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Chapter 2: Fair value measurement
Fair value should be the primary measurement attribute for substantially all investments for an investment entity. Fair value is likely to be more relevant information to evaluate the performance of the entity’s investments (both internally and externally) than consolidating the entity’s subsidiaries or using the equity method for the entity’s interests in associates or joint ventures. An entity is required to measure and evaluate the performance of substantially all of its investments on a fair value basis in order to qualify as an investment entity.
The fair value requirement applies to ‘investments’. This does not apply to non-investment assets or to financial liabilities. For example, head office property and related equipment held under IAS 16, ‘Property, plant and equipment’, do not need to be measured and evaluated on a fair value basis.
It is evident that fair value information is the primary measurement attribute if fair value information is:
- used internally by key management personnel to assess performance of substantially all of the entity’s investments; and
- provided to the entity’s investors, and the entity measures substantially all of its investments at fair value in its financial statements, where this is permitted or required by IFRS.
An investment entity would elect to account for:
- investment property using the fair value model in IAS 40;
- associates and joint ventures on a fair value basis by electing the exception from the equity method in IAS 28; and
- financial assets on fair value basis under IFRS 9.
Typical characteristics of an investment entity
An investment entity is expected to display the following characteristics in order to qualify as an investment entity, in addition to meeting the definition (these characteristics are considered typical of investment entities): holding more than one investment; having more than one investor; having investors that are not the entity’s related parties; and having ownership interests in the form of equity or similar interests.
The characteristics require applying additional judgement. An entity can be an investment entity in the absence of one or more of these characteristics, provided management has assessed why it is appropriate for the entity to qualify as an investment entity in the absence of the typical characteristic(s) and makes appropriate disclosure in the financial statements. It is considered highly unlikely, but possible, that an entity will qualify as an investment entity where it seems to strictly meet the definition but possesses none of the typical characteristics.
More than one investment
An investment entity will typically hold (directly or through another entity) more than one investment, with the objective of diversifying its risks and maximising returns.
All facts and circumstances, including an entity’s business purpose, should be considered, to determine whether the entity qualifies as an investment entity where it holds only one investment. Some scenarios where it might be appropriate for an entity to hold a single investment – and nevertheless qualify as an investment entity – are included in the standard:
- The entity has made only one investment because it is in a start-up period and has not yet identified suitable multiple investments.
- The entity has not yet made new investments to replace those that have been disposed of.
- The entity has been established to pool investors’ funds to purchase a single investment that would have been unobtainable by individual investors (for example, where the required minimum investment is too high for an individual investor).
- The entity is in the process of liquidation.
Holding a single investment: start-ups
Facts
An entity (LP) is formed in 20X1 as a limited partnership with a 10-year life. The offering memorandum states that LP’s purpose is to invest in entities with rapid growth potential, with the objective of realising capital appreciation over their life. Entity GP (the general partner of LP) provides 1% of the capital to LP and has the responsibility of identifying suitable investments for the partnership. Approximately 75 limited partners (who are unrelated to GP) provide 99% of the capital to the partnership.
LP begins its investment activities in 20X1, but no suitable investments are identified by the end of 20X1. In 20X2, LP acquires a controlling interest in one entity, ABC Corporation. LP is unable to close another investment transaction until 20X3, when it acquires equity interests in five additional operating companies. LP conducts no activities other than acquiring these equity interests. LP measures and evaluates its investments on a fair value basis, and this information is provided to GP and the external investors.
LP has plans to dispose of its interests in each of its investees during the 10- year stated life of the partnership. Such disposals include the outright sale for cash, the distribution of marketable equity securities to investors (following the successful public offering of the investees’ securities), and the disposal of investments to the public or other unrelated entities.
Is LP an investment entity?
Conclusion
From the information provided, LP meets the definition of an investment entity from its formation in 20X1 to 31 December 20X3, because the following conditions exist:
· LP has obtained funds from the limited partners and is providing those limited partners with investment management services.
· LP’s only activity is acquiring equity interests in operating companies, with the purpose of realising capital appreciation over the life of the investments. LP has identified and documented exit strategies for its investments, all of which are equity investments.
· LP measures and evaluates its investments on a fair value basis and reports this financial information to its investors.
In addition, LP displays the following typical characteristics of an investment entity:
· LP is funded by many investors.
· Its limited partners are unrelated to LP.
· Ownership in LP is represented by units of partnership interests acquired through a capital contribution.
· Although LP does not hold more than one investment throughout the period, this is because it was still in its start-up period and had not identified suitable investment opportunities.
More than one investor
An entity would typically obtain funds from several investors, with the objective of providing its investors with investment management services and investment opportunities that they might not have access to individually, in order to qualify as an investment entity.
An entity might have only one investor. The reasons why and whether it is consistent with the definition of an investment entity should be considered. There are some situations where it might be appropriate to conclude that an entity is an investment entity, despite having only one investor. These are situations where: An entity’s initial offering period has not expired and it is actively identifying additional suitable investors. The entity has not identified suitable investors to replace ownership interests that have been redeemed. The entity is in the process of liquidation.
Funds with a single investor: seed capital
Facts
An investment fund has been set up by its manager; initially, the manager is the sole shareholder (that is, the manager has provided ‘seed capital’). As at its first period end, the fund has not been successful in receiving funds from other prospective shareholders, but it is actively soliciting new investors. The fund invests in global equities and equity-related derivatives; and it provides its one shareholder with investment management services (as mandated in its prospectus). Its prospectus states that it expects to buy and sell investments regularly, and it expects holding periods of more than one year to be rare.
The fund generates returns from capital appreciations and investment income in the form of dividends. The fund measures all investments at fair value, and these valuations are the basis for subscriptions into and redemptions out of the fund. Subscriptions and redemptions can occur daily.
Is the fund an investment entity?
Conclusion
The fund is an investment entity.
It meets the definition of an investment entity if:
· It has been set up to provide investment management services to its investors. For this period, it has only one manager-shareholder, and so it is providing investment management services to itself, but this is not its longer-term manager intention.
· It is carrying on its investment activities with the objective of capital appreciation and investment income.
· It measures its underlying investments on a fair value basis, and fair value is the basis for subscriptions into and redemptions and out of the fund.
The fund displays the following characteristics:
· It holds multiple investments.
· It does not have multiple investors, but this is expected to be temporary and the fund manager is actively soliciting new investors.
· It does not have unrelated investors, because it has only a single investor.
· It issues ownership interests in the form of redeemable units that entitle the holders to a share of net assets.
Although the fund has a single investor, this is expected to be temporary. Failing to meet this typical characteristic does not mean that the fund is not an investment entity. In the context of the definition and the fund’s overall business purpose, it is an investment entity. The fund is required to make appropriate disclosures in its financial statements on why it qualifies as an investment entity even when it has only one investor.
The fund or entity might have been set up by a single investor to meet a specific objective or to help support the interest of a wider group of investors. For example, the entity is a fund that has been set up by a corporate entity to make investments on behalf of that corporate entity’s employees. The entity has a single investor but, in substance, it has been set up to support the interests of a wider group (that is, its parent investor’s employees). Other examples of such entities might include a pension fund, a government-owned investment fund or a family trust. Each of these is formed by or for a single investor but it represents or supports the interests of a wider group of investors. In some but not all cases, failing to meet this characteristic in such circumstances is not inconsistent with the overall business purpose and definition of an investment entity.
Funds with a single investor: sovereign wealth fund
Facts
The government of country X sets up a sovereign wealth fund (SWF) to manage its income from natural resources for the long-term benefit of its citizens. The SWF will, for example, be used to fund future pensions and significant capital projects carried out by the state. The fund is set up as a separate legal entity established under statute, and it is owned by the central bank of country X. It has issued shares to the bank. The fund employs a team of professional investment managers, who work to a mandate that is overseen by the central bank and approved annually by country X’s government. The fund makes multiple investments (some of which are controlling stakes) and sets out exit strategies for different classes of investment. The fund produces public reports twice-yearly, which detail the total value of the fund and of its main asset classes. Internal reporting is more detailed and also on a fair value basis.
Is country X’s SWF an investment entity?
Conclusion
Country X’s SWF is an investment entity because:
· It has been set up to provide investment management services to its investor (which, in this case, is the government of country X).
· It is carrying on its investment activities with the objective of capital appreciation and investment income.
· It measures its underlying investments on a fair value basis, and it reports its funds value on a fair value basis.
It also displays the following typical characteristics of an investment entity:
· It holds more than one investment.
· It has only one investor, which is the central bank of country X. It can nevertheless be seen, in substance, as investing the funds of the citizens of country X on their behalf. This is not inconsistent with the overall definition and business purpose of an investment entity. It has one related-party direct beneficiary, due to having one investor; but, again, it could be argued that, in substance, it operates on behalf of many unrelated beneficiary investors.
· The fund has issued units that entitle its investor to a share of its net assets.
Unrelated investors
An investment entity will typically have multiple investors that are not its related parties (as defined by IAS 24) and are not related to the group to which the investment entity belongs. If an entity has investors that are related to it, all facts and circumstances should be considered. Having related parties as investors makes it more likely that the entity (or other members of its group) could obtain benefits other than capital appreciation or investment income.
Related investors: nuclear power plant
Facts
A dedicated fund is set up by a corporate entity that runs a nuclear power plant. The corporate entity (which owns all of the units in the fund) needs to keep funds available in case of a technical failure of the nuclear power plant. The entity does not have the expertise to manage the fund, so it appoints a third-party asset manager. The entity can remove the fund manager on three months’ notice.
The fund invests in traded equity and debt instruments (as set out in the investment management agreement and fund founding documents), and its maximum exposure to one investment is not more than 10% of monies invested. The objective of the fund is to generate returns, either from dividends and interest or from selling the instruments. The fund does not invest in the nuclear energy industry, and the corporate entity has no other relationship with the fund; for example, it does not have options to buy any of the investments made by the fund.
The fund reports fair value information internally and to its corporate parent, and its performance is evaluated against a benchmark stock exchange index. The fund issues units that are redeemable at any time. The redeemable shares pay the net asset value of the fund when liquidated, and they are accounted for by the fund as equity under IAS 32. The units do not carry voting rights.
Is the fund an investment entity?
How does the corporate entity account for its interest in the fund?
Conclusion
The fund is an investment entity. It meets the definition of an investment entity:
· It provides investment management services to its investor.
· Its business purpose is to invest in debt and equity instruments for capital appreciation and investment income.
· It measures and evaluates the performance of its investments on a fair value basis.
· The fund also displays two of the four typical characteristics:
· The fund holds multiple investments.
· The fund only has one investor but, in these circumstances, that is not inconsistent with its overall business purpose and with the definition of an investment entity.
· The fund does not have unrelated investors, because there is only one investor; but, again, in these circumstances this is not inconsistent with the definition of an investment entity.
· Units issued by the fund entitle the holder to a proportionate share of the net asset value of the fund.
Two of the characteristics are not satisfied, because the fund has a single investor. When examining all the facts and circumstances, however, the fund concludes that it is an investment entity and that the failure to meet two of the typical characteristics is not inconsistent with the definition. It gives appropriate disclosure about its judgement under IFRS 12.
The corporate entity is not an investment entity, so it consolidates the fund (including any controlled investments made by the fund).
The entity might qualify as an investment entity even where its investors are related parties. For example, it might be a parallel fund (that is, investing in the same assets as another fund) set up by the manager of that other fund to incentivise and reward a group of the manager’s employees.
Ownership interests
An entity need not be a separate legal entity to qualify as an investment entity. Whatever its legal form, its ownership interest would generally be in the form of equity or similar interests (for example, partnership interest), to which a proportionate share of its net assets is attributable. This is because the entity will generally need a means by which it distributes, or attributes value from, its capital and income returns. Having different classes of investor does not mean that an entity is not an investment entity.
An entity’s ownership interests might be accounted for as debt, because they do not meet the definition of equity under IAS 32. The entity is still likely to be an investment entity, so long as it provides holders with exposure to variable returns from changes in the fair value of the entity’s net assets.
Can non-equity liabilities represent ownership interests?
Unit trusts and mutual funds often issue units that are accounted for as liabilities under IAS 32 guidance; this is because they do not qualify to be presented as equity under the IAS 32 ‘puttable’ amendment.
Where such units (whether or not they are presented as equity) entitle the entity’s holders to proportionate shares of net assets, they will not prevent the fund being considered an investment entity.
Some funds are financed through debt instruments (particularly in private equity) which participate in the returns of the fund. Such debt instruments would not prevent investment entity status under the ‘ownership interests’ typical characteristic.
Separate financial statements
There are two different situations where the accounting in separate financial statements is relevant to investment entities.
The first situation is where an entity controls investee subsidiaries but none of these subsidiaries is required to be consolidated; in other words, it does not control any subsidiaries that provide investment-related services.
The entity measures all of its subsidiaries at fair value through profit or loss, and it will present separate financial statements as its only financial statements.
Alternatively, an entity might be an investment entity that has some investee subsidiaries that are accounted for at fair value through profit or loss, and other subsidiaries that provide investment-related services and which are consolidated. It prepares consolidated financial statements under IFRS 10. The subsidiaries providing investment-related services are consolidated, and other investees are measured at fair value through profit or loss. The entity might also be required to prepare separate financial statements. In those separate financial statements, it should account for the subsidiaries that are measured at fair value through profit or loss in its consolidated financial statements in the same way as in its separate financial statements (that is, at fair value through profit or loss).
Re-assessment of investment entity status
The investment entity status should be re-assessed where facts and circumstances indicate that there is a change to one or more of the three elements making up the definition of an investment entity or to any of the typical characteristics.
Re-assessment on redemption of units leaving one significant investor
Due to a change in market conditions, investors in a fund are redeeming their units. As a result of this redemption, only one significant investor remains in the fund.
The fund should re-assess its investment entity status. In this case, the fund might continue to meet the definition, and remain an investment entity, in either of the following situations:
· if its business continues to be management of investments for capital appreciation and/or income, but now for one investor instead of many; or
· if it expects that this will be a temporary situation.
Any change in status is accounted for prospectively (that is, from the date when the change in status occurred).
The standard contains guidance on how an entity should account in its consolidated financial statements for a change in status – when it either becomes, or ceases to be, an investment entity. Entities which become investment entities will cease to consolidate subsidiaries. The entity will de-recognise the assets and liabilities of those subsidiaries, determine the fair value of the subsidiary and recognise the difference as a gain or loss in profit or loss. Entities which cease to be investment entities will apply the acquisition method under IFRS 3, ‘Business combinations’, and consolidate.
If an entity prepares separate financial statements, accounting for the change in status is done prospectively from the date of that change. Entities which become investment entities will account for the investment in subsidiaries at fair value through profit or loss, and recognise any difference from the previous carrying amount as a gain or loss in profit or loss. Entities which cease to be investment entities can continue to account for investments in subsidiaries in accordance with IFRS 9, account for those investments at cost or account for those investments using the equity accounting method. The fair value of the subsidiary at the date of the change in status is used as the deemed cost.
Accounting for a change in status in consolidated financial statements
Accounting for a change in status in separate financial statements
