International Accounting Standards Board
30 Cannon Street
London
EC4M 6XH |
5 January 2012
Dear Sir
Exposure Draft ED/2011/04: Investment Entities
We are pleased to comment on the above exposure draft (the ED). Following consultation, this letter represents the views of the BDO network1. We note that BDO USA, LLP will respond separately to the FASB on its related proposals.
We agree with the overall intention of the ED, being the identification of circumstances in which it is appropriate to account for controlled entities at fair value through profit or loss instead of consolidation. We also agree that the entities that would be likely to be identified through the application of the criteria set out in the ED should record their controlled investments at fair value through profit or loss.
However, we believe that certain controlled entities, that would not be within the scope of the ED, should also be required to be measured at fair value through profit or loss. We are not convinced that the criteria should be as restrictive as proposed in the ED.
We suggest that a preferable approach would be to determine the controlled entities that should be required to be measured at fair value through profit or loss by reference to how each controlled entity is managed. This could be through the use of criteria similar to those in IFRS 9 Financial Instruments when determining whether a particular financial asset is to be measured at amortised cost or fair value. We acknowledge that such an approach might be viewed as bringing the risk of abuse, but consider that appropriate safeguards could be put in place. We also consider that an approach of distinguishing investments in controlled entities that should be measured at fair value through profit or loss through the application of a clear principle is, provided it is clearly articulated, less susceptible to abuse than guidance that is based on a more structured approach. The Board appears implicitly to acknowledge this, through its prohibition on the use of fair value accounting by the parent of an investment entity where the parent is not an investment entity. It is not clear how the existence of a non-investment entity parent changes the nature of the underlying investee.
Linked to this, we also consider that the number of investors in an investment entity should not preclude measurement at fair value through profit or loss. While we understand the Board’s concerns, again we believe that appropriate safeguards could be incorporated into the guidance.
We support the notion of an overall disclosure objective, and agree with the type of information that is proposed to be disclosed. However, for some investment entities that hold a large number of controlled investees the proposals could give rise to disclosures of excessive length, with key aspects being subsumed within a large volume of detailed information. It may be appropriate to permit or require information to be disclosed by category of investment (such as those where dividend income is expected in the short term and those where it is anticipated that it will be some time before income is generated, perhaps due to restrictions on an investee’s ability to pay dividends). This has the potential to reduce clutter and focus readers of financial statements on more relevant aspects of the investments and their related potential to generate income.
We hope that you will find our comments and observations helpful. If you would like to discuss any of them, please contact Andrew Buchanan at +44 (0)20 7893 3300.
Yours faithfully
Andrew Buchanan
Global Head of IFRS
BDO IFR Advisory Limited
Appendix
Question 1
Do you agree that there is a class of entities, commonly thought of as an investment entity in nature, that should not consolidate controlled entities and instead measure them at fair value through profit or loss? Why or why not?
We agree. For those entities, the most relevant information for users of their financial statements is provided by measuring their interests in controlled and other investees at fair value through profit or loss. This approach would result in a consistent approach being taken to all of those entities’ investees, regardless of whether they are controlled, and would best reflect those entities’ activities. We note that this approach is followed under a number of national GAAPs.
However, while we agree with the notion of investment entities set out in the ED, we believe that this would capture only a subset of those controlled entities that should be measured at fair value through profit or loss. While the proposals set out in the ED would be a step in the right direction, we consider that they could be improved upon. Principal reasons, which link to our view that there is a wider range of controlled entities that should be measured at fair value through profit or loss, are:
1. We believe that it is inappropriate always to determine whether a controlled entity should be consolidated through the application of restrictive guidance which is intended to result in a restricted exception to the principle that an investor should consolidate all of those entities that it controls. In this context, we consider that the views set out by the three dissenting board members are strong and conceptually sound; we are concerned that there will be significant stress placed at the boundaries of the definition of an investment entity.
2. The proposal to define investment entities as set out in the ED is, in our view, overly restrictive in some circumstances. This would result in some entities being required to consolidate controlled entities that we believe should be permitted to be measured at fair value through profit or loss. For example, a bank might have an investment banking arm for certain of its investments, with certain of these investments being controlled entities. Depending on how these controlled entities are managed, an accounting approach of fair value through profit or loss might be more appropriate than consolidation.
Consequently, in our view, instead of defining investment entities through the application of restrictive guidance that provide an exception to the principle of consolidation, the focus would be better placed on establishing a sound principle which can be used in a robust manner to identify which investments in controlled entities should be required to be measured at fair value through profit or loss instead of being consolidated. This could be achieved by focussing on how a controlled entity is managed, through an approach which is similar to that of IFRS 9’s focus on an entity’s business model when determining whether a financial asset is to be measured at fair value or amortised cost. We note that paragraph 2(e) of the proposals anticipates fair value management and performance evaluation, although it is more restrictive as it requires that substantially all of the entity’s investments are managed on this basis. We would instead apply the test to each separate investment of an entity, with this approach being applied at all levels in a group, eliminating the ‘bright line’ prohibition set out in the ED.
We acknowledge the Board’s concern that such an approach could give rise to abuse, with entities establishing wholly owned subsidiaries that are used to raise debt, with the gross obligation then being obscured by an apparent approach of managing that subsidiary on a fair value basis. However, we believe that it would be possible to incorporate appropriate safeguards (please see our response to question 2 below).
Question 2
Do you agree that the criteria in this exposure draft are appropriate to identify entities that should be required to measure their investments in controlled entities at fair value through profit or loss? If not, what alternative criteria would you propose, and why are those criteria more appropriate?
We agree that it would be appropriate for the entities that would be identified by the application of the criteria in the ED to be measured at fair value through profit or loss. However, as noted above, we do not consider that this would identify all of the controlled entities that should be accounted for on this basis.
Instead, we consider that it would be preferable for the distinction between whether a controlled investment is required to be consolidated, or measured at fair value through profit or loss, to be based on an analysis of how each controlled investee is managed by its parent (whether direct or indirect). Consequently, an investor that manages and reports (internally) a particular controlled investment on a fair value basis would be required to present that investment on the same basis in its financial statements. We note that this would be consistent with the business model approach of IFRS 9. We would expect that some, but not necessarily all, investing entities would hold a portfolio of investments that they managed on a fair value basis rather than a single investment (although it would be inappropriate to rule out the potential for a single controlled investee to be measured at fair value through profit or loss).
Focussing on the manner in which an entity manages one or more of its investments would enable an approach based on clear principles to be adopted, eliminating the more structured approach proposed in the ED. We also note that, in its separate financial statements, an investor is permitted to measure its investments in controlled entities in accordance with IAS 39 Financial Instruments: Recognition and Measurement. While an entity taking advantage of this option would typically account for its investments in controlled entities using the Available for Sale category, if these investments were managed and reported internally on a fair value basis then an approach of fair value through profit or loss should be required.
As noted in our response to question 1, we understand and acknowledge the Board’s concerns at the potential abuse that could arise, and the associated risk of liabilities being obscured. In order to address those concerns, we believe that certain anti abuse requirements could be built into the accounting requirements, with these being regarded as being clear indicators that an entity is not being managed on a fair value basis. These could include:
· The controlled entity must not have any obligations (whether present or contingent, or which might arise in future) which are, or would realistically be, guaranteed or otherwise supported by its parent, any other entity in the group or any other entity or individual that would be regarded as being a related party in accordance with IAS 24 Related Party Disclosures of the controlled entity’s parent or any other entity in the group.
· The controlled entity’s own business activities must be separate from those of its parent and any other entity in the group. For example, a group which has as part of its own business activities investing in government debt and establishes a subsidiary which has investments in government debt, would be required to consolidate that subsidiary. Similarly, an entity or group that takes a decision to expand its existing business activities to new areas would not be permitted to measure a controlled entity, set up for the purposes of initial research and development activities and subsequent marketing of a new product, at fair value through profit or loss.
· If a controlled entity qualifies to be measured at fair value through profit or loss, reclassification of that entity to being a consolidated entity is prohibited unless the controlled entity’s lifetime activities change substantially from those contemplated at the point it is classified at fair value through profit or loss. This would assist in avoiding the potential for entities that are expected to incur losses in their start up phase being claimed to qualify for measurement at fair value (thereby potentially masking losses in the consolidated financial statements), with those entities then being subject to consolidation when they become profitable.
If the Board decides to continue with an approach of defining an investment entity through only the criteria set out in the ED, we have the following comments:
· Paragraph 2(c) requires that ‘ownership in the entity is represented by units of investment, such as shares or partnership interests, to which proportionate shares of net assets are attributed’. We understand that some investment funds offer high yield bonds as a participating interest in the performance of a fund. This type of ownership interest does not appear to alter the nature of the issuer and it is therefore unclear why such an entity would be precluded from being an investment entity. The scope could be extended to cover debt financed entities; this would also mean that entities with a mixed capital structure could still qualify as investment entities. We also note that IFRS 10 Consolidated Financial Statements views bonds as being an interest which is to be taken into account when determining whether an entity is a subsidiary, and that fixed rate bonds are viewed as giving rise to a variable return to the investor.
· Paragraph 2(f) requires an entity to provide financial information to its investor. This will always be the case for a legal entity, and it is not clear from the ED itself whether information in addition to financial statements would be required. However, paragraph BC 18 (which is not in fact part of the proposed guidance) clarifies that this requirement was included to deal with investments that are not legal entities. We consider that this clarification should be included in the body of the standard itself, and that guidance should be included setting out what financial information needs to be provided.
· Paragraph B9 requires an entity to have an exit strategy in order to qualify as an investment entity. This requirement is inconsistent with paragraph 2(a), which requires that ‘the entity’s only substantive activities are investing in multiple investments for capital appreciation, investment income (such as dividends or interest) or both.’ An entity does not need to have an exit strategy if it plans to hold investments for investment income only. We also consider that the requirement to document an exit strategy is drafted so broadly that any ‘boiler plate’ exit strategy would suffice, meaning that the requirement is superfluous.
Question 3
Should an entity still be eligible to qualify as an investment entity if it provides (or holds an investment in an entity that provides) services that relate to:
(a) its own investment activities?
(b) the investment activities of entities other than the reporting entity?
Why or why not?
(a) Yes. We do not consider there to be a distinction between an investment entity that deals with its investment decisions itself, and an investment entity that obtains that advice from an entity in which it holds an investment.
We note that paragraph B2 refers to ‘services that relate only to the investment entity’s own investment activities (eg investment advisory services), whereas paragraph BC11 refers to activities that ‘...are performed solely to support the investing activities of the investment entity’. The language of the Basis for Conclusions suggests a wider range of services, which might extend to the provision of IT services. We suggest that the text is clarified.
(b) It depends. On the basis of the approach proposed in the ED, whether the investing entity should still be eligible to qualify as an investment entity will depend on the activities of the investee entity that provides services that relate to the investment activities of other entities, including what those services are and whether they meet the restrictions that are proposed in the ED. We believe that this illustrates why, if the Board proceeds with the ED largely as drafted, it will be difficult to establish appropriate criteria to ensure that there is a clear distinction between those entities that qualify as investment entities and those that do not. This is because we anticipate that in circumstances where a reporting entity would find it desirable to classify a controlled investee as an investment entity, the application of the requirements that are proposed to be placed around the qualification criteria may become strained.
Question 4
(a) Should an entity with a single investor unrelated to the fund manager be eligible to qualify as an investment entity? Why or why not?
(b) If yes, please describe any structures/examples that in your view should meet this criterion and how you would propose to address the concerns raised by the Board in paragraph BC16.
(a) If the Board continues with its proposals as outlined in the ED, we believe that entities with a single investor unrelated to the fund manager should not be eligible to qualify as an investment entity.
Question 5
Do you agree that investment entities that hold investment properties should be required to apply the fair value model in IAS 40, and do you agree that the measurement guidance otherwise proposed in the exposure draft need apply only to financial assets, as defined in IFRS 9 and IAS 39 Financial Instruments: Recognition and Measurement? Why or why not?
We agree with the proposals for those assets.
In relation to investment property, the proposals set out in the ED are based on the assumption that investors in investment entities are best served with fair value information. An investment entity that holds investment property and accounts for that investment property under the cost model would be inconsistent with this view. We see no reason why an investment entity should be required to manage and evaluate the performance of its investments on a fair value basis, but be permitted to use depreciated cost accounting for investment property.
Question 6
Do you agree that the parent of an investment entity that is not itself an investment entity should be required to consolidate all of its controlled entities including those it holds through subsidiaries that are investment entities? If not, why not and how would you propose to address the Board’s concerns?
We disagree. In its rationale for issuing the ED, the Board has indicated its agreement with the presentation of controlled entities at fair value through profit or loss where this provides the most useful information to investors. We do not see why, when the most useful information is provided by measuring an entity or entities at fair value through profit or loss at one level in an organisation, this information suddenly becomes less useful simply because there are additional entities further up the group structure. The Board’s proposal appears to be an exception to an exception, with the sole purpose of limiting the use of (and consequently the usefulness of information provided by) the exception to measure investment entities at fair value through profit or loss.
Question 7
(a) Do you agree that it is appropriate to use this disclosure objective for investment entities rather than including additional specific disclosure requirements?
(b) Do you agree with the proposed application guidance on information that could satisfy the disclosure objective?
(a) We agree with the stated objectives, and the use of a disclosure objective. However, for some investment entities that hold a large number of controlled investees the proposals could give rise to disclosures of excessive length, with key aspects being subsumed within a large volume of detailed information. It may be appropriate to permit or require information to be disclosed by category of investment (such as those where dividend income is expected in the short term and those where it is anticipated that it will be some time before income is generated, perhaps due to restrictions on an investee’s ability to pay dividends). This has the potential to reduce clutter and focus readers of financial statements on more relevant aspects of the investments and their related potential to generate income.
(b) We agree.
Question 8
Do you agree with applying the proposals prospectively and the related proposed transition requirements? If not, why not? What transition requirements would you propose instead and why?
We disagree. If an entity qualifies as an investment entity, fair value information may be available not only for the current reporting period but also for prior periods. This would be consistent with its controlled entities being managed on a fair value basis.
Consequently, we would support retrospective application in circumstances where the entity obtained fair value information for prior periods at that time. If fair value information was not obtained at that time, prospective application would be appropriate to avoid the application of hindsight, other than in circumstances where the underlying investments were subject to level 1 measurement meaning that historic fair values could be obtained.
Question 9
(a) Do you agree that IAS 28 should be amended so that the mandatory measurement exemption would apply only to investment entities as defined in the exposure draft? If not, why not?
(b) As an alternative, would you agree with an amendment to IAS 28 that would make the measurement exemption mandatory for investment entities as defined in the exposure draft and voluntary for other venture capital organisations, mutual funds, unit trusts and similar entities, including investment-linked insurance funds? Why or why not?
(a) We disagree. While it might appear attractive to amend the requirements of IAS 28, investments within the scope of that standard are fundamentally different from controlled entities. From a conceptual perspective the consolidation of controlled entities, resulting in the recognition of their assets and liabilities, is sound. In contrast, equity accounting is less conceptually sound and is argued by some to be a mechanism which results in amounts being recorded in financial statements which are not necessarily representationally faithful of the investor’s interest. Some argue that investments in associates should, themselves, always be recorded at fair value. Consequently, it is a substantially less significant step to provide a wider exemption from equity accounting than from consolidation.
We also note that, if the proposed amendment were to be made, a number of entities that currently make use of the ability to measure investments in associates at fair value through profit or loss would be prohibited from doing so. We do not agree that this would result in better quality financial information, as these investments are being managed and evaluated by the investing entity on a fair value basis.
(b) We agree.
1 Service provision within the international BDO network of independent member firms (‘the BDO network’) in connection with IFRS (comprising International Financial Reporting Standards, International Accounting Standards, and Interpretations developed by the IFRS Interpretations Committee and the former Standing Interpretations Committee), and other documents, as issued by the International Accounting Standards Board is provided by BDO IFR Advisory Limited, a UK registered company limited by guarantee. Service provision within the BDO network is coordinated by Brussels Worldwide Services BVBA, a limited liability company incorporated in Belgium with its statutory seat in Brussels. Each of BDO International Limited (the governing entity of the BDO network), Brussels Worldwide Services BVBA, BDO IFR Advisory Limited and the member firms is a separate legal entity and has no liability for another such entity’s acts or omissions. Nothing in the arrangements or rules of the BDO network shall constitute or imply an agency relationship or a partnership between BDO International Limited, Brussels Worldwide Services BVBA,
BDO IFR Advisory Limited and/or the member firms of the BDO network.
BDO is the brand name for the BDO network and for each of the BDO member firms.
BDO IFR Advisory Limited, registered in England No 7295966
Registered office: c/o Hackwood Secretaries Limited, One Silk Street, London, EC2Y 8HQ© 2011 BDO IFR Advisory Limited, a UK registered company limited by guarantee. All rights reserved.