is generally conditioned upon the default of the derivative counterparty (i.e., the right to offset would not be deemed unconditional). The financial statement presentation for entities with significant repurchase and reverse repurchase agreements also could have been greatly affected by the proposed offsetting criteria.
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Convergence of Disclosure Requirements
In June 2011, the boards decided to take different paths in their offsetting journeys and ultimately decided to retain their existing offsetting models. In addition, to address practice inconsistencies noted during deliberations, the IASB decided to clarify and modify certain interpretative offsetting guidance in IAS 32. As a result of these decisions, the differences under U.S. GAAP and IFRSs continue to be significant regarding the presentation of offsetting of financial instruments on the face of the statement of financial position. To accommodate constituents’ preference for the presentation of both gross and net information in the financial statements, the boards attempted to reconcile their different presentation models by deciding to create new, converged disclosure requirements. Accordingly, the boards decided to: • Retain the objective, for offsetting disclosures, that an entity “should disclose information about rights of set-off and related arrangements (such as collateral arrangements) associated with the entity’s financial assets and financial liabilities to enable users of its financial statements to understand the effect of those rights and arrangements on the entity’s financial position.” Modify the scope so that the disclosure requirements apply only to instruments under enforceable master netting agreements or similar arrangements (e.g., derivatives, securities lending arrangements, and repurchase agreements). Clarify that the disclosure requirements would not apply to entities that have “no qualifying assets or liabilities that are subject to a right of set-off (other than collateral agreements) at the reporting date.”
•
•
Required disclosures will include: 1. The gross amounts of the financial assets and financial liabilities. 2. The amounts of financial assets and financial liabilities offset in the statement of financial position. 3. The net amount after taking in account (1) and (2) (which should be the same as the amounts reported in the statement of financial position). 4. The effect of rights of set off that are only enforceable and exercisable in the bankruptcy, default, or insolvency of either party and that are not taken into account in arriving at the amounts presented in the statement of financial position (including collateral). 5. The net exposure after taking into account the effect of items (2) and (4).
Next Steps
The boards are expected to issue final standards by the end of the calendar year. Both the FASB and IASB agree that the standards (i.e., the new disclosure requirements and the clarifications approved by the IASB) would be effective for annual and interim reporting periods beginning on or after January 1, 2013. Retrospective application will be required for the new guidance. Preparers of financial statements are encouraged to begin gathering data now so that they are prepared to comply with the new offsetting disclosure requirements by the relevant effective date. Information that companies should gather includes: • • Details regarding the nature of the rights of set off embedded within a financial instrument (or a related side arrangement). Information regarding any collateral arrangements associated with the entity’s portfolio of financial instruments.
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In addition, preparers need to start considering how and where to incorporate these disclosures in their notes to the financial statements. Finally, since the boards were unable to converge the guidance on offsetting on the face of the balance sheets, preparers should ensure that they are well equipped to explain any differences between their financial position and the financial position of their international counterparts as a result of disparate offsetting models.
Revenue Recognition Exposure Draft
On November 14, 2011, as a result of redeliberations on their June 2010 ED, the FASB and IASB jointly issued a revised ED on revenue recognition (see Deloitte’s November 15, 2011, Heads Up for additional details). The ED, issued by the FASB as a proposed ASU, outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and would supersede substantially all current revenue recognition guidance. Comments on the ED are due by March 13, 2012. The boards agreed that a final standard would not be effective before annual periods beginning on or after January 1, 2015, for public companies, with a minimum of a one-year deferral for nonpublic companies. The final effective date will be set by the boards during redeliberations of the ED, and entities will be required to adopt the final standard retrospectively (with certain optional practical expedients). Early application will not be permitted for the FASB’s proposed ASU; however, the IASB’s permits early application. While many of the proposed revenue recognition provisions will not apply to investment companies, certain principles could have an effect on the investment adviser. Under the ED, the timing and measurement of revenue for some contracts with uncertain or variable consideration may change. For example, under current U.S. GAAP, investment managers may use two potential methods to recognize revenue for performance-based incentive fees in accordance with EITF Topic D-96 (codified in ASC 605-25-20-S99). Because this guidance would be superseded if the ED is finalized, accounting for the performancebased incentive fees may change (the ED requires such a fee to be reasonably assured before being recognized). For an entity to conclude that a fee is reasonably assured, the entity’s experience with similar contracts has to be predictive (which may not be the case when the fee is highly susceptible to external factors such as market volatility). Revenue recognition for these fees may therefore have to be deferred.
Investment Companies Exposure Draft
Background
On October 21, 2011, the FASB issued a proposed ASU that would amend the criteria in ASC 946 for an entity to qualify as an investment company (referred to as an “ICE” in this discussion). An ICE that meets all of the revised criteria would continue to measure its investment assets at fair value; however, in a fund-of-funds structure, an ICE would be required to consolidate a controlling financial interest in another ICE or an investment property entity (IPE). The proposed ASU also would require additional disclosures by the ICE. Comments on the proposal are due February 15, 2012. See Deloitte’s October 21, 2011, Heads Up for more information. The proposed ASU is the result of a joint project with the IASB to amend the guidance on ICEs. In August 2011, the IASB issued an ED that would provide similar, but not identical, guidance on accounting for ICEs. In addition, on October 21, 2011, the FASB issued a proposal that defines an IPE (see discussion below).
Revised Definition of an ICE
The proposed ASU states that an entity qualifies as an ICE if it satisfies the following criteria:
a. Nature of the investment activities. The [ICE’s] only substantive activities are investing in multiple investments for returns from capital appreciation, investment income (such as dividends or interest), or both. aa. Express business purpose. The express business purpose of the [ICE] is investing to provide returns from capital appreciation, investment income (such as dividends or interest), or both.
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b. Unit ownership. Ownership in the [ICE] is represented by units of investments, in the form of equity or partnership interests, to which a portion of the net assets are attributed. c. Pooling of funds. The funds of the [ICE’s] investors are pooled to avail investors of professional investment management. The entity has investors who are not related to the parent (if there is a parent) and those investors, in aggregate, hold significant ownership interests in the entity. cc. Fair value management. Substantially all of the [ICE’s] investments are managed, and their performance evaluated, on a fair value basis. d. Reporting entity. The [ICE] provides financial results about its investment activities to its investors. The entity can be but does not need to be a legal entity.
In addition, entities that are regulated under the Investment Company Act of 1940 (the “1940 Act”) would be included within the scope of the ICE guidance in ASC 946 regardless of whether they meet the revised criteria. Although ASC 946 currently does not apply to real estate investment trusts, the proposed ASU would remove this scope exception. Accordingly, some real estate investment trusts would be ICEs. However, real estate entities that meet the proposed definition of an IPE would be excluded from the scope of ASC 946 and would apply the proposed requirements for IPEs, even if they meet the criteria to qualify as an ICE.
Accounting for Underlying Investments
An ICE should measure all of its investments (including real estate properties): • Initially at their transaction price, which would include commissions and other charges that are part of the purchase transaction. • Subsequently at fair value, with changes in fair value recognized through profit or loss. However, in a fund-of-funds structure, an ICE that controls a wholly owned or partially owned ICE or IPE should consolidate that ICE or IPE under ASC 810. The proposed ASU would not require consolidation of a controlling financial interest in an ICE or IPE in a master-feeder structure. When consolidating an ICE or IPE, an ICE should retain any specialized accounting applied by the subsidiary in the consolidated financial statements. Conversely, an ICE should account for its investment in another ICE or an IPE that it can significantly influence at fair value (i.e., the equity method of accounting would be prohibited). Currently, some ICEs consolidate other ICEs only when the parent ICE owns 100 percent of the ICE subsidiary. However, the proposed guidance would require consolidation in a fund-of-funds structure whenever there is a controlling financial interest, which may include less than wholly owned ICE subsidiaries. An ICE would need to look to the consolidation guidance in ASC 810 to determine which consolidation model to apply (i.e., the variable interest entity model, the voting interest entity model, or the control of partnerships model) when assessing whether it has a controlling financial interest. As noted in the FASB Consolidation Project section in this publication, the Board has also proposed updates to consolidation guidance that entities should monitor. The proposed ASU also provides implementation guidance on each of the six criteria for determining whether an entity qualifies as an ICE, as outlined below.
Nature of Investment Activity
To satisfy the first criterion, an entity’s only substantive activities should be investing activities and its only significant assets and liabilities should be related to those investment activities. However, the proposed ASU includes an exception for situations in which an ICE (or an investee of the ICE) provides services related to its investment activities, such as investment advisory or transfer agent services. If these services are provided by an investee, the investee would be either (1) consolidated under ASC 810 if the ICE has a controlling financial interest in the investee or (2) accounted for under the equity method of accounting in ASC 323 if the ICE has significant influence over the investee.
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A second component of this criterion is the necessity to hold multiple investments. Under the proposed ASU, an ICE “is required to hold multiple investments at the same time, directly or indirectly through another [ICE].” However, it is not required to hold multiple investments at all points in time. For example, an ICE is not required to hold multiple investments when (1) its initial offering period has not expired, (2) it is still identifying suitable investments or is in the process of replacing investments disposed of, or (3) it is in the process of liquidation. Finally, the proposed ASU provides a number of examples of relationships and activities that demonstrate that an entity is investing “other than for capital appreciation or investment income.” When assessing the relationships and activities in these examples, the ICE should consider its relationships and activities as well as those of its affiliates. The FASB and IASB determined that the multiple investment criterion was an important characteristic of an ICE because it represents a means of diversification to maximize returns. However, the proposed ASU takes into account situations in which an entity may hold a single investment and still meet the definition of an ICE. For example, an ICE may establish a subsidiary ICE that holds an individual investment for legal or other reasons (commonly referred to as a blocker fund). In this instance, the subsidiary entity would not be precluded from qualifying as an ICE as long as it meets the other criteria.
Express Business Purpose
Under the second criterion, the entity’s express business purpose must be to invest for returns from capital appreciation, investment income, or both. This may be evidenced in the entity’s formation documents or other publications or in how the entity presents itself to its investors. An entity’s express business purpose also is evidenced in its investment plans. Accordingly, an exit strategy should exist for how the ICE intends to realize capital appreciation from its investments. The entity does not have to identify the specific method of disposing of its investments, but rather identify potential strategies that would realize capital appreciation. Exit strategies can vary depending on the type of investment. Disposal of an investment only through a liquidation process or to satisfy investor redemptions does not qualify as an exit strategy.
Unit Ownership
Under the third criterion, investors would be required to acquire ownership units, such as equity or partnership interests, that represent a “specifically identifiable portion of the net assets of the investment company.” However, the ownership unit does not have to represent a “proportionate interest in all of the underlying investments of the investment company.” The proposed ASU also clarifies that having multiple classes, including shares with preferential rights, would not prevent an entity from meeting the ICE criteria. For CLOs and CDOs in which the investor ownership is classified as a liability rather than equity, this criterion may not be satisfied.
Pooling of Funds
The proposed ASU also clarifies that to meet the definition of an ICE, the entity must have investors that (1) are not related parties of the entity’s parent (if there is a parent) and (2) in the aggregate hold a significant interest in the entity. Under this criterion, investors that are related to the parent should be considered a single investor. Further, when a parent or its related parties has an implicit or explicit arrangement that would require it to acquire another investor’s ownership interests, “those investments should be combined and treated as if they were owned by the parent.” Certain arrangements may be structured so that an entity (master fund) has a single investor (feeder fund) and so that the feeder fund has its own third-party investors that, in the aggregate, hold a significant interest in the feeder fund. The proposed ASU clarifies that the master fund may still meet the definition of an ICE as long as (1) the master fund meets all the other criteria for an ICE and (2) the feeder fund meets all the criteria for an ICE.
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Fair Value
Under the proposed ASU, all investments must be managed, and their performance evaluated on, a fair value basis. This evaluation would focus more on how the potential ICE evaluates or manages the investment rather than on the nature of the investment. In paragraph 29 of its Basis for Conclusions, the FASB indicated that “money market funds, which currently report their investments at amortized cost, would be considered to be managing their investments on a fair value basis. This conclusion is based on money market funds being managed to minimize the differences between the carrying value and the fair value of their investments to maintain a constant net asset value.”
Reporting Entity
The last criterion requires the ICE to be a reporting entity. This assessment should take into account the economic substance (rather than the legal form) of the entity. The entity does not have to be a legal entity.
Reassessment
The assessment of whether an entity meets the ICE criteria should be made upon formation of the entity and reassessed if there is a subsequent change in the purpose and design of the entity. A change in an entity’s status as an ICE should be accounted for prospectively from the date of the change (as opposed to the beginning of the reporting period). If an entity no longer meets the ICE criteria, it should account for the change prospectively by applying other GAAP. The fair value of an investment as of the date of the change would be the investment’s initial carrying amount. If upon reassessment an entity meets the ICE criteria, it should recognize the effect as a cumulative-effect adjustment to net assets.
Presentation and Disclosures
Under the proposed ASU, if an ICE consolidates a controlling financial interest in a less than wholly owned ICE or IPE subsidiary, the ICE would present the noncontrolling interest in its financial statements. The ICE would be required to comply with the presentation requirements related to noncontrolling interests in ASC 810-10, including a reconciliation of the net assets attributable to the parent and the net assets attributable to the noncontrolling interests from the beginning to the end of the period. The proposed ASU also would require an ICE to separately present rental income and operating expenses related to real estate properties within its statement of changes in net assets. In addition, it should separately present the fair value of real estate property (excluding any debt associated with the real estate property) in the statement of assets and liabilities. ICEs are currently required to present a schedule of financial highlights. The proposed ASU would modify how the amounts included in the financial highlights schedule are calculated when an ICE consolidates a less than wholly owned ICE or IPE. Specifically, the proposed ASU would require an ICE to calculate the financial highlights (including the expense ratio) by using the consolidated amounts “excluding amounts attributable to noncontrolling interests.” In addition, if an ICE consolidates an IPE subsidiary, the ICE would also be required to “disclose an expense ratio that excludes the effects of consolidating its investment property entities.” The ICE would be required to “provide a reconciliation of the amounts used in calculating its financial highlights and the amounts used in the consolidated financial statements.” The proposed ASU provides an example of the proposed amendments to the presentation requirements and the financial highlights schedule. Finally, the proposed ASU would require additional disclosures, including changes in an entity’s status as an ICE, any support provided by the ICE to its investees, and any significant restrictions on the investee’s ability to transfer funds to the ICE.
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Convergence With IFRSs
The FASB and IASB jointly developed the criteria for determining whether an entity qualifies as an ICE. While the proposed ASU would amend the current requirements in ASC 946, there is no concept of an ICE under IFRSs; therefore, a final standard would represent a significant change under IFRSs. Although the ICE criteria would be substantively the same under U.S. GAAP and IFRSs, differences will remain. First, under the proposed ASU, entities regulated by the 1940 Act would be included in the scope of the guidance in ASC 946 regardless of whether it meets the ICE criteria. The IASB’s proposal does not contain a similar provision. The second significant difference concerns IPEs. There is no concept of an IPE under IFRSs nor are there proposed amendments to add such a concept. An entity that meets the definition of an IPE under the FASB’s proposed ASU on IPEs may meet the definition of an ICE under IFRSs. As a result, there will be presentation and disclosure differences for such entities. There will also be differences associated with how an ICE accounts for its controlling financial interests in other ICEs in a fund-of-funds structure. Under the proposed ASU, an ICE would consolidate a controlling financial interest in another ICE or an IPE. In contrast, under the IASB’s proposed guidance, an ICE would account for a controlling financial interest in another ICE at fair value. Finally, there would be differences in the financial statements of a non-ICE parent that consolidates an ICE subsidiary. In a manner consistent with current U.S. GAAP, the non-ICE parent would retain the specialized accounting applied by the ICE subsidiary within the consolidated financial statements. In contrast, under the IASB’s proposed guidance, a non-ICE parent would not retain the specialized accounting applied by the ICE subsidiary. See Deloitte’s IFRS in Focus newsletter for further details on the IASB’s exposure draft.
Effective Date and Transition
The FASB has not established an effective date for the proposal and will consider feedback on the proposed amendments before setting one. The transition requirements for an entity that no longer meets the definition of an ICE would depend on whether it is practicable to determine the carrying amounts of the assets, liabilities, and noncontrolling interests of the entity’s subsidiary (or the carrying amount of an equity method investment) as if the proposed amendments had been applied when the reporting entity obtained its controlling financial interest in the subsidiary. If determining the carrying amounts is not practicable, the entity would apply the business combination or equity method guidance by using the fair value of its investments as of the transition date. If, as a result of the initial application of the proposal’s amendments, an entity qualifies as an ICE, or an ICE consolidates another ICE or IPE, the effect would be accounted for prospectively as an adjustment to opening net assets as of the date of adoption.
Investment Property Entities Exposure Draft
Background
On October 21, 2011, the FASB issued a proposed ASU on investment property entities that would require certain entities to measure their real estate investments at fair value, with changes in fair value reflected in net income. Entities that meet the FASB’s proposed definition of an “investment property entity” would recognize rental income “when lease payments are received or as the lease payments become receivable in accordance with the contractual terms of the related lease” rather than on a straight-line basis (see Deloitte’s October 21, 2011, Heads Up for more information on the proposal). During redeliberations of the proposed new lease accounting standard, the FASB and IASB tentatively decided that a lessor’s lease of investment property would be outside of the scope of the proposed new lease accounting standard. This scope exception will apply to all lessors of investment property; it is not limited to investment property entities.
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Proposed Scope of the Standard
The scope of the FASB’s proposed ASU is limited to entities that qualify as investment property entities (IPEs). This entitybased scope differs from the scope of the international investment property standard, IAS 40, which is asset-based. The FASB has also tentatively decided to make fair value measurement a requirement for IPEs. This guidance differs from that under IAS 40, which provides a fair value option and not a requirement. Because the FASB took on the investment property project as an attempt, in part, to converge U.S. GAAP with international accounting standards, respondents to the FASB’s proposed ASU may question why the FASB would propose an accounting standard whose scope differs significantly from that of IAS 40. The IASB has not indicated that it would consider limiting the scope of IAS 40 to apply only to IPEs. Some international entities that have elected to measure their real estate investments at fair value under IAS 40 may not be able to do so under the FASB’s definition of an IPE (e.g., insurance companies with real estate investments). Accordingly, the FASB and IASB will most likely receive pressure from their constituents to develop a converged standard.
Definition of an IPE
Under the proposed ASU, an entity that meets all of the following criteria is an IPE:
1. Nature of the business activities. Substantially all of the entity’s business activities are investing in real estate property properties. 2. Express business purpose. The express business purpose of the entity is to invest in real estate property or properties for total return including an objective to realize capital appreciation, for example, through disposal of real estate property or properties. Real estate properties held by an entity for either of the following purposes do not meet this criterion: a. The entity’s own use in the production or supply of goods or services or for administrative purposes b. Development for sale in the ordinary course of business upon completion. 3. Unit ownership. Ownership in the entity is represented by units of investments, in the form of equity or partnership interests, to which a proportion of net assets are attributed. 4. Pooling of funds. The funds of the entity’s investors are pooled to avail the investors of professional investment management. The entity has investors who are not related to the parent (if there is a parent) and those investors, in aggregate, hold a significant ownership interest in the entity. 5. Reporting entity. The entity provides financial results about its investment activities to its investors. The entity can be but does not need to be a legal entity.
Notwithstanding the above criteria, a subsidiary entity that does not meet the criteria related to unit ownership and pooling of funds criteria may still be within the scope of the IPE guidance if the subsidiary entity has a parent entity that is required to account for its investments at fair value in accordance with the IPE guidance or other guidance (e.g., investment company guidance) or has a parent entity that is a not-for-profit entity under ASC 958 that measures its investments at fair value. During deliberations of the proposed ASU, the FASB tentatively decided that for the purposes of evaluating whether substantially all of its business activities are investing in real estate properties, “real estate properties” would only include real estate that is owned directly or indirectly through controlling financial interests. In accordance with this tentative decision, noncontrolling investments in real estate, mortgage loans, and real estate securities would not be considered real estate properties. While an IPE would not be prohibited from making such investments, the significance of such investments may need to be considered when evaluating whether the entity’s primary business activities are investing in real estate properties. This would affect whether an entity is an IPE, an investment company, or a traditional operating company. An entity’s express business purpose is also demonstrated by its investment plans; thus, the proposed ASU states that an entity should “have an exit strategy to dispose of its property . . . to realize capital appreciation to maximize total returns” for its investment properties. However, an IPE is not required to determine the specific method and timing for disposing
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of the investment property. Disposal of an investment property only through a liquidation process or to satisfy investor redemptions does not qualify as an exit strategy. The FASB has also proposed certain amendments to the investment company criteria as part of a separate proposed ASU (see Deloitte’s October 21, 2011, Heads Up for more information). An entity that invests in real estate property but does not meet the proposed IPE criteria may still be within the scope of the proposed investment company ASU, in which case it would be required to measure investments owned by the entity at fair value, including investments in investment properties.
Presentation and Disclosure
The proposed ASU would require an IPE to separately present within the income statement all of the following related to its investment properties: (1) rental revenues, (2) rental operating expenses, and (3) changes in fair value recognized in earnings. In addition, an IPE would separately present, within the statement of financial position, the (1) fair value of investment properties held and (2) any debt associated with the investment properties. This would be a significant change in presentation for many entities. For example, many real estate investment funds that currently account for themselves as investment companies under ASC 946 and that also meet the definition of an IPE would be required to follow this presentation guidance. Although there is diversity in practice, many such funds record operating earnings from their real estate investments only when they are received as distributions from the underlying investee, and they present their real estate investments net of the associated financing in the statement of net assets. An IPE would apply the consolidation guidance in ASC 810 to the following interests: • • A controlling interest in another IPE or an investment company, as defined in ASC 946. A controlling interest in an operating entity that provides services to the IPE parent (e.g., a property management service company).
An IPE that consolidates another IPE or an investment company, as defined in ASC 946, would retain the IPE’s or investment company’s specialized accounting. All other controlling interests in entities would not be consolidated; instead, such interests would be measured at fair value through earnings in each reporting period. An IPE would only apply the equity method of accounting prescribed in ASC 323 to an investment in an operating entity that provides services to the IPE for which it has significant influence (e.g., property management services). Any other investment (e.g., an investment in an IPE or an investment company) for which the IPE has significant influence would be measured at fair value, with all changes in fair value recognized through earnings in each reporting period. Investments in loans, debt securities, and cost method investments would be accounted for under other GAAP.
Thinking Ahead
Because of the similarities between the IPE project and the investment company project, the FASB recommends that the two proposed ASUs be reviewed concurrently. To facilitate comparison, the FASB has decided that the comment periods for the two standards will coincide. Comments on the proposed ASUs are due by February 15, 2012. The FASB has acknowledged constituents’ concerns related to the scope of IPEs and that a definition of IPEs that is too narrow or too broad might inappropriately include or exclude certain entities. It is expected that the FASB will closely evaluate the feedback it receives regarding the scope of the proposed ASU and further evaluate the definition of an IPE.
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Consolidation Exposure Draft
The consolidation project began as a joint project between the FASB and IASB to develop improved, converged consolidation standards that would apply to all entities (i.e., VIEs and voting interest entities). However, the boards eventually decided not to converge on all aspects of this topic, mainly because of differences regarding “control with less than a majority of the voting rights” and the consideration of “potential voting rights.” In May 2011, the IASB issued new and amended guidance on consolidated financial statements, joint arrangements, and disclosures of interests in other entities. The FASB, however, ultimately decided on a narrower project to address whether a decision maker is acting as a principal or as an agent and issued an ED on this topic on November 3, 2011.
VIEs and Voting Interest Entities
The FASB’s proposed guidance contains a single model for qualitatively assessing whether a decision maker (or general partner) is a principal or an agent. This assessment would focus on three factors, which would be evaluated on the basis of the purpose and design of the entity: (1) rights held by other parties, (2) the decision maker’s compensation, and (3) exposure to variability of returns from other interests held by the decision maker. In addition, the proposal would: • • • • Amend the criteria for determining whether (1) an entity is a VIE and (2) a reporting entity is the VIE’s primary beneficiary. Revise the definitions of protective rights, participating rights, and kickout rights. In particular, the proposal would align the analysis of these rights under the VIE, voting interest, and partnership models in ASC 810-10. Amend the guidance on assessing partnerships for consolidation (in particular, whether the general partner consolidates a limited partnership) and move this guidance from ASC 810-20 to ASC 810-10. Eliminate the indefinite deferral in ASU 2010-10 for interests in certain entities.
The proposed principal-versus-agent guidance would allow the FASB to eliminate the deferral in ASU 2010-10 for certain investment funds since these entities would be evaluated under a qualitative approach in determining whether their decision maker (e.g., an investment manager) is acting as a principal or as an agent. The proposed changes would also allow for the consideration of removal rights, even when those rights require the agreement of multiple parties. (Under the current VIE model, removal rights are not considered in the consolidation analysis unless a single entity has the unilateral ability to exercise those rights.) In addition, the qualitative assessment would allow a general partner to consider its economics when determining whether it should consolidate a partnership. For entities controlled by vote, under the IASB model, entities holding less than 50 percent of the outstanding shares of another entity may be required to consolidate that investee; the IASB describes this concept as “effective” or “de facto” control. The FASB decided not to include this concept in U.S. GAAP. Further, potential voting rights (such as convertible debt or warrants) would be considered in the consolidation analysis under the IASB’s guidance. Thus, this aspect of the guidance on voting interest entities in U.S. GAAP will not be converged with that in IFRSs. The FASB and IASB have tentatively concluded that investment companies should recognize and measure their investments (including entities they control) at FV-NI. The boards have used the guidance on investment companies in U.S. GAAP (ASC 946) as the basis for developing the attributes of an investment company. The FASB and IASB differ on whether the parent of an investment company subsidiary would retain, in the consolidated financial statements, the accounting that applies in the subsidiary’s stand-alone financial statements. The FASB believes that the parent of an investment company subsidiary should recognize and measure that subsidiary’s investments at FV-NI in the consolidated financial statements. However, the IASB would agree with that accounting only if the parent itself qualified as an investment company; otherwise, the IASB would want the parent to reflect the assets and liabilities underlying the subsidiary’s investments in the consolidated financial statements. Therefore, the definition of an investment company, which is subject to change as described above, will be important when entities evaluate the proposed guidance on consolidation under both U.S. GAAP and IFRSs.
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Consideration Points
U.S. entities should consider any potential impacts of the FASB’s principal-versus-agent guidance on (1) structures involving VIEs, including funds managed by investment managers; (2) partnerships and similar entities applying the guidance in ASC 810-20; and (3) rights granted to noncontrolling interest holders. In addition, U.S. entities should monitor any changes that the FASB makes to the definition of an investment company, since such changes could cause a change in the number of companies that qualify for investment company accounting.
Next Steps
The IASB’s new consolidation standards are effective for annual periods beginning on or after January 1, 2013; earlier application is permitted as long as each of the other standards in this group is also early applied. Comments on the FASB’s proposed principal-versus-agent ASU are due by February 15, 2012.
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Other Related Developments
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Dodd-Frank Act Updates
Background of Dodd-Frank Act
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) , arguably one of the most extensive pieces of legislation in U.S. history. Enacted in the wake of the recent financial crisis and affecting numerous financial services industry participants, the Dodd-Frank Act calls for hundreds of new rules and regulations, over 50 studies, and the creation of both new regulators and new areas of responsibility for existing regulators. The Dodd-Frank Act aims to (1) promote U.S. financial stability by “improving accountability and transparency in the financial system,” (2) put an end to the notion of “too big to fail,” (3) “protect the American taxpayer by ending bailouts,” and (4) “protect consumers from abusive financial services practices.” To achieve these broad objectives, the Dodd-Frank Act includes many provisions whose magnitude will not be fully appreciated until regulators have implemented them by adopting new rules and regulations. In this vein, over the past year, the SEC has finalized several required rules, completed required studies and reports for Congress, and exposed various proposals for public comment. The summary below highlights certain key developments that affect the investment management industry.
Registration of Fund Advisers
On June 22, 2011, the SEC adopted final rules and amendments under the Investment Advisers Act of 1940 (the “Advisers Act”) related to the implementation of various provisions of the Dodd-Frank Act. The implementation rules primarily formalize SEC registration requirements and exemptions related to private fund advisers (as defined) as well as extend until March 30, 2012, the deadline by which previously unregistered advisers relying on the existing private adviser exemption under the Advisers Act must register with the SEC. The rules implement provisions of Title IV of the Dodd-Frank Act, including: • • • • Defining SEC registration obligations of larger advisers to hedge funds, private equity funds, and other private funds. Defining “venture capital fund,” “family office,” and “foreign private adviser” to exempt such investment advisory organizations from the new registration obligations. Defining a registration exemption for private fund advisers with less than $150 million in “regulatory assets under management” (“regulatory AUM,” as newly defined). Extending certain recordkeeping and reporting obligations to registration-exempt venture capital fund advisers and other private fund advisers with less than $150 million in regulatory AUM (collectively, “exempt reporting advisers”). Increasing the minimum regulatory AUM threshold for any adviser to register or remain registered with the SEC (vs. state supervision).
•
For more information about the implementation rules, see Deloitte’s Implementation of the Investment Adviser Oversight Provisions of the Dodd-Frank Act.
Form PF
In January, 2011, pursuant to Title IV of the Dodd-Frank Act, the SEC and the U.S. Commodity Futures Trading Commission (CFTC) jointly proposed rules under the Advisers Act and the Commodity Exchange Act that would require private fund advisers registered with the SEC, the CFTC, or both to file Form PF, at least annually, with the SEC. The proposed CFTC rule would also require commodity pool operators (CPOs) and commodity trading advisors (CTAs) registered with the CFTC to file
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Form PF with the SEC, but only if those CPOs and CTAs are also registered with the SEC as investment advisers and advise at least one private fund. On October 26, 2011, the SEC voted to adopt the proposed rules. Form PF implements Section 404 of the Dodd-Frank Act, which directs the SEC to collect systemic risk information from registered private fund advisers for its review and the consideration of the Financial Stability Oversight Council (the FSOC). Such information differs by fund type (e.g., hedge fund, private equity fund, private liquidity fund) but generally requires private fund advisers to disclose risk-related details, such as those related to liquidity, leverage, and use of counterparties. Compliance with filing requirements on Form PF will occur over a two-stage phase-in period. The majority of private fund advisers will be required to begin filing Form PF after the end of their first fiscal year or fiscal quarter, as applicable, ending on or after December 15, 2012. Advisers with at least $5 billion in assets under management attributable to hedge funds or private equity funds, and liquidity fund advisers with at least $5 billion in combined assets under management attributable to liquidity funds and registered money market funds, must begin filing Form PF after the end of their first fiscal year or fiscal quarter, as applicable, ending on or after June 15, 2012.
Pay to Play
On June 30, 2010, the SEC voted unanimously to adopt a new rule under the Advisers Act to deter investment advisers from engaging in “pay-to-play” practices. The rule (Rule 206(4)-5) restricts an investment adviser or certain employees of an advisory firm from making campaign contributions to politicians who may be in a position to influence the selection of the adviser to manage assets of state and local public pension funds and other government investment plans. To curb these so-called pay-to-play practices, the rule and rule amendments (to Rules 204-2 and 206(4)-3) implement new restrictions and impose new requirements, primarily on direct and indirect political contributions, solicitation services, and recordkeeping. During 2011, the SEC proposed to amend the investment adviser pay-to-play rule in response to changes made by the Dodd-Frank Act. The amendments, which were adopted in June 2011, changed the scope of the rule to apply both to exempt reporting advisers and foreign private advisers and prevent the unintended narrowing of the application of the rule as a result of the repeal of the private adviser exception. The amendments also added municipal advisors to the categories of registered entities — referred to as “regulated persons” — that are exempted from the rule’s prohibition of payments to third parties by advisers to solicit government entities. Municipal advisors must be registered under Section 15B of the Exchange Act and subject to pay-to-play rules adopted by the Municipal Securities Rulemaking Board (MSRB). The amendments extended the date by which advisers must comply with the ban on third-party solicitation from September 13, 2011, to June 13, 2012. The SEC staff has posted responses to frequently asked questions about the pay-to-play rule that cover compliance and coverage period dates for recordkeeping obligations; definitions of the terms “covered associates,” “government entity,” and “official”; and third-party solicitors.
Net Worth Standard
On January 25, 2011, the SEC voted to propose amendments to its definition of an “accredited investor” to conform to the requirements of Section 413(a) of the Dodd-Frank Act. The new definition would exclude the value of a person’s primary residence in the determination of whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million. Under Securities Act rules, “accredited investors” can invest in certain private and limited offerings such as certain hedge funds that are exempt from Securities Act registration requirements. The new definition of net worth must remain in effect until July 21, 2014, at which point the SEC will be required to review the definition of the term “accredited investor” every four years to determine whether it continues to be appropriate. The deadline for public comment on the proposed rule was March 11, 2011. Since then there have been no significant developments on this matter.
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Compensation Rules
On March 29, 2011, the SEC, jointly with six other federal agencies, issued a proposed rule in response to Section 956 of the Dodd-Frank Act that would (1) require certain financial institutions to disclose the design of their incentive-based compensation arrangements and (2) prohibit companies from implementing compensation arrangements that would promote excessive risk. Under the proposal: • Institutions would be required to file annual reports that discuss their incentive-based compensation arrangements. Such reports would include, but not be limited to, the following:
o o o
A narrative description of components. A concise description of policies and procedures governing such arrangements. A statement describing how the structure of such arrangements prevents (1) excessive compensation and (2) a material financial loss to the entity.
•
Incentive-based compensation plans that encourage inappropriate risk would be prohibited. In addition, for covered entities whose assets exceed $50 billion, at least 50 percent of incentive-based executive compensation would have to be deferred for three years. The proposed rule assigns certain responsibilities to the board of directors (or a committee of the board), such as identifying and approving compensation arrangements for “covered persons, other than executive officers, that individually have the ability to expose the firm to possible losses that are substantial.” Institutions would need to establish policies and procedures that require an incentive-based compensation arrangement to be adopted and approved by their board of directors.
•
Comments on the proposal were due by May 31, 2011. There have been no significant updates since the closing of the comment period.
Regulation of OTC Derivatives
Title VII of the Dodd-Frank Act establishes a comprehensive framework for regulating over-the-counter (OTC) derivatives. It gives the SEC the authority to regulate “security-based swaps” and was intended to take effect on July 16, 2011, approximately one year after the Dodd-Frank Act’s enactment date. Anticipating that it would not meet the Dodd-Frank Act’s mandated deadlines for certain provisions under Title VII, the SEC issued three interim temporary rules on July 1, 2011, and July 7, 2011, that address clearing agencies and various aspects of security-based swaps. In addition, the SEC plans to develop a detailed plan to ensure that the Title VII regulations can be implemented efficiently and cost-effectively.
Other Developments
Custody Rule Updates
On December 30, 2009, the SEC finalized amendments to the custody requirements of Rule 206(4)-2 under the Advisers Act and related forms (the “custody rule”), which became effective for registered investment advisers as of March 12, 2010. As a result of the Dodd-Frank Act, certain advisers to private funds are required to register with the SEC by no later than March 30, 2012, which will cause such advisers to become subject to the custody rule. The SEC’s objective in issuing the custody rule was to increase protections for investors that entrust their securities and funds to registered investment advisers. In its recent inspections of investment advisers, the Office of Compliance Inspections and Examinations (OCIE) has focused on custody and has used some means of confirming client assets. For private funds, OCIE may request access to review the auditor’s work papers to avoid sending confirmations, although this is uncommon.
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Violations noted during recent inspections include the following: • • An adviser held client funds in an account in the adviser employees’ names. An adviser temporarily deposited client assets in commingled accounts or in accounts held by affiliates of the adviser.
Advisers are not permitted to maintain custody of client funds or securities in accounts in their names or in an adviser employee’s name. The custody rule requires client funds and securities to be maintained by a qualified custodian (QC) in (1) a separate account for each client under that client’s name or (2) accounts that contain only the adviser’s clients’ funds and securities under the adviser’s name as agent or trustee for the client. The following violations were also noted during inspections: • An adviser, who was not a QC, received stock certificates from customers and instead of returning them to the customers, forwarded them to the QC. Under Rule 206(4)-2(a)(1) of the Advisers Act, the adviser should have returned the stock certificates to the client within three business days. An adviser of a pooled investment vehicle did not timely distribute audited financial statements.
•
The custody rule contains an audit provision that, if used, requires the adviser to distribute audited financial statements within 120 days after year end (180 days for a fund of fund). In the SEC’s Staff’s Responses to Questions About the Custody Rule, the staff indicated that it “ would not recommend enforcement action . . . against an adviser . . . that reasonably believed that the pool’s audited financial statements would be distributed within the 120-day deadline, but failed to have them distributed in time under certain unforeseeable circumstances.” The SEC may question whether there was a reasonable belief that the audited financial statements could be timely distributed, particularly when the financial statements were significantly delayed or had been delayed for multiple years. In addition, Rule 206(4)-2 of the Advisers Act requires that an independent accountant notify the SEC within one business day of finding any material discrepancy during the course of a surprise examination. Over the last year, the SEC has received such notification letters from accounting firms and has shared the following observations: • • Certain advisers that were not relying on the audit provision did not comply with the quarterly account statements requirements of Rule 206(4)-2(a)(3). An adviser to a pooled investment vehicle that was investing in public and private securities was not able to engage a QC for its private securities until October 2010; therefore, the QC did not send the quarterly statements for its private securities to clients until after that date.
The SEC staff has also responded to custody-rule-related questions regarding compliance dates, such as when QCs must deliver account statements; omnibus accounts and system conversions; dates of the surprise examination; pooled investment vehicle compliance; internal control reports; and filing of the amended Form ADV. In addition, it has answered questions on when “top-tier” pooled investment vehicles that invest in funds of funds must distribute their audited financial statements if the advisor wishes to rely on the audit exception (because the audit of the “top-tier” fund cannot be completed before completion of the funds of funds in which it invests). The SEC’s Division of Investment Management would not recommend enforcement action under Rule 206(4)-2 if the audited financial statements of the top-tier pool are distributed to pool investors within 260 days of the end of the top-tier pool’s fiscal year.
RIC Modernization Act
The Regulated Investment Company Modernization Act of 2010 (the “Act”) updated various technical tax rules applicable to regulated investment companies (RICs), reducing the tax risks and administrative burdens on RICs and their shareholders. The Act also extends to RICs certain favorable provisions that previously had applied only to real estate investment trusts (REITs) , which are subject to similar tax treatment under Subchapter M of the Internal Revenue Code. Key components of the Act are summarized below.
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Capital Loss Carryovers
Individuals are permitted unlimited carryforwards of net capital losses, which retain their character as short term or long term. However, since RICs could only carry forward capital losses for up to eight taxable years, such losses were treated as 100 percent short term. The Act updates the capital loss carryforward rules for RICs so that they match the rules for individuals. For taxable years beginning after December 22, 2010, RICs are permitted unlimited carryforwards of net capital losses, and net long-term capital loss retains its character when carried forward instead of being treated as a short-term capital loss. Net capital losses incurred in taxable years beginning before December 23, 2010, continue to be treated as 100 percent short term and expire according to their original schedule. Further, such losses may not be used to offset capital gains until all net capital losses arising in post-enactment years have been used. As a result, some net capital loss carryovers incurred in pre-enactment years that would have been used under prior law may expire.
Gross Income and Asset Diversification Tests
A RIC must derive at least 90 percent of its income from certain enumerated sources of “good income” (e.g., dividends, interest, gains from the sale or other disposition of stock). For taxable years for which the due date of the tax return (including extensions) is after December 22, 2010, a RIC can cure inadvertent failures to comply with the gross income test by paying a tax equal to the amount by which the RIC failed the test. For example, if 89 percent of gross income is good income, the RIC will owe a tax equal to 1 percent of gross income. In prior years, if the RIC failed to comply with this requirement by even one dollar it was subject to tax as a corporation at a 35 percent rate. In addition to the gross income test, a RIC must satisfy certain asset diversification tests. Similar requirements apply to REITs. However, REITs may remedy inadvertent failures of such tests. For example, if a REIT fails the asset tests by a de minimis amount, but comes into compliance within six months after discovering the failure, the REIT is treated as satisfying the asset tests. For non-de minimis failures, a REIT can avoid disqualification if the failure is due to reasonable cause and the REIT notifies the IRS, disposes of the assets, and pays an excise tax equal to the greater of (1) $50,000 or (2) the highest corporate tax rate times the net income from the bad assets during the period of failure. The Act extends the same remedies to RICs for taxable years for which the return is due after December 22, 2010.
Deferral of Late Year Losses
A RIC must distribute essentially all of its calendar-year income (pre-October 31 income in the case of gains) by December 31 of each calendar year. Under prior law, a RIC that suffered losses after December 31 (or, in the case of capital assets, after October 31) that reduced its taxable income, net capital gain, or current earnings and profits would have to change information that was previously reported on a shareholder’s information return or cost basis statement. To remedy this situation, the Act allows a RIC to elect to treat a post-December 31 loss (or, in the case of capital assets, a post-October 31 loss) as arising on the first day of the fund’s next taxable year. For example, if a RIC has a net ordinary loss for items measured as of October 31, and net ordinary income for items measured as of December 31, the maximum loss deferral would be the excess of the post-October loss over post-December income. This change applies to taxable years beginning after December 22, 2010. See the Deloitte article, Regulated Investment Company Modernization Act of 2010, for more information about other modifications to dividends and distribution rules, excise tax, and other provisions.
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Appendixes
Asset Management: Accounting and Financial Reporting Update Appendixes: Other Developments
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Appendix A — Links to Titles of Standards and Other Literature
The titles of the standards and other literature referred to in this publication are available from the sources below.
FASB ASC References
For titles of FASB Accounting Standards Codification references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”
FASB Accounting Standards Updates and Other FASB Literature
See the FASB’s Web site for the titles of: • • • Accounting Standards Updates. Pre-Codification literature (Statements, Staff Positions, EITF Issues, and Topics). Concepts Statements.
International Standards
See Deloitte’s IAS Plus Web site for the titles of: • • International Financial Reporting Standards. International Accounting Standards.
Asset Management: Accounting and Financial Reporting Update Appendixes: Appendix A — Links to Titles of Standards and Other Literature
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Appendix B — Abbreviations
Abbreviation AICPA ASC ASU AUM CFTC CPO CTA ED EITF EPS FASB FSOC FV-NI GAAP IASB ICE IFRS IPE MD&A MoU MSRB OCIE OTC PCAOB QC REIT RIC SEC VIE Description American Institute of Certified Public Accountants FASB Accounting Standards Codification FASB Accounting Standards Update assets under management U.S. Commodity Futures Trading Commission commodity pool operator commodity trading advisor exposure draft Emerging Issues Task Force earnings per share Financial Accounting Standards Board Financial Stability Oversight Council fair value through net income generally accepted accounting principles International Accounting Standards Board investment company International Financial Reporting Standard investment property entity management’s discussion and analysis Memorandum of Understanding Municipal Securities Rulemaking Board Office of Compliance Inspections and Examinations over the counter Public Company Accounting Oversight Board qualified custodian real estate investment trust registered investment company Securities and Exchange Commission variable interest entity
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Appendix C — Deloitte Specialists and Acknowledgments
Asset Management Specialists and Contacts
Bob Contri Vice Chairman, U.S. Financial Services Leader +1 212 436 2043 [email protected] Rob Fabio Asset Management Industry Professional Practice Director +1 516 918 7285 [email protected] Susan L. Freshour Financial Services Industry Professional Practice Director +1 212 436 4814 [email protected] Maryna Tully Asset Management Industry Professional Practice Director +1 609 806 7022 [email protected]
Acknowledgments
In addition, we would like to thank the following Deloitte professionals for contributing to this document: Rajiv Basu Mark Bolton Lynne Campbell Scott Cerutti Alysha Cooke Mark Crowley Gautam Das Joe DiLeo Chris Dubrowski Rob Fabio Chris Harris Amanda Kim Elizabeth Kim Art Kulans Marie-Eve Logan Michael Lorenzo Kristen Mascis Steve McKinney Adrian Mills Ryan Moore Stuart Moss Rob Moynihan Mike Mueller Jeff Nickell Magnus Orrell Jeanine Pagliaro Sandy Pfeffer Alfred Popken James Primus Sean Prince Joseph Renouf Yvonne Rudek Courtney Sachtleben Sherif Sakr Pat Scheibel Zeta Schultz Pei-Chun Shih Jade Shopp Sean St. Germain Denise Thompson Maryna Tully Abhinetri Velanand Court Watson Peter Wilm
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Appendix D — Other Resources
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This document contains general information only and Deloitte & Touche LLP and Deloitte Tax LLP are not, by means of this document, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This document is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Any tax advice included in this document was not intended or written to be used, and it cannot be used by the taxpayer, for the purposes of avoiding any penalties that may be imposed by any governmental taxing authority or agency. Deloitte & Touche LLP and Deloitte Tax LLP, its affliates and related entities shall not be responsible for any loss sustained by any person who relies on this document. Copyright © 2011 Deloitte Development LLC. All rights reserved.
doc_204942974.pdf
Asset management, broadly defined, refers to any system that monitors and maintains things of value to an entity or group. It may apply to both tangible assets such as buildings and to intangible concepts such as intellectual property and goodwill.
Asset Management Accounting and Financial Reporting Update
December 2011
Financial Services Industry
Contents
Foreword Introduction Updates to Guidance
Reconsidering Effective Control for Repurchase Agreements (ASU 2011-03) Achieving Common Fair Value Measurement and Disclosure Requirements Under U.S. GAAP and IFRSs (ASU 2011-04) 2 3 iii iv
On the Horizon
Convergence Update and Areas of SEC Regulatory Focus Financial Instruments Project — Classification and Measurement Financial Instruments Project — Offsetting Revenue Recognition Exposure Draft Investment Companies Exposure Draft Investment Property Entities Exposure Draft Consolidation Exposure Draft 7 11 12 14 14 18 21
Other Related Developments
Dodd Frank Act Updates Registration of Fund Advisers Form PF Pay to Play Net Worth Standard Compensation Rules Regulation of OTC Derivatives Other Developments Custody Rule Updates RIC Modernization Act 24 24 24 25 25 26 26 26 26 27
Appendixes
Appendix A — Links to Titles of Standards and Other Literature Appendix B — Abbreviations Appendix C — Deloitte Specialists and Acknowledgments Appendix D — Other Resources 30 31 32 33
Foreword
December 2011 We are pleased to announce our fourth annual accounting and financial reporting update — presented for the first time by sector. This publication covers the asset management sector and is divided into three sections. The first, “Updates to Guidance,” summarizes accounting and reporting updates that asset management entities need to start preparing for now. The second, “On the Horizon,” consists of standard-setting topics that asset management entities should consider as they plan for the future. The third includes a discussion of other hot topics related to asset management. The following are links to the publications for each of the other financial services sectors: • • • Banking & Securities Insurance Real Estate
We hope you find this more condensed and focused publication a useful resource as you begin to prepare your annual reports and plan for the upcoming year. Please visit us as www.deloitte.com for more information. In addition, watch for our Heads Up newsletter covering highlights from the 2011 AICPA National Conference on Current SEC and PCAOB Developments. As always, we encourage you to contact your Deloitte team for additional information and assistance, and we welcome your feedback.
Bob Contri Vice Chairman, U.S. Financial Services Leader Deloitte LLP
Susan L. Freshour Financial Services Industry Professional Practice Director Deloitte & Touche LLP
Asset Management: Accounting and Financial Reporting Update Foreword
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Introduction
In the wake of the financial crisis, the financial services industry has operated in a much more challenging business environment. This year, the industry continues to confront difficult domestic and international economic issues and to face overall public scrutiny and dissatisfaction. In response, regulators and standard setters have established new accounting and reporting rules for financial service companies, many of which have or will become effective in the near future.
Economic Challenges
The state of the global economy continues to have a significant impact on all sectors of the financial services industry. The U.S. economy still struggles with high unemployment rates, a weak housing market, low interest rates, ongoing worries about the debt situation, the downgrade of the U.S. credit rating, and government spending. Other countries in the global markets, particularly in the eurozone, have also continued to struggle with their own debt issues and have seen a rise in political uncertainty and unrest. The public continues to blame financial institutions for many of the hardships that the global economy is facing. Many of the criticisms have fallen upon the ears of legislators, who continue to look for ways to improve the situation. In an effort to win back public confidence, regulators have sought ways to increase investor protection and to make the financial positions of public financial institutions more transparent. As a result, financial services firms are making significant changes to their compliance functions and are rethinking the strategies that they have in place for the future.
Regulatory Reform
This year marked the one-year anniversary of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which mandated extensive rulemaking in response to the financial crisis. Although only a quarter of the proposed regulations have been written, some significant changes have already been made. In addition to the increased scrutiny by regulators, additional capital requirements, and customer protection rules, the financial services industry most recently has been faced with new regulations on derivatives and the Volcker Rule. Companies must make strategic decisions to navigate this new, more strictly regulated business environment.
Convergence and Accounting Changes
This year, standard setters are still busy updating and writing guidance that will affect the financial services industry as a whole. The FASB and IASB (the “boards”) continue to work together on converging their guidance into a single, comprehensive set of global accounting standards. In addition, standard setters have placed greater emphasis on improving the transparency of accounting and the related disclosures for financial statement users. Amid all the turmoil and change, it appears certain that change and volatility are here to stay for the foreseeable future. Companies in the financial services industry will have to respond and adapt. This publication describes accounting developments over the past year that may be relevant to financial services companies. Some of these developments apply to the 2011 fiscal year, while others are on the horizon. Companies should consider formulating a plan to prepare for the changes that lie ahead.
Asset Management: Accounting and Financial Reporting Update Introduction
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Updates to Guidance
Asset Management: Accounting and Financial Reporting Update Updates to Guidance: Updates to Guidance?
1
Reconsidering Effective Control for Repurchase Agreements (ASU 2011-03)
Introduction
On April 29, the FASB issued ASU 2011-03, which eliminates from U.S. GAAP the requirement for entities to consider whether a transferor (i.e., seller) has the ability to repurchase the financial assets in a repurchase agreement (“repo”). Such requirement was one of the criteria under ASC 860 that entities used to determine whether the transferor maintained effective control. Although entities must consider all the effective-control criteria under ASC 860, the elimination of this requirement may lead to more conclusions that a repo arrangement should be accounted for as a secured borrowing rather than as a sale.
Background
Repos can take different forms. In one type, the entity (1) transfers financial assets to a purchaser and receives cash and (2) promises to repurchase the same (or substantially the same) financial assets on a future date and at a specified price. In essence, the entity “borrows” cash equal to the sales price of the financial assets and has the obligation to return that cash (i.e., repurchase the financial asset) on a future date. In these transactions, the financial assets held by the purchaser effectively “collateralize” the entity’s debt (i.e., the obligation to repurchase the financial assets in the future). Whether to account for such a transaction as a sale or a secured borrowing depends on whether the entity meets certain criteria in ASC 860. Under ASC 860, an entity that maintains effective control over transferred financial assets must account for the transfer as a secured borrowing rather than as a sale. Further, ASC 860 states that an entity maintains effective control in a repo if certain criteria are met. One of these criteria indicates that an entity maintains effective control over a financial asset when the transferor “is able to repurchase or redeem [the financial asset] on substantially the agreed terms, even in the event of default by the transferee.” To comply with this criterion, the entity must maintain cash or sufficient collateral “to fund substantially all of the cost of purchasing replacement financial assets from others.” An entity that meets this criterion (and other criteria discussed in ASC 860-10-40-24) maintains effective control over the transferred financial assets and must account for the transfer as a secured borrowing. An entity that does not meet this criterion would need to account for the transfer of financial assets as a sale if it meets other criteria in ASC 860.
Overview of the Changes
The ASU removes from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee. The ASU does not change the other criteria in ASC 860 used in the assessment of effective control. Accordingly, upon the adoption of the ASU’s guidance, a transferor in a repo transaction is deemed to have effective control (i.e., account for the repo as a secured borrowing) if the following three conditions in ASC 860-10-40-24 are met: • • • “The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred.” “The agreement is to repurchase or redeem them before maturity, at a fixed or determinable price.” “The agreement is entered into contemporaneously with, or in contemplation of, the transfer.”
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Implementation of the guidance above is not without its challenges or complexities, especially for investment companies that enter into treasury roll and certain mortgage dollar roll transactions. One of the complicated accounting issues in certain dollar roll transactions is determining whether the security to be repurchased from the counterparties is substantially the same as the security transferred to the counterparty. Preparers, therefore, should carefully consider the fundamental characteristics of the transferred and reacquired securities to determine the appropriate accounting treatment of the transaction. If the transaction is accounted for as a secured borrowing, there will be an additional complexity related to considerations in connection with the financing cost accrual and the impact on investment company expense ratios.
Effective Date
The guidance in the ASU is effective prospectively for transactions, or modifications of existing transactions, that occur on or after the first interim or annual period beginning on or after December 15, 2011. For example, a calendar-year-end entity will be required to apply the new guidance as of January 1, 2012. Early adoption is not permitted.
Achieving Common Fair Value Measurement and Disclosure Requirements Under U.S. GAAP and IFRSs (ASU 2011-04)
Overview
On May 12, 2011, the FASB issued ASU 2011-04 to conform (1) the definition of fair value and (2) common requirements for measurement and disclosure of fair value under U.S. GAAP and IFRSs. While the ASU largely retains the fair value measurement principles under ASC 820, it expands current disclosure requirements and changes how fair value measurement guidance is applied in certain circumstances. The ASU affects all entities with assets, liabilities, or equity instruments measured or disclosed at fair value. The resources and time commitment needed for implementation will most likely vary by entity but could be significant for those that would also have to implement controls that comply with the Sarbanes-Oxley Act of 2002.
Significant Amendments and Potential Implementation Challenges
Disclosures
Additional Disclosures Required by the ASU For fair value measurements categorized in Level 3 of the fair value hierarchy: • Description of the valuation processes used by the entity. • Development of descriptions of valuation processes to be included in the financial statements, including policies, procedures, and related analysis. • Judgments about whether a change would result in a significantly different fair value measurement and whether there is an interrelationship among the unobservable inputs. • Yes. Potential Implementation Challenge Applicable to Nonpublic1 Entities?
• Qualitative description of sensitivity of fair value to changes in unobservable inputs and their interrelationships if a change would result in a significantly different fair value measurement.
• No.
1
As defined in the FASB Accounting Standards Codification.
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Additional Disclosures Required by the ASU • Quantitative disclosures about unobservable inputs. This is not required if the entity does not develop quantitative unobservable inputs when measuring fair value (e.g., when using prices from prior transactions or third-party pricing information without adjustment). However, the entity is not allowed to ignore reasonably available quantifiable unobservable inputs that are significant to the fair value measurement. Further, goodwill fair value measurements categorized as Level 3 are exempted from this requirement. Any transfers between fair value measurements classified as Level 1 and Level 2 resulting in the disclosure of all transfers between levels. For those assets and liabilities not measured at fair value in the statement of position for which fair value is disclosed (e.g., loans receivable or own debt measured at amortized cost as required by ASC 825), the level within the fair value hierarchy. This is in addition to the existing requirement to disclose the fair value and to describe the method and significant assumptions used to estimate fair value for certain financial instruments (see ASC 825).
Potential Implementation Challenge • Gathering data, depending on the number and complexity of unobservable inputs involved (e.g., illiquid options), establishing whether the data is reasonably available, and building processes to gather information from third parties if it is reasonably available.
Applicable to Nonpublic Entities? • Yes.
Systems may not have such tracking capabilities and therefore may require an adjustment or manual tracking, which may increase the risk of error. Assessment of the level in the fair value hierarchy for these fair value measurements disclosed may be subjective and may require entities to implement additional processes and controls in making the disclosure.
No, only transfers from Level 3 are required.
Yes.
Many of the potential implementation challenges outlined above will be especially burdensome to investment companies with significant Level 3 investments. The removal of the word “significant” from the requirement under ASC 820 to disclose transfers between Levels 1 and 2 will affect entities that had previously only disclosed such transfers on the basis of significance.
Highest and Best Use and Valuation Premise
The ASU specifies that the highest and best use and valuation premise concepts only apply in the measurement of the fair value of nonfinancial assets, thus potentially prohibiting the grouping of financial instruments in the determination of their fair values. One exception to this principle is discussed below. Investment companies that use an enterprise value approach when valuing controlling debt and equity interests in an investee should focus on this portion of the ASU because the accounting treatment may be affected by this new guidance.
Offsetting Positions in Market Risks or Counterparty Credit Risk
The ASU permits an entity to measure a group of financial instruments with offsetting market or counterparty credit risk on a net risk exposure basis if the reporting entity does all of the following: • Manages the group of financial assets and financial liabilities on the basis of the reporting entity’s net exposure to a particular market risk (or risks) or to the credit risk of a particular counterparty in accordance with the reporting entity’s documented risk management or investment strategy. Provides information on that basis about the group of financial assets and financial liabilities to the reporting entity’s management. Is required or has elected to measure those financial assets and financial liabilities at fair value in the statement of financial position at the end of each reporting period.
• •
A reporting entity should consistently apply its accounting policy decision to measure the group of financial assets and financial liabilities on the basis of its net long- or short-risk position (the unit of measurement). The ASU’s guidance applies
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to the fair value measurement of financial instruments and not to financial statement presentation. Entities may be required to allocate the fair value of a net risk position to specific assets or liabilities (in a manner similar to the unit of account allocation specified in other ASC topics).
Premiums or Discounts in Fair Value Measurement
Blockage factors (i.e., a premium or discount that reflects size as a characteristic of the holding, as opposed to a characteristic of the asset or liability, because the market’s normal daily trading volume is insufficient to absorb the quantity held by the entity) are generally not allowed in a fair value measurement. Entities are exempt from this principle when the unit of measurement is specified to be the entire holding (e.g., when entities apply the guidance discussed in the Offsetting Positions in Market Risks or Counterparty Credit Risk section above). To remove blockage factors previously included in a fair value measurement, entities may need to reassess the manner in which fair value is determined.
Instruments Classified as Shareholders’ Equity of the Reporting Entity
The ASU aligns the fair value measurement of instruments classified as shareholders’ equity of the reporting entity with the guidance on measuring the fair value of liabilities. If there is no observable transaction (quoted price) for the transfer of the equity classified instrument, the entity would measure the fair value of the instrument from the perspective of a market participant holding the identical instrument as an asset. An entity may therefore have to review its existing policy for measuring the fair value of instruments classified as shareholders’ equity of the reporting entity.
Convergence
The ASU’s primary goal was to converge guidance with IFRSs on (1) how to measure fair value and (2) what to disclose about fair value measurements within the financial statements. Although the ASU was principally successful, the following differences remain: • • Under IFRSs, a fair value measurement must be based on observable inputs for a day-one gain or loss to be recognized in earnings. There is no such requirement under U.S. GAAP. There is no practical expedient exception to a fair value measurement of certain investments (e.g., hedge funds) under IFRSs. Under U.S. GAAP, net asset value may be used for a fair value measurement for certain investments as a practical expedient. A quantitative measurement uncertainty analysis is required under IFRSs for financial instruments. There is no such requirement under U.S. GAAP. Under IFRSs, nonpublic entities are not exempt from certain fair value measurement disclosure requirements. However, guidance in U.S. GAAP contains such an exemption. Under IFRSs, fair value cannot be less than the present value of the amount payable on demand. Under U.S. GAAP, the fair value of a deposit liability is the amount payable on demand at the reporting date.
• • •
Effective Date and Transition
The ASU’s measurement and disclosure requirements are effective for public entities for reporting periods (including interim periods) beginning after December 15, 2011 (i.e., for calendar-year entities, the beginning of first quarter ended March 31, 2012), and for nonpublic entities for annual periods beginning after December 15, 2011. Nonpublic entities may early adopt the amendments for interim periods beginning after December 15, 2011. The amendments in the ASU should be applied prospectively (i.e., no cumulative adjustment to opening retained earnings). Entities should disclose the change, if any, in valuation technique and related inputs resulting from application of the amendments and should quantify and disclose the total effect of the change, if practicable.
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On the Horizon
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Convergence Update and Areas of SEC Regulatory Focus
Development of IFRS Adoption in the United States
November 2008 Roadmap
In November 2008, the SEC issued and sought comments on a proposal, Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers, for evaluating the future role of IFRSs in the U.S. capital markets. After consideration of comment letters on the proposed roadmap, the SEC determined that before a decision about a transition to IFRSs from the current financial reporting system could be made, a more comprehensive work plan was needed, including details of the scope, timeframe, and method for any such transition.
February 2010 Work Plan
In February 2010, the SEC issued a statement of continued support for a single set of high-quality, globally accepted accounting standards. At that time, the statement also included a work plan that identified six areas of particular importance that needed further analysis by the SEC staff in determining whether, when, and how to incorporate IFRSs into the U.S. financial reporting system for U.S. issuers. The six areas of concern were: 1. Sufficient development and application of IFRSs for the U.S. domestic reporting system. 2. The independence of standard setting for the benefit of investors. 3. Investor understanding and education regarding IFRSs. 4. Examination of the U.S. regulatory environment that would be affected by a change in accounting standards. 5. The impact on issuers, both large and small, including changes to accounting systems, changes to contractual arrangements, corporate governance considerations, and litigation contingencies. 6. Human capital readiness. At that time, the statement indicated that a determination about the use of IFRSs in the United States would be made in 2011. The SEC staff committed to providing public progress reports on the work plan.
October 2010 Progress Report on Work Plan
In October of 2010, the SEC staff issued its first progress report on the work plan, in which it clarified that it would be in a better position to determine whether to incorporate IFRSs into the U.S. domestic financial reporting system after successful completion of the work plan and existing FASB and IASB convergence projects. Although many countries that have previously adopted IFRSs have done so at a single point in time by using a “first-time adoption” or “switch-over” conversion approach, such methods have been criticized by some U.S. constituents. Other constituents, especially large issuers, have indicated their preference for a so-called “big-bang” transition.
2011 SEC Staff Papers
In May 2011, the SEC’s Office of the Chief Accountant issued a staff paper pursuant to the work plan that outlined a new possible framework for incorporation of IFRSs into the U.S. financial reporting system. The SEC staff paper approach combined elements of convergence and endorsement (dubbed “condorsement” by a member of the SEC staff at the 2010 AICPA National Conference on Current SEC and PCAOB Developments).
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Under an endorsement approach, jurisdictions would incorporate individual IFRSs into their local financial reporting systems in accordance with specified endorsement processes and usually by using specified endorsement criteria. The European Union and Australia have followed such an approach. The staff paper notes that the United States would follow similar processes and that the FASB and SEC would have specific responsibilities. In particular, the FASB would incorporate newly issued IFRSs into U.S. GAAP, and the SEC and the FASB would retain the ability to modify or supplement IFRSs when doing so would be in the public interest or necessary for the protection of U.S. investors. During a transition phase, the framework would follow a convergence approach under which the FASB would bring U.S. GAAP closer to IFRSs by addressing and evaluating differences between the sets of standards and incorporating IFRSs into U.S. GAAP, with a focus on minimizing transition costs. While the term “U.S. GAAP” would be retained, the ultimate goal of the framework is that at the end of the transition period, a “U.S. issuer compliant with U.S. GAAP should also be able to represent that it is compliant with IFRS as issued by the IASB.” The SEC has not committed to a method of adoption and no timeline has been specified, but the staff paper mentions a transition period of five to seven years. On July 31, 2011, the comment period closed for constituents to submit responses to the SEC. The SEC is currently analyzing more than 140 comment letters received in response to the proposed framework outlined in the staff paper. Concerns included the following: •
Timing of decision — Many respondents encouraged the SEC to make a final decision and establish a comprehensive implementation plan with a definitive timeline before the end of 2011 to help facilitate a timely and cost effective transition. Conversely, other respondents encouraged the SEC to make a decision on incorporation of IFRSs only when the boards have completed MoU projects and established a clear plan to address the remaining substantive differences between IFRSs and U.S. GAAP. IASB’s due process and quality of IFRSs — Some respondents suggested that the SEC critically evaluate the IASB’s standard-setting process, including the robustness of its due process and the quality of its standards relative to U.S. GAAP. Respondents also expressed concerns regarding the uniform application of principles-based accounting standards given the (1) diverse legal and cultural environments of the countries applying IFRSs and (2) significant judgments needed in their application. Transition:
o
•
•
Phased versus single effective date for U.S. issuers — Constituents expressed mixed views about whether a phased approach should be used to incorporate IFRSs into the U.S. financial reporting system or whether IFRSs should be incorporated all at once on a single effective date. Prospective versus retrospective application — Most preparers suggested that, whenever possible, IFRSs incorporated into U.S. GAAP be applied prospectively because a retrospective application would be costly and burdensome. Some users of financial statements indicated a preference for retrospective application because such a transition would allow them to compare a preparer’s financial results for the periods presented in its financial statements. Early adoption — Most preparers preferred an option to adopt IFRSs voluntarily during the transition period. Users of financial statements had mixed views on this topic. Although some noted that early adoption might be advantageous for certain companies, others indicated that it could result in the presentation of information that was not comparable for certain periods.
o
o
•
Role of the FASB — Most respondents agreed that the FASB should play a strong role in the IASB’s standardsetting process and serve as the voice of the United States in the development of IFRSs. Many agreed with the staff paper’s proposal to give the FASB authority to modify IFRSs incorporated into U.S. GAAP because they believed that such an “endorsement” approach would offer greater protection to U.S. investors than would direct incorporation of IFRSs. However, respondents had mixed views on the circumstances in which the FASB should
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be able to modify IFRSs. Some believed that modifications of IFRSs should not be limited to rare circumstances but rather should be made whenever the FASB determines that they are needed to protect the interests of U.S. investors. Others were concerned that such modifications would lead to a U.S. flavor of IFRSs and preferred that the FASB establish specific criteria that it would have to apply to determine whether modifications of IFRSs would be in the best interest of U.S. investors. On November 16, 2011, as part of its work plan, the SEC staff published two papers with information relevant to the SEC’s assessment of the sufficient development and application of IFRSs for the U.S. domestic financial reporting system. One paper, A Comparison of U.S. GAAP and IFRS, focuses on the more significant differences between the two sets of standards. The other, An Analysis of IFRS in Practice, reviews a selection of annual consolidated financial statements of both SEC registrants and nonregistrants that prepare their financial statements in accordance with IFRSs and discusses the comments they receive from the SEC. In a speech at the December 2011 AICPA National Conference on Current SEC and PCAOB developments, the SEC staff commented that it expects to complete a final comprehensive report on its work plan in the next several months.
The Road Ahead for the SEC, FASB, and IASB
Irrespective of the SEC’s decisions on the timing and method of incorporation of IFRSs into the U.S. financial reporting system, the FASB and IASB continue to make progress on the convergence of U.S. GAAP and IFRSs in “high-priority” accounting areas, including revenue recognition, leases, insurance contracts, financial instruments, and consolidation. Such progress is highlighted in the table below.2
Financial Crisis–Related Projects IFRS 9: Financial instruments (replacement of IAS 39) Deferral of mandatory effective date of IFRS 9 Impairment Hedge accounting General hedge accounting Macro hedge accounting Asset and liability offsetting (amendments to IFRS 7 and IAS 32) Memorandum of Understanding Projects Leases Revenue recognition (revised ED, comments due by March 13, 2012) Other Projects Insurance contracts Consolidation — investment entities (ED, comments due by February 15, 2012) Consolidation — policy and procedures (ED, comments due by February 15, 2012) Comment period Comment period 2011 Q4 Target IFRS 2011 Q4 2012 H1 Target ED (reexpose) Comment period 2012 H1 Review draft or revised ED 2012 H2 Target IFRS Target IFRS 2012 H2 Review draft Target IFRS Target ED X X X MoU X X MoU X Joint X X Joint X X Target completion Reexposure X X 2011 Q4 2012 H1 2012 H2 MoU Joint
Deferred and Proposed Projects
Projects relevant to the financial services industry that were previously added to the IASB’s agenda but later deferred include those on financial instruments with characteristics of equity, financial statement presentation, liabilities, income taxes, and EPS.
2
As reprinted from the IASB’s Web site. See the FASB’s Web site and the IASB’s Web site for a full list of projects.
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Areas of SEC Regulatory Focus
Increased Scrutiny of Accounting and Reporting by Financial Institutions
In 2011, the SEC established two specialized teams of financial services disclosure experts to (1) review disclosure statements filed by large financial institutions and (2) review disclosure statements filed by approximately 700 mid-tier and smaller community banks. The teams will focus on disclosure trends particular to these two industry segments and ensure that clear comprehensive information is provided in accordance with SEC requirements.3 Although the teams are not specifically focusing on investment companies, the themes of their review may be helpful for investment managers to understand. As discussed further below, companies in the financial services sector can expect increased scrutiny from regulators.
Potential Litigation Loss Contingencies
SEC disclosure teams want financial institutions to clarify their exposure to potential losses due to litigation and other contingencies. Previously, the inability to accurately make any estimate of the risk that disclosure could prejudice ongoing legal proceedings was acceptable to limit disclosure. While there are no new requirements, the SEC expects companies to provide clearer information regarding the nature of the loss contingency and a possible loss or range of loss. The SEC also expects that a registrant would continually evaluate and refine estimates over time as events and circumstances change, especially since, in theory, the ability to estimate should increase as the registrant gets closer to settling the matter. Registrants are permitted to aggregate the disclosures so as not to prejudice their position in legal proceedings. In particular, the SEC would like improvement in the area of surprise disclosures when a large charge was recorded with no previous disclosure (i.e., from immaterial to large settlement).
Sovereign Debt Exposures
The SEC wants clarity in disclosures regarding the level of exposure and how sovereign debt exposure is monitored. Currently, there is no staff view on the specific changes to the application of U.S. GAAP or impairments under U.S. GAAP for registrants holding U.S. government obligations. However, on the basis of informal discussions, the conclusion that U.S. treasuries are not other-than-temporarily impaired (except in limited circumstances) is consistent with the expectations of both the FASB and the SEC staff.
Performance-Based Compensation
The SEC wants investors to understand how executives at financial institutions are compensated and why a particular compensation strategy is selected (i.e., prioritizing short-term over long-term).
Overall Quality of MD&A
Expectations related to the quality of MD&A include: • • Management’s expectations of the impact of the external economic environment on the company. Transparent qualitative discussions to help investors understand the trends and qualitative factors that affect loss allowances and expectations going forward of the impact that trends and the external economic environment will have on allowance levels. Directional consistency between underlying credit trends and how the allowance is changing as expected (e.g., “If 10 percent of our loans were downgraded by one loan class, our allowance would change by x amount”).
•
3
For additional information, see the SEC’s Division of Corporation Finance Filing Review Process.
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Financial Instruments Project — Classification and Measurement
Background
In May 2010, the FASB issued a proposed ASU that outlines a comprehensive new model of accounting for financial assets and financial liabilities related to (1) classification and measurement, (2) impairment, and (3) hedge accounting. The FASB elicited extensive feedback from various constituents by organizing a series of roundtables in October 2010, and it received more than 2,800 comment letters on the proposal. Redeliberations have been in progress since December 2010 and are expected to continue. While the ASU covers many topics, several of which are still being deliberated, the discussion below highlights those that most significantly affect the investment management industry.
Fair Value Option for Financial Instruments
An unconditional fair value option would not be provided for either financial assets or financial liabilities. A conditional fair value option would permit measurement of a group of financial assets and financial liabilities at fair value if the entity manages the net exposure related to those financial assets and liabilities and it provides information on that basis to its management. In addition, there is a conditional fair value option for hybrid instruments to avoid bifurcation of an embedded derivative after an entity has determined that the embedded derivative feature would otherwise have required separate accounting.
Financial Liabilities
Financial liabilities that meet the criteria for amortized cost are classified and measured at amortized cost unless they are (1) a financial liability for which the entity’s business strategy is to subsequently transact at fair value or (2) a short sale.
Financial Assets Held to Settle Nonrecourse Liabilities
In circumstances in which financial assets will be used to settle nonrecourse financial liabilities, an entity should measure the financial liabilities consistently with the measure of the related financial assets. In other words, a write-down on the financial asset would entail a symmetrical write down of the nonrecourse financial liability.
Loan Commitments, Revolving Lines of Credit, and Standby Letters of Credit
In accordance with the current tentative decisions, loan commitments, revolving lines of credit, and standby letters of credit would be carried at fair value through net income (FV-NI) if the entity’s business strategy for the underlying loans is to hold them for sale.
Initial Measurement Principle and Accounting for Transaction Fees and Costs
As clarified in the FASB’s June 8, 2011, summary of meeting decisions, entities that follow the specialized industry guidance in ASC 946 will initially measure financial instruments at the transaction price. The Board voted by a wide 6 to 1 majority to retain this specialized industry guidance. Under the Board’s tentative decision, investment companies subsequently measure a financial instrument at fair value, with transaction fees and costs recorded in unrealized gains/losses until the instrument is sold, at which time such amounts are reclassified to realized gains/losses. This represents an exception to the initial measurement principle tentatively selected for financial instruments subsequently measured at FV-NI and initially measured at fair value. While most entities will expense transaction costs incurred for the acquisition or issuance of a financial instrument that is initially and subsequently measured at fair value, investment companies will be permitted to report transaction costs in unrealized gains/losses until the instrument is sold.
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Deferral of IFRS 9
In November, the IASB tentatively decided to consider changes to the classification and measurement requirements in IFRS 9 and delayed the mandatory effective date from January 1, 2013, to January 1, 2015. The decision to reopen and defer IFRS 9 will enable the boards to address potential application issues in IFRS 9, consider the interaction between IFRS 9 and tentative decisions made as part of the IASB’s insurance contracts project, and to consider potential convergence with the FASB’s model on the classification and measurement of financial instruments. However, because significant changes would be disruptive for companies that early adopt IFRS 9 or for those that have made significant implementation efforts, the Board decided that these changes should be made as soon as possible and that the scope of changes should be limited. Some IASB members expressed concern that reconciling IFRS 9 with the FASB’s model might lead to “scope creep” because some of the differences are significant. For example, the FASB’s model prohibits the reclassification of all financial instruments, while IFRS 9 permits an entity to reclassify financial assets when an entity’s business strategy changes. Furthermore, the FASB’s tentative model retains the requirement to bifurcate certain embedded derivatives from hybrid financial assets, while IFRS 9 requires an entity to classify and measure hybrid financial assets in their entirety (i.e., without bifurcating embedded derivatives). Addressing these and other differences between IFRS 9 and the FASB’s tentative model on the classification and measurement of financial instruments may require significant changes to IFRS 9.
Financial Instruments Project — Offsetting
Background
In January 2011, the boards issued a joint ED outlining a proposed revision to the model for determining when a reporting entity should offset (i.e., present net) financial assets and financial liabilities on the face of the statement of financial position. The boards issued the ED in hopes of harmonizing the significant presentation differences between financial statements prepared under U.S. GAAP and those prepared under IFRSs, particularly for financial institutions. Under the ED’s proposed model, reporting entities would have been required to present all recognized financial assets and financial liabilities, including derivative instruments (financial and nonfinancial), “collectively eligible assets and eligible liabilities,” net on the face of the statement of financial position when the entities (1) had an unconditional and legally enforceable right to set off the eligible asset and eligible liability and (2) intended either: • • To settle the eligible asset and eligible liability net. To realize the eligible asset and settle the eligible liability simultaneously.
In all other circumstances, netting of financial assets and financial liabilities would have been precluded. Feedback received on the ED was mixed. Some commenters agreed with the proposed criteria because they believed that a gross presentation on the statement of financial position generally provides better information about an entity’s future cash flows. Others believed that a net presentation of instruments subject to master netting arrangements better reflects an entity’s credit exposures and provides more useful information to financial statement readers. There was general consensus, however, that both gross and net information was useful and should be included in the financial statements, either on the face of the statement of financial position or in the notes to the financial statements. Had the proposed model been adopted, the amounts of total assets and liabilities reported in statements of financial position of certain U.S. GAAP filers with large derivative portfolios would have significantly increased because the right to offset derivative instruments and related cash collateral receivables and payables under a master netting arrangement is generally conditioned upon the default of the derivative counterparty (i.e., the right to offset would not be deemed unconditional). The financial statement presentation for entities with significant repurchase and reverse repurchase agreements also could have been greatly affected by the proposed offsetting criteria.
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Convergence of Disclosure Requirements
In June 2011, the boards decided to take different paths in their offsetting journeys and ultimately decided to retain their existing offsetting models. In addition, to address practice inconsistencies noted during deliberations, the IASB decided to clarify and modify certain interpretative offsetting guidance in IAS 32. As a result of these decisions, the differences under U.S. GAAP and IFRSs continue to be significant regarding the presentation of offsetting of financial instruments on the face of the statement of financial position. To accommodate constituents’ preference for the presentation of both gross and net information in the financial statements, the boards attempted to reconcile their different presentation models by deciding to create new, converged disclosure requirements. Accordingly, the boards decided to: • Retain the objective, for offsetting disclosures, that an entity “should disclose information about rights of set-off and related arrangements (such as collateral arrangements) associated with the entity’s financial assets and financial liabilities to enable users of its financial statements to understand the effect of those rights and arrangements on the entity’s financial position.” Modify the scope so that the disclosure requirements apply only to instruments under enforceable master netting agreements or similar arrangements (e.g., derivatives, securities lending arrangements, and repurchase agreements). Clarify that the disclosure requirements would not apply to entities that have “no qualifying assets or liabilities that are subject to a right of set-off (other than collateral agreements) at the reporting date.”
•
•
Required disclosures will include: 1. The gross amounts of the financial assets and financial liabilities. 2. The amounts of financial assets and financial liabilities offset in the statement of financial position. 3. The net amount after taking in account (1) and (2) (which should be the same as the amounts reported in the statement of financial position). 4. The effect of rights of set off that are only enforceable and exercisable in the bankruptcy, default, or insolvency of either party and that are not taken into account in arriving at the amounts presented in the statement of financial position (including collateral). 5. The net exposure after taking into account the effect of items (2) and (4).
Next Steps
The boards are expected to issue final standards by the end of the calendar year. Both the FASB and IASB agree that the standards (i.e., the new disclosure requirements and the clarifications approved by the IASB) would be effective for annual and interim reporting periods beginning on or after January 1, 2013. Retrospective application will be required for the new guidance. Preparers of financial statements are encouraged to begin gathering data now so that they are prepared to comply with the new offsetting disclosure requirements by the relevant effective date. Information that companies should gather includes: • • Details regarding the nature of the rights of set off embedded within a financial instrument (or a related side arrangement). Information regarding any collateral arrangements associated with the entity’s portfolio of financial instruments.
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In addition, preparers need to start considering how and where to incorporate these disclosures in their notes to the financial statements. Finally, since the boards were unable to converge the guidance on offsetting on the face of the balance sheets, preparers should ensure that they are well equipped to explain any differences between their financial position and the financial position of their international counterparts as a result of disparate offsetting models.
Revenue Recognition Exposure Draft
On November 14, 2011, as a result of redeliberations on their June 2010 ED, the FASB and IASB jointly issued a revised ED on revenue recognition (see Deloitte’s November 15, 2011, Heads Up for additional details). The ED, issued by the FASB as a proposed ASU, outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and would supersede substantially all current revenue recognition guidance. Comments on the ED are due by March 13, 2012. The boards agreed that a final standard would not be effective before annual periods beginning on or after January 1, 2015, for public companies, with a minimum of a one-year deferral for nonpublic companies. The final effective date will be set by the boards during redeliberations of the ED, and entities will be required to adopt the final standard retrospectively (with certain optional practical expedients). Early application will not be permitted for the FASB’s proposed ASU; however, the IASB’s permits early application. While many of the proposed revenue recognition provisions will not apply to investment companies, certain principles could have an effect on the investment adviser. Under the ED, the timing and measurement of revenue for some contracts with uncertain or variable consideration may change. For example, under current U.S. GAAP, investment managers may use two potential methods to recognize revenue for performance-based incentive fees in accordance with EITF Topic D-96 (codified in ASC 605-25-20-S99). Because this guidance would be superseded if the ED is finalized, accounting for the performancebased incentive fees may change (the ED requires such a fee to be reasonably assured before being recognized). For an entity to conclude that a fee is reasonably assured, the entity’s experience with similar contracts has to be predictive (which may not be the case when the fee is highly susceptible to external factors such as market volatility). Revenue recognition for these fees may therefore have to be deferred.
Investment Companies Exposure Draft
Background
On October 21, 2011, the FASB issued a proposed ASU that would amend the criteria in ASC 946 for an entity to qualify as an investment company (referred to as an “ICE” in this discussion). An ICE that meets all of the revised criteria would continue to measure its investment assets at fair value; however, in a fund-of-funds structure, an ICE would be required to consolidate a controlling financial interest in another ICE or an investment property entity (IPE). The proposed ASU also would require additional disclosures by the ICE. Comments on the proposal are due February 15, 2012. See Deloitte’s October 21, 2011, Heads Up for more information. The proposed ASU is the result of a joint project with the IASB to amend the guidance on ICEs. In August 2011, the IASB issued an ED that would provide similar, but not identical, guidance on accounting for ICEs. In addition, on October 21, 2011, the FASB issued a proposal that defines an IPE (see discussion below).
Revised Definition of an ICE
The proposed ASU states that an entity qualifies as an ICE if it satisfies the following criteria:
a. Nature of the investment activities. The [ICE’s] only substantive activities are investing in multiple investments for returns from capital appreciation, investment income (such as dividends or interest), or both. aa. Express business purpose. The express business purpose of the [ICE] is investing to provide returns from capital appreciation, investment income (such as dividends or interest), or both.
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b. Unit ownership. Ownership in the [ICE] is represented by units of investments, in the form of equity or partnership interests, to which a portion of the net assets are attributed. c. Pooling of funds. The funds of the [ICE’s] investors are pooled to avail investors of professional investment management. The entity has investors who are not related to the parent (if there is a parent) and those investors, in aggregate, hold significant ownership interests in the entity. cc. Fair value management. Substantially all of the [ICE’s] investments are managed, and their performance evaluated, on a fair value basis. d. Reporting entity. The [ICE] provides financial results about its investment activities to its investors. The entity can be but does not need to be a legal entity.
In addition, entities that are regulated under the Investment Company Act of 1940 (the “1940 Act”) would be included within the scope of the ICE guidance in ASC 946 regardless of whether they meet the revised criteria. Although ASC 946 currently does not apply to real estate investment trusts, the proposed ASU would remove this scope exception. Accordingly, some real estate investment trusts would be ICEs. However, real estate entities that meet the proposed definition of an IPE would be excluded from the scope of ASC 946 and would apply the proposed requirements for IPEs, even if they meet the criteria to qualify as an ICE.
Accounting for Underlying Investments
An ICE should measure all of its investments (including real estate properties): • Initially at their transaction price, which would include commissions and other charges that are part of the purchase transaction. • Subsequently at fair value, with changes in fair value recognized through profit or loss. However, in a fund-of-funds structure, an ICE that controls a wholly owned or partially owned ICE or IPE should consolidate that ICE or IPE under ASC 810. The proposed ASU would not require consolidation of a controlling financial interest in an ICE or IPE in a master-feeder structure. When consolidating an ICE or IPE, an ICE should retain any specialized accounting applied by the subsidiary in the consolidated financial statements. Conversely, an ICE should account for its investment in another ICE or an IPE that it can significantly influence at fair value (i.e., the equity method of accounting would be prohibited). Currently, some ICEs consolidate other ICEs only when the parent ICE owns 100 percent of the ICE subsidiary. However, the proposed guidance would require consolidation in a fund-of-funds structure whenever there is a controlling financial interest, which may include less than wholly owned ICE subsidiaries. An ICE would need to look to the consolidation guidance in ASC 810 to determine which consolidation model to apply (i.e., the variable interest entity model, the voting interest entity model, or the control of partnerships model) when assessing whether it has a controlling financial interest. As noted in the FASB Consolidation Project section in this publication, the Board has also proposed updates to consolidation guidance that entities should monitor. The proposed ASU also provides implementation guidance on each of the six criteria for determining whether an entity qualifies as an ICE, as outlined below.
Nature of Investment Activity
To satisfy the first criterion, an entity’s only substantive activities should be investing activities and its only significant assets and liabilities should be related to those investment activities. However, the proposed ASU includes an exception for situations in which an ICE (or an investee of the ICE) provides services related to its investment activities, such as investment advisory or transfer agent services. If these services are provided by an investee, the investee would be either (1) consolidated under ASC 810 if the ICE has a controlling financial interest in the investee or (2) accounted for under the equity method of accounting in ASC 323 if the ICE has significant influence over the investee.
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A second component of this criterion is the necessity to hold multiple investments. Under the proposed ASU, an ICE “is required to hold multiple investments at the same time, directly or indirectly through another [ICE].” However, it is not required to hold multiple investments at all points in time. For example, an ICE is not required to hold multiple investments when (1) its initial offering period has not expired, (2) it is still identifying suitable investments or is in the process of replacing investments disposed of, or (3) it is in the process of liquidation. Finally, the proposed ASU provides a number of examples of relationships and activities that demonstrate that an entity is investing “other than for capital appreciation or investment income.” When assessing the relationships and activities in these examples, the ICE should consider its relationships and activities as well as those of its affiliates. The FASB and IASB determined that the multiple investment criterion was an important characteristic of an ICE because it represents a means of diversification to maximize returns. However, the proposed ASU takes into account situations in which an entity may hold a single investment and still meet the definition of an ICE. For example, an ICE may establish a subsidiary ICE that holds an individual investment for legal or other reasons (commonly referred to as a blocker fund). In this instance, the subsidiary entity would not be precluded from qualifying as an ICE as long as it meets the other criteria.
Express Business Purpose
Under the second criterion, the entity’s express business purpose must be to invest for returns from capital appreciation, investment income, or both. This may be evidenced in the entity’s formation documents or other publications or in how the entity presents itself to its investors. An entity’s express business purpose also is evidenced in its investment plans. Accordingly, an exit strategy should exist for how the ICE intends to realize capital appreciation from its investments. The entity does not have to identify the specific method of disposing of its investments, but rather identify potential strategies that would realize capital appreciation. Exit strategies can vary depending on the type of investment. Disposal of an investment only through a liquidation process or to satisfy investor redemptions does not qualify as an exit strategy.
Unit Ownership
Under the third criterion, investors would be required to acquire ownership units, such as equity or partnership interests, that represent a “specifically identifiable portion of the net assets of the investment company.” However, the ownership unit does not have to represent a “proportionate interest in all of the underlying investments of the investment company.” The proposed ASU also clarifies that having multiple classes, including shares with preferential rights, would not prevent an entity from meeting the ICE criteria. For CLOs and CDOs in which the investor ownership is classified as a liability rather than equity, this criterion may not be satisfied.
Pooling of Funds
The proposed ASU also clarifies that to meet the definition of an ICE, the entity must have investors that (1) are not related parties of the entity’s parent (if there is a parent) and (2) in the aggregate hold a significant interest in the entity. Under this criterion, investors that are related to the parent should be considered a single investor. Further, when a parent or its related parties has an implicit or explicit arrangement that would require it to acquire another investor’s ownership interests, “those investments should be combined and treated as if they were owned by the parent.” Certain arrangements may be structured so that an entity (master fund) has a single investor (feeder fund) and so that the feeder fund has its own third-party investors that, in the aggregate, hold a significant interest in the feeder fund. The proposed ASU clarifies that the master fund may still meet the definition of an ICE as long as (1) the master fund meets all the other criteria for an ICE and (2) the feeder fund meets all the criteria for an ICE.
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Fair Value
Under the proposed ASU, all investments must be managed, and their performance evaluated on, a fair value basis. This evaluation would focus more on how the potential ICE evaluates or manages the investment rather than on the nature of the investment. In paragraph 29 of its Basis for Conclusions, the FASB indicated that “money market funds, which currently report their investments at amortized cost, would be considered to be managing their investments on a fair value basis. This conclusion is based on money market funds being managed to minimize the differences between the carrying value and the fair value of their investments to maintain a constant net asset value.”
Reporting Entity
The last criterion requires the ICE to be a reporting entity. This assessment should take into account the economic substance (rather than the legal form) of the entity. The entity does not have to be a legal entity.
Reassessment
The assessment of whether an entity meets the ICE criteria should be made upon formation of the entity and reassessed if there is a subsequent change in the purpose and design of the entity. A change in an entity’s status as an ICE should be accounted for prospectively from the date of the change (as opposed to the beginning of the reporting period). If an entity no longer meets the ICE criteria, it should account for the change prospectively by applying other GAAP. The fair value of an investment as of the date of the change would be the investment’s initial carrying amount. If upon reassessment an entity meets the ICE criteria, it should recognize the effect as a cumulative-effect adjustment to net assets.
Presentation and Disclosures
Under the proposed ASU, if an ICE consolidates a controlling financial interest in a less than wholly owned ICE or IPE subsidiary, the ICE would present the noncontrolling interest in its financial statements. The ICE would be required to comply with the presentation requirements related to noncontrolling interests in ASC 810-10, including a reconciliation of the net assets attributable to the parent and the net assets attributable to the noncontrolling interests from the beginning to the end of the period. The proposed ASU also would require an ICE to separately present rental income and operating expenses related to real estate properties within its statement of changes in net assets. In addition, it should separately present the fair value of real estate property (excluding any debt associated with the real estate property) in the statement of assets and liabilities. ICEs are currently required to present a schedule of financial highlights. The proposed ASU would modify how the amounts included in the financial highlights schedule are calculated when an ICE consolidates a less than wholly owned ICE or IPE. Specifically, the proposed ASU would require an ICE to calculate the financial highlights (including the expense ratio) by using the consolidated amounts “excluding amounts attributable to noncontrolling interests.” In addition, if an ICE consolidates an IPE subsidiary, the ICE would also be required to “disclose an expense ratio that excludes the effects of consolidating its investment property entities.” The ICE would be required to “provide a reconciliation of the amounts used in calculating its financial highlights and the amounts used in the consolidated financial statements.” The proposed ASU provides an example of the proposed amendments to the presentation requirements and the financial highlights schedule. Finally, the proposed ASU would require additional disclosures, including changes in an entity’s status as an ICE, any support provided by the ICE to its investees, and any significant restrictions on the investee’s ability to transfer funds to the ICE.
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Convergence With IFRSs
The FASB and IASB jointly developed the criteria for determining whether an entity qualifies as an ICE. While the proposed ASU would amend the current requirements in ASC 946, there is no concept of an ICE under IFRSs; therefore, a final standard would represent a significant change under IFRSs. Although the ICE criteria would be substantively the same under U.S. GAAP and IFRSs, differences will remain. First, under the proposed ASU, entities regulated by the 1940 Act would be included in the scope of the guidance in ASC 946 regardless of whether it meets the ICE criteria. The IASB’s proposal does not contain a similar provision. The second significant difference concerns IPEs. There is no concept of an IPE under IFRSs nor are there proposed amendments to add such a concept. An entity that meets the definition of an IPE under the FASB’s proposed ASU on IPEs may meet the definition of an ICE under IFRSs. As a result, there will be presentation and disclosure differences for such entities. There will also be differences associated with how an ICE accounts for its controlling financial interests in other ICEs in a fund-of-funds structure. Under the proposed ASU, an ICE would consolidate a controlling financial interest in another ICE or an IPE. In contrast, under the IASB’s proposed guidance, an ICE would account for a controlling financial interest in another ICE at fair value. Finally, there would be differences in the financial statements of a non-ICE parent that consolidates an ICE subsidiary. In a manner consistent with current U.S. GAAP, the non-ICE parent would retain the specialized accounting applied by the ICE subsidiary within the consolidated financial statements. In contrast, under the IASB’s proposed guidance, a non-ICE parent would not retain the specialized accounting applied by the ICE subsidiary. See Deloitte’s IFRS in Focus newsletter for further details on the IASB’s exposure draft.
Effective Date and Transition
The FASB has not established an effective date for the proposal and will consider feedback on the proposed amendments before setting one. The transition requirements for an entity that no longer meets the definition of an ICE would depend on whether it is practicable to determine the carrying amounts of the assets, liabilities, and noncontrolling interests of the entity’s subsidiary (or the carrying amount of an equity method investment) as if the proposed amendments had been applied when the reporting entity obtained its controlling financial interest in the subsidiary. If determining the carrying amounts is not practicable, the entity would apply the business combination or equity method guidance by using the fair value of its investments as of the transition date. If, as a result of the initial application of the proposal’s amendments, an entity qualifies as an ICE, or an ICE consolidates another ICE or IPE, the effect would be accounted for prospectively as an adjustment to opening net assets as of the date of adoption.
Investment Property Entities Exposure Draft
Background
On October 21, 2011, the FASB issued a proposed ASU on investment property entities that would require certain entities to measure their real estate investments at fair value, with changes in fair value reflected in net income. Entities that meet the FASB’s proposed definition of an “investment property entity” would recognize rental income “when lease payments are received or as the lease payments become receivable in accordance with the contractual terms of the related lease” rather than on a straight-line basis (see Deloitte’s October 21, 2011, Heads Up for more information on the proposal). During redeliberations of the proposed new lease accounting standard, the FASB and IASB tentatively decided that a lessor’s lease of investment property would be outside of the scope of the proposed new lease accounting standard. This scope exception will apply to all lessors of investment property; it is not limited to investment property entities.
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Proposed Scope of the Standard
The scope of the FASB’s proposed ASU is limited to entities that qualify as investment property entities (IPEs). This entitybased scope differs from the scope of the international investment property standard, IAS 40, which is asset-based. The FASB has also tentatively decided to make fair value measurement a requirement for IPEs. This guidance differs from that under IAS 40, which provides a fair value option and not a requirement. Because the FASB took on the investment property project as an attempt, in part, to converge U.S. GAAP with international accounting standards, respondents to the FASB’s proposed ASU may question why the FASB would propose an accounting standard whose scope differs significantly from that of IAS 40. The IASB has not indicated that it would consider limiting the scope of IAS 40 to apply only to IPEs. Some international entities that have elected to measure their real estate investments at fair value under IAS 40 may not be able to do so under the FASB’s definition of an IPE (e.g., insurance companies with real estate investments). Accordingly, the FASB and IASB will most likely receive pressure from their constituents to develop a converged standard.
Definition of an IPE
Under the proposed ASU, an entity that meets all of the following criteria is an IPE:
1. Nature of the business activities. Substantially all of the entity’s business activities are investing in real estate property properties. 2. Express business purpose. The express business purpose of the entity is to invest in real estate property or properties for total return including an objective to realize capital appreciation, for example, through disposal of real estate property or properties. Real estate properties held by an entity for either of the following purposes do not meet this criterion: a. The entity’s own use in the production or supply of goods or services or for administrative purposes b. Development for sale in the ordinary course of business upon completion. 3. Unit ownership. Ownership in the entity is represented by units of investments, in the form of equity or partnership interests, to which a proportion of net assets are attributed. 4. Pooling of funds. The funds of the entity’s investors are pooled to avail the investors of professional investment management. The entity has investors who are not related to the parent (if there is a parent) and those investors, in aggregate, hold a significant ownership interest in the entity. 5. Reporting entity. The entity provides financial results about its investment activities to its investors. The entity can be but does not need to be a legal entity.
Notwithstanding the above criteria, a subsidiary entity that does not meet the criteria related to unit ownership and pooling of funds criteria may still be within the scope of the IPE guidance if the subsidiary entity has a parent entity that is required to account for its investments at fair value in accordance with the IPE guidance or other guidance (e.g., investment company guidance) or has a parent entity that is a not-for-profit entity under ASC 958 that measures its investments at fair value. During deliberations of the proposed ASU, the FASB tentatively decided that for the purposes of evaluating whether substantially all of its business activities are investing in real estate properties, “real estate properties” would only include real estate that is owned directly or indirectly through controlling financial interests. In accordance with this tentative decision, noncontrolling investments in real estate, mortgage loans, and real estate securities would not be considered real estate properties. While an IPE would not be prohibited from making such investments, the significance of such investments may need to be considered when evaluating whether the entity’s primary business activities are investing in real estate properties. This would affect whether an entity is an IPE, an investment company, or a traditional operating company. An entity’s express business purpose is also demonstrated by its investment plans; thus, the proposed ASU states that an entity should “have an exit strategy to dispose of its property . . . to realize capital appreciation to maximize total returns” for its investment properties. However, an IPE is not required to determine the specific method and timing for disposing
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of the investment property. Disposal of an investment property only through a liquidation process or to satisfy investor redemptions does not qualify as an exit strategy. The FASB has also proposed certain amendments to the investment company criteria as part of a separate proposed ASU (see Deloitte’s October 21, 2011, Heads Up for more information). An entity that invests in real estate property but does not meet the proposed IPE criteria may still be within the scope of the proposed investment company ASU, in which case it would be required to measure investments owned by the entity at fair value, including investments in investment properties.
Presentation and Disclosure
The proposed ASU would require an IPE to separately present within the income statement all of the following related to its investment properties: (1) rental revenues, (2) rental operating expenses, and (3) changes in fair value recognized in earnings. In addition, an IPE would separately present, within the statement of financial position, the (1) fair value of investment properties held and (2) any debt associated with the investment properties. This would be a significant change in presentation for many entities. For example, many real estate investment funds that currently account for themselves as investment companies under ASC 946 and that also meet the definition of an IPE would be required to follow this presentation guidance. Although there is diversity in practice, many such funds record operating earnings from their real estate investments only when they are received as distributions from the underlying investee, and they present their real estate investments net of the associated financing in the statement of net assets. An IPE would apply the consolidation guidance in ASC 810 to the following interests: • • A controlling interest in another IPE or an investment company, as defined in ASC 946. A controlling interest in an operating entity that provides services to the IPE parent (e.g., a property management service company).
An IPE that consolidates another IPE or an investment company, as defined in ASC 946, would retain the IPE’s or investment company’s specialized accounting. All other controlling interests in entities would not be consolidated; instead, such interests would be measured at fair value through earnings in each reporting period. An IPE would only apply the equity method of accounting prescribed in ASC 323 to an investment in an operating entity that provides services to the IPE for which it has significant influence (e.g., property management services). Any other investment (e.g., an investment in an IPE or an investment company) for which the IPE has significant influence would be measured at fair value, with all changes in fair value recognized through earnings in each reporting period. Investments in loans, debt securities, and cost method investments would be accounted for under other GAAP.
Thinking Ahead
Because of the similarities between the IPE project and the investment company project, the FASB recommends that the two proposed ASUs be reviewed concurrently. To facilitate comparison, the FASB has decided that the comment periods for the two standards will coincide. Comments on the proposed ASUs are due by February 15, 2012. The FASB has acknowledged constituents’ concerns related to the scope of IPEs and that a definition of IPEs that is too narrow or too broad might inappropriately include or exclude certain entities. It is expected that the FASB will closely evaluate the feedback it receives regarding the scope of the proposed ASU and further evaluate the definition of an IPE.
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Consolidation Exposure Draft
The consolidation project began as a joint project between the FASB and IASB to develop improved, converged consolidation standards that would apply to all entities (i.e., VIEs and voting interest entities). However, the boards eventually decided not to converge on all aspects of this topic, mainly because of differences regarding “control with less than a majority of the voting rights” and the consideration of “potential voting rights.” In May 2011, the IASB issued new and amended guidance on consolidated financial statements, joint arrangements, and disclosures of interests in other entities. The FASB, however, ultimately decided on a narrower project to address whether a decision maker is acting as a principal or as an agent and issued an ED on this topic on November 3, 2011.
VIEs and Voting Interest Entities
The FASB’s proposed guidance contains a single model for qualitatively assessing whether a decision maker (or general partner) is a principal or an agent. This assessment would focus on three factors, which would be evaluated on the basis of the purpose and design of the entity: (1) rights held by other parties, (2) the decision maker’s compensation, and (3) exposure to variability of returns from other interests held by the decision maker. In addition, the proposal would: • • • • Amend the criteria for determining whether (1) an entity is a VIE and (2) a reporting entity is the VIE’s primary beneficiary. Revise the definitions of protective rights, participating rights, and kickout rights. In particular, the proposal would align the analysis of these rights under the VIE, voting interest, and partnership models in ASC 810-10. Amend the guidance on assessing partnerships for consolidation (in particular, whether the general partner consolidates a limited partnership) and move this guidance from ASC 810-20 to ASC 810-10. Eliminate the indefinite deferral in ASU 2010-10 for interests in certain entities.
The proposed principal-versus-agent guidance would allow the FASB to eliminate the deferral in ASU 2010-10 for certain investment funds since these entities would be evaluated under a qualitative approach in determining whether their decision maker (e.g., an investment manager) is acting as a principal or as an agent. The proposed changes would also allow for the consideration of removal rights, even when those rights require the agreement of multiple parties. (Under the current VIE model, removal rights are not considered in the consolidation analysis unless a single entity has the unilateral ability to exercise those rights.) In addition, the qualitative assessment would allow a general partner to consider its economics when determining whether it should consolidate a partnership. For entities controlled by vote, under the IASB model, entities holding less than 50 percent of the outstanding shares of another entity may be required to consolidate that investee; the IASB describes this concept as “effective” or “de facto” control. The FASB decided not to include this concept in U.S. GAAP. Further, potential voting rights (such as convertible debt or warrants) would be considered in the consolidation analysis under the IASB’s guidance. Thus, this aspect of the guidance on voting interest entities in U.S. GAAP will not be converged with that in IFRSs. The FASB and IASB have tentatively concluded that investment companies should recognize and measure their investments (including entities they control) at FV-NI. The boards have used the guidance on investment companies in U.S. GAAP (ASC 946) as the basis for developing the attributes of an investment company. The FASB and IASB differ on whether the parent of an investment company subsidiary would retain, in the consolidated financial statements, the accounting that applies in the subsidiary’s stand-alone financial statements. The FASB believes that the parent of an investment company subsidiary should recognize and measure that subsidiary’s investments at FV-NI in the consolidated financial statements. However, the IASB would agree with that accounting only if the parent itself qualified as an investment company; otherwise, the IASB would want the parent to reflect the assets and liabilities underlying the subsidiary’s investments in the consolidated financial statements. Therefore, the definition of an investment company, which is subject to change as described above, will be important when entities evaluate the proposed guidance on consolidation under both U.S. GAAP and IFRSs.
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Consideration Points
U.S. entities should consider any potential impacts of the FASB’s principal-versus-agent guidance on (1) structures involving VIEs, including funds managed by investment managers; (2) partnerships and similar entities applying the guidance in ASC 810-20; and (3) rights granted to noncontrolling interest holders. In addition, U.S. entities should monitor any changes that the FASB makes to the definition of an investment company, since such changes could cause a change in the number of companies that qualify for investment company accounting.
Next Steps
The IASB’s new consolidation standards are effective for annual periods beginning on or after January 1, 2013; earlier application is permitted as long as each of the other standards in this group is also early applied. Comments on the FASB’s proposed principal-versus-agent ASU are due by February 15, 2012.
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Other Related Developments
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Dodd-Frank Act Updates
Background of Dodd-Frank Act
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) , arguably one of the most extensive pieces of legislation in U.S. history. Enacted in the wake of the recent financial crisis and affecting numerous financial services industry participants, the Dodd-Frank Act calls for hundreds of new rules and regulations, over 50 studies, and the creation of both new regulators and new areas of responsibility for existing regulators. The Dodd-Frank Act aims to (1) promote U.S. financial stability by “improving accountability and transparency in the financial system,” (2) put an end to the notion of “too big to fail,” (3) “protect the American taxpayer by ending bailouts,” and (4) “protect consumers from abusive financial services practices.” To achieve these broad objectives, the Dodd-Frank Act includes many provisions whose magnitude will not be fully appreciated until regulators have implemented them by adopting new rules and regulations. In this vein, over the past year, the SEC has finalized several required rules, completed required studies and reports for Congress, and exposed various proposals for public comment. The summary below highlights certain key developments that affect the investment management industry.
Registration of Fund Advisers
On June 22, 2011, the SEC adopted final rules and amendments under the Investment Advisers Act of 1940 (the “Advisers Act”) related to the implementation of various provisions of the Dodd-Frank Act. The implementation rules primarily formalize SEC registration requirements and exemptions related to private fund advisers (as defined) as well as extend until March 30, 2012, the deadline by which previously unregistered advisers relying on the existing private adviser exemption under the Advisers Act must register with the SEC. The rules implement provisions of Title IV of the Dodd-Frank Act, including: • • • • Defining SEC registration obligations of larger advisers to hedge funds, private equity funds, and other private funds. Defining “venture capital fund,” “family office,” and “foreign private adviser” to exempt such investment advisory organizations from the new registration obligations. Defining a registration exemption for private fund advisers with less than $150 million in “regulatory assets under management” (“regulatory AUM,” as newly defined). Extending certain recordkeeping and reporting obligations to registration-exempt venture capital fund advisers and other private fund advisers with less than $150 million in regulatory AUM (collectively, “exempt reporting advisers”). Increasing the minimum regulatory AUM threshold for any adviser to register or remain registered with the SEC (vs. state supervision).
•
For more information about the implementation rules, see Deloitte’s Implementation of the Investment Adviser Oversight Provisions of the Dodd-Frank Act.
Form PF
In January, 2011, pursuant to Title IV of the Dodd-Frank Act, the SEC and the U.S. Commodity Futures Trading Commission (CFTC) jointly proposed rules under the Advisers Act and the Commodity Exchange Act that would require private fund advisers registered with the SEC, the CFTC, or both to file Form PF, at least annually, with the SEC. The proposed CFTC rule would also require commodity pool operators (CPOs) and commodity trading advisors (CTAs) registered with the CFTC to file
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Form PF with the SEC, but only if those CPOs and CTAs are also registered with the SEC as investment advisers and advise at least one private fund. On October 26, 2011, the SEC voted to adopt the proposed rules. Form PF implements Section 404 of the Dodd-Frank Act, which directs the SEC to collect systemic risk information from registered private fund advisers for its review and the consideration of the Financial Stability Oversight Council (the FSOC). Such information differs by fund type (e.g., hedge fund, private equity fund, private liquidity fund) but generally requires private fund advisers to disclose risk-related details, such as those related to liquidity, leverage, and use of counterparties. Compliance with filing requirements on Form PF will occur over a two-stage phase-in period. The majority of private fund advisers will be required to begin filing Form PF after the end of their first fiscal year or fiscal quarter, as applicable, ending on or after December 15, 2012. Advisers with at least $5 billion in assets under management attributable to hedge funds or private equity funds, and liquidity fund advisers with at least $5 billion in combined assets under management attributable to liquidity funds and registered money market funds, must begin filing Form PF after the end of their first fiscal year or fiscal quarter, as applicable, ending on or after June 15, 2012.
Pay to Play
On June 30, 2010, the SEC voted unanimously to adopt a new rule under the Advisers Act to deter investment advisers from engaging in “pay-to-play” practices. The rule (Rule 206(4)-5) restricts an investment adviser or certain employees of an advisory firm from making campaign contributions to politicians who may be in a position to influence the selection of the adviser to manage assets of state and local public pension funds and other government investment plans. To curb these so-called pay-to-play practices, the rule and rule amendments (to Rules 204-2 and 206(4)-3) implement new restrictions and impose new requirements, primarily on direct and indirect political contributions, solicitation services, and recordkeeping. During 2011, the SEC proposed to amend the investment adviser pay-to-play rule in response to changes made by the Dodd-Frank Act. The amendments, which were adopted in June 2011, changed the scope of the rule to apply both to exempt reporting advisers and foreign private advisers and prevent the unintended narrowing of the application of the rule as a result of the repeal of the private adviser exception. The amendments also added municipal advisors to the categories of registered entities — referred to as “regulated persons” — that are exempted from the rule’s prohibition of payments to third parties by advisers to solicit government entities. Municipal advisors must be registered under Section 15B of the Exchange Act and subject to pay-to-play rules adopted by the Municipal Securities Rulemaking Board (MSRB). The amendments extended the date by which advisers must comply with the ban on third-party solicitation from September 13, 2011, to June 13, 2012. The SEC staff has posted responses to frequently asked questions about the pay-to-play rule that cover compliance and coverage period dates for recordkeeping obligations; definitions of the terms “covered associates,” “government entity,” and “official”; and third-party solicitors.
Net Worth Standard
On January 25, 2011, the SEC voted to propose amendments to its definition of an “accredited investor” to conform to the requirements of Section 413(a) of the Dodd-Frank Act. The new definition would exclude the value of a person’s primary residence in the determination of whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million. Under Securities Act rules, “accredited investors” can invest in certain private and limited offerings such as certain hedge funds that are exempt from Securities Act registration requirements. The new definition of net worth must remain in effect until July 21, 2014, at which point the SEC will be required to review the definition of the term “accredited investor” every four years to determine whether it continues to be appropriate. The deadline for public comment on the proposed rule was March 11, 2011. Since then there have been no significant developments on this matter.
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Compensation Rules
On March 29, 2011, the SEC, jointly with six other federal agencies, issued a proposed rule in response to Section 956 of the Dodd-Frank Act that would (1) require certain financial institutions to disclose the design of their incentive-based compensation arrangements and (2) prohibit companies from implementing compensation arrangements that would promote excessive risk. Under the proposal: • Institutions would be required to file annual reports that discuss their incentive-based compensation arrangements. Such reports would include, but not be limited to, the following:
o o o
A narrative description of components. A concise description of policies and procedures governing such arrangements. A statement describing how the structure of such arrangements prevents (1) excessive compensation and (2) a material financial loss to the entity.
•
Incentive-based compensation plans that encourage inappropriate risk would be prohibited. In addition, for covered entities whose assets exceed $50 billion, at least 50 percent of incentive-based executive compensation would have to be deferred for three years. The proposed rule assigns certain responsibilities to the board of directors (or a committee of the board), such as identifying and approving compensation arrangements for “covered persons, other than executive officers, that individually have the ability to expose the firm to possible losses that are substantial.” Institutions would need to establish policies and procedures that require an incentive-based compensation arrangement to be adopted and approved by their board of directors.
•
Comments on the proposal were due by May 31, 2011. There have been no significant updates since the closing of the comment period.
Regulation of OTC Derivatives
Title VII of the Dodd-Frank Act establishes a comprehensive framework for regulating over-the-counter (OTC) derivatives. It gives the SEC the authority to regulate “security-based swaps” and was intended to take effect on July 16, 2011, approximately one year after the Dodd-Frank Act’s enactment date. Anticipating that it would not meet the Dodd-Frank Act’s mandated deadlines for certain provisions under Title VII, the SEC issued three interim temporary rules on July 1, 2011, and July 7, 2011, that address clearing agencies and various aspects of security-based swaps. In addition, the SEC plans to develop a detailed plan to ensure that the Title VII regulations can be implemented efficiently and cost-effectively.
Other Developments
Custody Rule Updates
On December 30, 2009, the SEC finalized amendments to the custody requirements of Rule 206(4)-2 under the Advisers Act and related forms (the “custody rule”), which became effective for registered investment advisers as of March 12, 2010. As a result of the Dodd-Frank Act, certain advisers to private funds are required to register with the SEC by no later than March 30, 2012, which will cause such advisers to become subject to the custody rule. The SEC’s objective in issuing the custody rule was to increase protections for investors that entrust their securities and funds to registered investment advisers. In its recent inspections of investment advisers, the Office of Compliance Inspections and Examinations (OCIE) has focused on custody and has used some means of confirming client assets. For private funds, OCIE may request access to review the auditor’s work papers to avoid sending confirmations, although this is uncommon.
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Violations noted during recent inspections include the following: • • An adviser held client funds in an account in the adviser employees’ names. An adviser temporarily deposited client assets in commingled accounts or in accounts held by affiliates of the adviser.
Advisers are not permitted to maintain custody of client funds or securities in accounts in their names or in an adviser employee’s name. The custody rule requires client funds and securities to be maintained by a qualified custodian (QC) in (1) a separate account for each client under that client’s name or (2) accounts that contain only the adviser’s clients’ funds and securities under the adviser’s name as agent or trustee for the client. The following violations were also noted during inspections: • An adviser, who was not a QC, received stock certificates from customers and instead of returning them to the customers, forwarded them to the QC. Under Rule 206(4)-2(a)(1) of the Advisers Act, the adviser should have returned the stock certificates to the client within three business days. An adviser of a pooled investment vehicle did not timely distribute audited financial statements.
•
The custody rule contains an audit provision that, if used, requires the adviser to distribute audited financial statements within 120 days after year end (180 days for a fund of fund). In the SEC’s Staff’s Responses to Questions About the Custody Rule, the staff indicated that it “ would not recommend enforcement action . . . against an adviser . . . that reasonably believed that the pool’s audited financial statements would be distributed within the 120-day deadline, but failed to have them distributed in time under certain unforeseeable circumstances.” The SEC may question whether there was a reasonable belief that the audited financial statements could be timely distributed, particularly when the financial statements were significantly delayed or had been delayed for multiple years. In addition, Rule 206(4)-2 of the Advisers Act requires that an independent accountant notify the SEC within one business day of finding any material discrepancy during the course of a surprise examination. Over the last year, the SEC has received such notification letters from accounting firms and has shared the following observations: • • Certain advisers that were not relying on the audit provision did not comply with the quarterly account statements requirements of Rule 206(4)-2(a)(3). An adviser to a pooled investment vehicle that was investing in public and private securities was not able to engage a QC for its private securities until October 2010; therefore, the QC did not send the quarterly statements for its private securities to clients until after that date.
The SEC staff has also responded to custody-rule-related questions regarding compliance dates, such as when QCs must deliver account statements; omnibus accounts and system conversions; dates of the surprise examination; pooled investment vehicle compliance; internal control reports; and filing of the amended Form ADV. In addition, it has answered questions on when “top-tier” pooled investment vehicles that invest in funds of funds must distribute their audited financial statements if the advisor wishes to rely on the audit exception (because the audit of the “top-tier” fund cannot be completed before completion of the funds of funds in which it invests). The SEC’s Division of Investment Management would not recommend enforcement action under Rule 206(4)-2 if the audited financial statements of the top-tier pool are distributed to pool investors within 260 days of the end of the top-tier pool’s fiscal year.
RIC Modernization Act
The Regulated Investment Company Modernization Act of 2010 (the “Act”) updated various technical tax rules applicable to regulated investment companies (RICs), reducing the tax risks and administrative burdens on RICs and their shareholders. The Act also extends to RICs certain favorable provisions that previously had applied only to real estate investment trusts (REITs) , which are subject to similar tax treatment under Subchapter M of the Internal Revenue Code. Key components of the Act are summarized below.
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Capital Loss Carryovers
Individuals are permitted unlimited carryforwards of net capital losses, which retain their character as short term or long term. However, since RICs could only carry forward capital losses for up to eight taxable years, such losses were treated as 100 percent short term. The Act updates the capital loss carryforward rules for RICs so that they match the rules for individuals. For taxable years beginning after December 22, 2010, RICs are permitted unlimited carryforwards of net capital losses, and net long-term capital loss retains its character when carried forward instead of being treated as a short-term capital loss. Net capital losses incurred in taxable years beginning before December 23, 2010, continue to be treated as 100 percent short term and expire according to their original schedule. Further, such losses may not be used to offset capital gains until all net capital losses arising in post-enactment years have been used. As a result, some net capital loss carryovers incurred in pre-enactment years that would have been used under prior law may expire.
Gross Income and Asset Diversification Tests
A RIC must derive at least 90 percent of its income from certain enumerated sources of “good income” (e.g., dividends, interest, gains from the sale or other disposition of stock). For taxable years for which the due date of the tax return (including extensions) is after December 22, 2010, a RIC can cure inadvertent failures to comply with the gross income test by paying a tax equal to the amount by which the RIC failed the test. For example, if 89 percent of gross income is good income, the RIC will owe a tax equal to 1 percent of gross income. In prior years, if the RIC failed to comply with this requirement by even one dollar it was subject to tax as a corporation at a 35 percent rate. In addition to the gross income test, a RIC must satisfy certain asset diversification tests. Similar requirements apply to REITs. However, REITs may remedy inadvertent failures of such tests. For example, if a REIT fails the asset tests by a de minimis amount, but comes into compliance within six months after discovering the failure, the REIT is treated as satisfying the asset tests. For non-de minimis failures, a REIT can avoid disqualification if the failure is due to reasonable cause and the REIT notifies the IRS, disposes of the assets, and pays an excise tax equal to the greater of (1) $50,000 or (2) the highest corporate tax rate times the net income from the bad assets during the period of failure. The Act extends the same remedies to RICs for taxable years for which the return is due after December 22, 2010.
Deferral of Late Year Losses
A RIC must distribute essentially all of its calendar-year income (pre-October 31 income in the case of gains) by December 31 of each calendar year. Under prior law, a RIC that suffered losses after December 31 (or, in the case of capital assets, after October 31) that reduced its taxable income, net capital gain, or current earnings and profits would have to change information that was previously reported on a shareholder’s information return or cost basis statement. To remedy this situation, the Act allows a RIC to elect to treat a post-December 31 loss (or, in the case of capital assets, a post-October 31 loss) as arising on the first day of the fund’s next taxable year. For example, if a RIC has a net ordinary loss for items measured as of October 31, and net ordinary income for items measured as of December 31, the maximum loss deferral would be the excess of the post-October loss over post-December income. This change applies to taxable years beginning after December 22, 2010. See the Deloitte article, Regulated Investment Company Modernization Act of 2010, for more information about other modifications to dividends and distribution rules, excise tax, and other provisions.
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Appendixes
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Appendix A — Links to Titles of Standards and Other Literature
The titles of the standards and other literature referred to in this publication are available from the sources below.
FASB ASC References
For titles of FASB Accounting Standards Codification references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”
FASB Accounting Standards Updates and Other FASB Literature
See the FASB’s Web site for the titles of: • • • Accounting Standards Updates. Pre-Codification literature (Statements, Staff Positions, EITF Issues, and Topics). Concepts Statements.
International Standards
See Deloitte’s IAS Plus Web site for the titles of: • • International Financial Reporting Standards. International Accounting Standards.
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Appendix B — Abbreviations
Abbreviation AICPA ASC ASU AUM CFTC CPO CTA ED EITF EPS FASB FSOC FV-NI GAAP IASB ICE IFRS IPE MD&A MoU MSRB OCIE OTC PCAOB QC REIT RIC SEC VIE Description American Institute of Certified Public Accountants FASB Accounting Standards Codification FASB Accounting Standards Update assets under management U.S. Commodity Futures Trading Commission commodity pool operator commodity trading advisor exposure draft Emerging Issues Task Force earnings per share Financial Accounting Standards Board Financial Stability Oversight Council fair value through net income generally accepted accounting principles International Accounting Standards Board investment company International Financial Reporting Standard investment property entity management’s discussion and analysis Memorandum of Understanding Municipal Securities Rulemaking Board Office of Compliance Inspections and Examinations over the counter Public Company Accounting Oversight Board qualified custodian real estate investment trust registered investment company Securities and Exchange Commission variable interest entity
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Appendix C — Deloitte Specialists and Acknowledgments
Asset Management Specialists and Contacts
Bob Contri Vice Chairman, U.S. Financial Services Leader +1 212 436 2043 [email protected] Rob Fabio Asset Management Industry Professional Practice Director +1 516 918 7285 [email protected] Susan L. Freshour Financial Services Industry Professional Practice Director +1 212 436 4814 [email protected] Maryna Tully Asset Management Industry Professional Practice Director +1 609 806 7022 [email protected]
Acknowledgments
In addition, we would like to thank the following Deloitte professionals for contributing to this document: Rajiv Basu Mark Bolton Lynne Campbell Scott Cerutti Alysha Cooke Mark Crowley Gautam Das Joe DiLeo Chris Dubrowski Rob Fabio Chris Harris Amanda Kim Elizabeth Kim Art Kulans Marie-Eve Logan Michael Lorenzo Kristen Mascis Steve McKinney Adrian Mills Ryan Moore Stuart Moss Rob Moynihan Mike Mueller Jeff Nickell Magnus Orrell Jeanine Pagliaro Sandy Pfeffer Alfred Popken James Primus Sean Prince Joseph Renouf Yvonne Rudek Courtney Sachtleben Sherif Sakr Pat Scheibel Zeta Schultz Pei-Chun Shih Jade Shopp Sean St. Germain Denise Thompson Maryna Tully Abhinetri Velanand Court Watson Peter Wilm
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Appendix D — Other Resources
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This document contains general information only and Deloitte & Touche LLP and Deloitte Tax LLP are not, by means of this document, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This document is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Any tax advice included in this document was not intended or written to be used, and it cannot be used by the taxpayer, for the purposes of avoiding any penalties that may be imposed by any governmental taxing authority or agency. Deloitte & Touche LLP and Deloitte Tax LLP, its affliates and related entities shall not be responsible for any loss sustained by any person who relies on this document. Copyright © 2011 Deloitte Development LLC. All rights reserved.
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