The Investment Companies Expert Panel serves the needs of AICPA members on financial and business reporting and audit and attest matters. The expert panel protects the public interest by bringing together knowledgeable parties in the investment companies industry to deliberate and come to agreement on key investment company issues.
I. Administrative items/AICPA matters:
1. The May 23, 2012, Expert Panel (EP) meeting highlights are available on
http://www.aicpa.org/InterestAreas/FRC/IndustryInsights/DownloadableDocuments/INV/INV_EP_Minutes/2012/INV_E P_May23_2012_Meeting.pdf. The meeting highlights from the September 2012 EP meeting and October 2012
conference call are being finalized.
2. The AICPA publications staff updated the EP on the current status and timing of the 2012 AICPA Audit Risk Alert - Investment Companies Industry Developments (INV ARA).
3. As previously discussed during EP meetings and calls, ASU 2011-04 removed the “in-use” and “in-exchange” concepts from Topic 820. When a private equity fund or business development company (BDC) owns both debt and equity instruments, the question arises whether they would need to value these instruments as a single unit of account or value each instrument individually. In addition, when using enterprise value, whether it is appropriate to assume a change of control in the transaction which would trigger debt being called at par, and therefore lead to debt being valued at par.
The panel members expressed a view that until removal of “in-use” and “in-exchange” concepts, it was clear that the use of the enterprise value approach to value debt and equity instruments when a private equity fund or BDC has control would have been appropriate. The EP members have observed that it may be challenging to determine that debt and equity represent the same unit of account. Earlier this year, the EP subgroup developed a white paper and discussed this matter with the FASB staff seeking clarification. Based on information in that white paper, the IC EP subgroup developed Technical Practice Aids (TPAs) draft for TIS Section 6910 Investment Companies. At this time, the subgroup is evaluating feedback from FinREC members and others.
4. The EP is considering developing and presenting another webinar on the financial reporting, audit and attest issues affecting investment companies.
II. Accounting/Reporting Issues:
1. Regarding the proposed Accounting Standards Update (ASU), Financial Services—Investment Companies (Topic 946):
Amendments to the Scope, Measurement, and Disclosure Requirements: In the September 2012 meeting, the EP members discussed the FASB’s recent decision to amend paragraph 946-210-50-9 to require all investment companies (registered and nonregistered) to disclose each investment owned by an investee fund that represents a ‘significant’
2 portion (rather than those that exceed 5 percent) of the reporting investment company’s net assets at the reporting date. ASC 946-210-50-9 currently indicates: “if the reporting investment company's proportional share of any investment owned by any individual investee exceeds 5 percent of the reporting investment company's net assets at the reporting date, each such investment shall be named and categorized as discussed in paragraph 946-210-50-6”. The FASB also recently tentatively decided to require an investment to disclose several items for significant investments in another investment company (investee fund).
During the September 2012 EP meeting, the EP members discussed how there are different considerations for registered (RICs) versus nonregistered investment companies, as certain information is already publicly available to investors in RICs, while there may be operational challenges for nonregistered investment companies regarding availability of audited information from the investee fund, and timing of obtaining such information from the investee fund. During the October EP conference call, an EP member informed the EP that they informally reached out to the FASB staff to discuss the FASB’s tentative decisions with respect to the disclosures and inquired whether the proposed disclosures would be subject to an exposure period. At this time, the EP is awaiting the FASB staff’s response. During the November EP call, the EP members shared that the FASB held an Education Session on this topic on November 6, 2012 which primarily focused on real estate investments. At this time, the Board anticipates issuing the final Standard in the first half of 2013.
The EP continues monitoring this development and will consider determining a methodology that could be consistently considered throughout the industry.
2. The EP members discussed how funds use broker quotes and vendor prices for the purposes of the fair value disclosure and leveling within the ASC 820 fair value measurement hierarchy. Certain funds may use broker quotes to price investments and classify them as Level 3. However, there may be pricing services (such as IDC) that price the same securities at a price close to these broker quotes, and, therefore, these may be able to be categorized as Level 2. There also may be situations where the same security is classified as Level 2 in one period, based on the price received from a pricing service, and, based on the quote from a broker, as Level 3 in another period.
The EP members shared that generally, reporting entities use vendor prices, when available, and, when vendor prices are not available, they use broker pricing. The EP members noted that in some cases the prices provided by the pricing service may simply be transmitting quotes they received from brokers. Regardless of the source, however, reporting entities would need to analyze all information available about the inputs used in vendor prices or broker quotes before determining whether Level 2 or Level 3 would be appropriate. As some vendor prices and/or broker quotes may not provide sufficient transparency, a reporting entity’s management should attempt to obtain sufficient understanding about valuation techniques and models used in these prices. The reporting entity may consider comparing valuations received to market information and information received from other vendors, if available, and perform back testing. The EP acknowledged certain challenges about obtaining transparency of inputs used in broker quotes, yet, noted that not all broker quotes would necessarily be considered a Level 3 input.
The EP members also noted that FASB FSP 157-3 “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” provides guidance on how vendor prices and broker quotes need to be considered in assessing observable and unobservable inputs for the fair value measurement.
The SEC and the PCAOB continue to focus on the registrant’s validation of prices received from third-party vendors for the purposes of determining the fair value measurement levels. Reporting entities should continue performing due diligence of the pricing services, review procedures, develop and test qualitative and quantitative methodologies, perform comparison analysis and back testing, and consider hiring an outside valuation specialist, when necessary.
Consistent with paragraph BC 90 of ASU 2011-04, when a reporting entity uses significant unobservable inputs that it did not develop, such as unadjusted prices from third parties, for fair value measurements categorized as Level 3, a reporting entity should not need to create quantitative information about inputs used, but would disclose that it used broker quotes (however, a reporting entity cannot ignore other quantitative information that is reasonably available.) 3. Several (solvent) European countries, like Germany and Denmark, and the European Financial Stability Fund, have
recently issued bonds at auction that ended up paying negative interest rates. The EP began discussing how to account for the negative rate in the statement of operations (i.e., whether it would be considered negative interest income,
3 interest expense, or a realized loss). The EP members will consider developing an illustrative example for EP discussion at a future meeting or call.
4. ASU 2012-04, Technical Corrections, revised the scope exemption for an entity to prepare a statement of cash flows, and indicates:
For an investment company…. to be exempt from the requirement to provide a statement of cash flows, all of the following conditions must be met:
a. During the period, substantially all (emphasis added) of the entity’s investments were carried at and classified as Level 1 or Level 2 measurements in accordance with Topic 820
b. The entity had little or no debt, based on the average debt outstanding during the period, in relation to average total assets…..
c. The entity provides a statement of changes in net assets.
Also, as noted in the November 2011 EP meeting highlights, “a change in the investments criterion from substantially all securities being "liquid" to substantially all securities being classified as Level 1 or 2 in the ASC 820 hierarchy, could impact an entity’s assessment of the requirement to include a cash flow statement. The EP discussed this change in light of the SEC’s 1940 Act definition of an illiquid security.1”
During the November 2012 EP conference call, the EP revisited that discussion and observed that some securities held by open-end registered investment companies classified within Level 3 may be liquid. The panel noted a long-standing industry practice of using a 10% threshold for the securities held in Level 3 (those considered “illiquid” in prior accounting guidance) and a 10% threshold for debt outstanding during the period in evaluating criteria whether an investment company should be providing a statement of cash flows. The EP members do not anticipate investment companies changing their accounting policy as a result of issuance of this ASU.
5. A Working Draft of a new chapter in the AICPA Accounting and Valuation Guide: Investments in Privately Held Company Equity Securities Issued as Compensation. Chapter 8, “Inferring Value From Transactions in a Private Company’s Securities” chapter provides a framework on how to evaluate private transactions and secondary market transactions and their relevance for estimating fair value of the other securities within an enterprise. At the October conference call, an EP member shared that some in the private equity and venture capital funds community are concerned that this working draft (although nonauthoritative when issued as final) may have unintended consequences when determining fair value for investment companies. During the November 2012 conference call, the EP members observed that the guidance in this Accounting and Valuation Guide is intended for valuations of the securities issued as compensation, and not necessarily for equity investments measured in accordance with Topic 820. An EP member also inquired whether debt and equity instruments held by a business development company need to be bifurcated for valuation purposes in connection with this new chapter as well as draft TPAs being developed by the EP (refer to item I.3 above). The EP members observed that since Topic 946 does not specify the unit of account, the entity may determine that the fair value would be maximized in a transaction that involves both the debt and equity positions, and those positions may be grouped as long as other guidance in GAAP does not prohibit such grouping. If other accounting guidance that specifies a unit of account is considered; however, the answer may change.
6. The FASB recently decided to revisit scope of balance sheet offsetting guidance (Accounting Standards Update No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities) and tentatively limited it to derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending
arrangements. The proposed ASU is anticipated soon and will have a 25-day comment period. When finalized, the ASU would be effective for annual and interim reporting periods beginning on or after January 1, 2013. The EP members shared that this project resulted from certain questions that arose regarding whether trade receivable and trade payables and unsettled regular way trades, and exchange-traded securities, among other items, are within the scope of ASU 2011-11. The clarified scope of the offsetting guidance is intended to simplify accounting and legal analysis of master netting arrangements.
1 Refer to page 5 of the document in the attached link. http://www.sec.gov/rules/final/1986/ic-14983.pdf. Note that the 10 percent limit referred to in this document was subsequently increased to fifteen percent; see Revisions of Guidelines to Form N-1A, Investment Company Act Release No. 18612 (Mar. 12, 1992).
4 III. Audit and Attest Issues
1. An EP member inquired about an illustrative examination report on a transfer agent’s internal control pursuant to SEC Rule 17Ad-13; specifically, whether this example report should include an inherent limitations paragraph (this illustrative report is presented in paragraph 11.35 of the 2012 AICPA Audit and Accounting Guide Investment Companies). The 2008 edition of the Guide included such paragraph in the example report as well as explanation that the report was prepared based on AT 501. In 2008, AT 501 was superseded by SSAE 15 and now only applies when a practitioner is engaged to perform an examination of the design and operating effectiveness of an entity’s internal control over financial reporting that is integrated with an audit of financial statements; therefore, the examination report on a transfer agent’s internal control under the SEC Rule 17Ad-13 currently follows the guidance under AT101. The reporting requirements serve as a minimum of what needs to be included in the report. Since an inherent limitation paragraph is not a requirement in AT 101, the EP considered including this paragraph as optional wording in the illustrative examination report in the future editions of the Guide.
2. During the October 2012 conference call, the EP discussed the timing of communication of the audit firm with audit committees in light of the recently issued PCAOB Auditing Standard No. 16, Communications with Audit Committees, and Amendments to other PCAOB Standards. Footnote 43 in the Auditing Standard (AS) No. 16 states:
43/ Consistent with Rule 2-07 of Regulation S-X, 17 C.F.R. § 210.2-07, in the case of a registered investment company, audit committee communication should occur annually, and if the annual communication is not within 90 days prior to the filing of the auditor's report, the auditor should provide an update in the 90-day period prior to the filing of the auditor's report, of any changes to the previously reported information.
This exception currently enables large fund complexes with individual funds’ fiscal year-ends that are spread throughout the year to have quarterly audit committee meetings (rather than monthly audit committee meetings). Some are interpreting the changes to Auditing Standard 16 to require certain communications to take place prior to issuance of the opinion for each individual fund within a large fund complex. This interpretation of Auditing Standard No. 16 may cause audit committees to move to a monthly meeting schedule (so that they can receive and discuss the required communications prior to issuance of each opinion). Yet, others believe, from PCAOB's 2010 Proposing Release No. 2010-001 and PCAOB’s 2010 Proposing Release No. 2010-2010-001 and the 2012 adopting release (No. 2012-004), that the PCAOB did not intend to change current practice for investment companies.
EP members observed that, unless the PCAOB or the SEC issue clear guidance regarding application of this Standard for mutual fund complexes, some may interpret that communications between the auditor and audit committee must take place before issuing the auditor’s opinion; however, the nature of such communication may be flexible (for example, through a conference call or e-mail), unless otherwise required by the Standard.
The EP members also discussed that, if the frequency of these communication increases for large fund complexes with different reporting periods for individual funds, it may present an additional burden to the registrants, as the funds may incur additional costs in preparing for meetings.
The SEC has not yet approved this Standard. During the November 2012 conference call, the EP briefly revisited this topic but did not identify any new considerations. The EP will continue monitoring this development.
3. The EP members shared views with respect to the extent of testing existence and valuations of investments for business development companies (BDCs):
a. With respect to testing existence of investments held by BDCs, the EP noted that during the November 2011 EP meeting, the SEC staff indicated that a strong case could be made that confirmation of 100 percent of a BDC’s investments and inclusion of a statement in the auditor’s report that the auditor confirmed 100 percent of the securities owned by the BDC are required. This topic is also covered in the upcoming 2012 AICPA Investment Companies Industry Audit Risk Alert.
b. An EP member also shared that the PCAOB recently challenged the financial information (such as budgets and cash flows) received by BDCs from the underlying portfolio companies and why the auditor did not corroborate the information received (through inquiry or confirmation of the underlying portfolio companies). The EP
5 members noted that to the extent the valuation is being driven from future earnings or growth reports, the PCAOB would anticipate the additional work done by registrant and auditor to validate completeness and accuracy of information received, especially as it relates to the future projected financial information. BDCs may be performing their own projections and use unaudited quarterly information and internal cash flow projections to support their valuations, and the auditors are being challenged to support and document their understanding about assumptions and inputs used by BDCs.
IV. SEC Staff Update
The following comments and observations were compiled by the AICPA Investment Companies Expert Panel and AICPA staff and are not authoritative positions or interpretations issued by the SEC or its staff. The comments and observations were not transcribed by the SEC or its staff and have not been considered or acted upon by the SEC or its staff. Accordingly, these comments and observations do not constitute a statement of the views of the SEC or its staff.
1. An EP member noted, in a recent financial statement review, a high yield bond fund (an open-end registered investment company, and not a business development company (BDC)) was requested to break out, if material, on the face of the statement of operations the amount of income received from payment-in-kind (PIK) securities. While Article 6-07 of Regulation S-X does require that the “bases for recognition and measurement” of “non-cash dividends” (i.e., accounting policy) be disclosed, and that “any other category of income” (which appears to refer to “other income”, not “interest income”) exceeding 5% of gross investment income be detailed, the EP is not aware of a requirement in either S-X or GAAP requiring PIK interest income to be broken out from other interest income. While in this case the fund determined the amount was not material, so the question became moot, more generally, the EP would like to understand if this is now an SEC staff position.
The SEC staff indicated that the question originally arose in connection with BDCs. The SEC staff position is that BDCs with a material amount of PIK interest should present the PIK as a reconciling item on the cash flow statement or in a footnote to the cash flow statement. For example, the SEC staff reminded registrants that PIK should not be included in other line items such as purchases and sales. Also, as noted in the January 13, 2011, EP meeting highlights, when securities pay interest partially in cash and partially in kind, registrants should disclose that a portion of the interest is PIK and should disclose both the cash and PIK rates in the schedule of investments (SOI) or in a footnote to the SOI.
Registrants are encouraged to consult with the SEC staff when there is a material amount of PIK income and the registrant does not present a statement of cash flows.
2. The EP asked the SEC staff whether a consent is required of the independent registered public accounting firm if no financial statements of any kind and no "expertization" language referring to the firm are included/incorporated in a registration statement. Some believe that no consent is necessary in those instances, but on occasion fund counsel will
2. The EP asked the SEC staff whether a consent is required of the independent registered public accounting firm if no financial statements of any kind and no "expertization" language referring to the firm are included/incorporated in a registration statement. Some believe that no consent is necessary in those instances, but on occasion fund counsel will