Assessment Of Investment Entities – FAQ | IFRS

Assessment of investment entities

The assessment of investment entities is documenting whether an entity meets the definition, all facts and circumstances should be considered, including the entity’s purpose and design [IFRS 10 B85A]. It will often be straightforward to determine whether an entity is an investment entity. However, in view of the fundamental importance this assessment has on affected entities’ financial statements, IFRS 10 provides extensive application guidance.

More detail on each element of the definition is provided below:

1 Investment services condition

One of the essential activities of an investment entity is that it obtains funds from investors in order to provide those investors with investment management services. This is a feature that distinguishes investment entities and other entities, although not in isolation; other features need to be present for an entity to meet the definition of an investment entity.

2 Business purpose condition

The second part of the definition of an investment entity is that the entity has committed to its investor(s) that its business purpose is to invest funds solely for returns from capital appreciation, investment income, or both [IFRS 10 27(b)].

Typically an entity’s investment objectives (ie its business purpose) will be evidenced by documents such as:

  1. the offering memorandum
  2. publications distributed
  3. other corporate or partnership documents.

Further evidence may include how the entity presents itself to third parties. An entity that presents itself as an investor whose objective is to jointly develop, produce or market products with its investees is not an investment entity [IFRS 10 B85B].

As well as its own investing activities, an investment entity may provide (directly or through a subsidiary):

  1. investment-related services (for example, investment advisory services, investment management, investment support and administrative services) to third parties as well as to its own investors, even if those activities are substantial to the entity – on the condition the entity continues to meet the definition of an investment entity
  2. management services and strategic advice to investees
  3. financial support to investees (such as a loan, capital commitment or guarantee) [IFRS 10 B85C and IFRS 10 B85D].

Activities b) and c) are only permitted if these activities are undertaken to maximise the investment return (capital appreciation or investment income) from its investees and do not represent a separate substantial business activity or a separate substantial source of income to the investment entity.

If an investment entity has a subsidiary (that isn’t an investment entity) that provides investment related services or activities such as those mentioned above to the investment entity, the subsidiary should be consolidated.

Mandatory requirement

It is not uncommon for entities meeting the definition to nonetheless have a preference for consolidation of an investment entity subsidiary. Arguments are sometimes made as to why subsidiary investments should not be consolidated.

For example, people may question whether showing the investments as a single line in the consolidated financial statements provides useful information to investors. In particular they argue that such a treatment:

  • results in intercompany items between the investment entity parent and the investment entity subsidiary not being eliminated. This means that
    • the consolidated financial statements may show a large intercompany debtor
    • the fair value of the investments will be affected not just by its investments but also by its creditor to the parent and any other financing
  • means the values of the individual investments held by the subsidiary will not be shown
  • means any external liabilities held by the subsidiary such as bank loans will not be shown (being
  • merged into the overall fair value of the investment entity subsidiary).

However these reasons do not override the mandatory requirement not to consolidate the investment entity subsidiary.

What can preparers do?

Preparers of investment entity parent financial statements can assist users in understanding the information on investment entity subsidiaries and investments by providing additional information and disclosures. This can be in the form of pro-forma information on their investments. This would need to be described as additional disclosure not required by IFRS.

Exit strategy Assessment of investment entities

The definition of an investment entity does not refer directly to exit strategies. However, the application guidance makes it clear that an investment entity does not plan to hold its investments indefinitely but instead holds them for a limited period [IFRS 10 B85F]. Accordingly, to meet the definition, an investment entity is required to have an exit strategy documenting how it plans to realise capital appreciation.

The requirements allow some flexibility as to the scope and detail of that strategy, as noted in the following sections.

Exit strategies should cover substantially all of an investment entity’s equity investments, non-financial investments and debt investments that have the potential to be held indefinitely. Those debt investments that have a maturity date are already seen as having an exit strategy as there is no possibility of holding them indefinitely. As well as those investments that have an exit strategy by default through limited life, exit strategies also do not need to include investments in other investment entities that are formed in connection with the entity for legal, regulatory, tax or similar business reasons if those entities have an exit strategy for their investments.

An exit strategy need not address each individual investment but should identify potential strategies for different types or portfolios of investments. It should however include a substantive time frame for exiting the investment. Exit mechanisms that are only put in place for default events, such as a breach of contract or non-performance, are not considered exit strategies for the purpose of this assessment.

Exit strategies can vary by type of investment. The application guidance in IFRS 10 provides some examples of how investment entities can exit: Assessment of investment entities

  • private equity securities – via IPO, trade sale of a business, placement, distributions to investors of ownership interests in investees and sales of assets, liquidation or sale in an active market
  • publicly traded equities – selling the investment in a private placement or in a public market
  • real estate investments – sale of the real estate through specialised property dealers or the open market.

What should an exit strategy contain? Assessment of investment entities

Exit strategies should be documented and include the following:

  • the type of investment (or portfolio of investments the strategy relates to)
  • how exit of the investment will be achieved
  • expected outcomes and results to be achieved before the strategy is exercised
  • the time frame involved
  • value of the investment to be achieved on exit
  • confirmation the board has approved the strategy.

Benefits from investees Assessment of investment entities

An investment entity’s business purpose is to invest funds solely for returns from capital appreciation, investment income, or both. By contrast, a non-investment holding company normally seeks to obtain a wider range of benefits from its subsidiaries and typically operates more as an integrated business in order to obtain these benefits. Accordingly, a non-investment parent typically has more involvement in its subsidiaries’ operations and the subsidiaries typically have more involvement with each other.

IFRS 10 aims to capture this distinction by stating that an entity does not meet the business purpose component of the investment entity definition if it obtains (or has the objective of obtaining) benefits from its investees that are ‘unavailable to parties unrelated to the investee’.

IFRS 10 provides guidance on particular types of benefits from and involvement with investee entities and whether they are compatible with an investing business model. Put broadly, the more involvement the entity has with its investees (and the investees have with each other), the less likely it is that the entity will qualify as an investment entity. Conversely, it will be easier to demonstrate an entity meets the business purpose part of the definition when investees are substantially autonomous and operate independently of the investment entity and one another. The following table provides a summary of permitted and prohibited types of involvement with investees:

Permitted [IFRS 10 B85I and IFRS 10 B85J]

Prohibited [IFRS 10 B85I and IFRS 10 B85J]

The following benefits gained from investees are permitted for an investment entity:

  • using an investment in an investee as collateral for borrowings
  • intercompany trading between investees in the same industry, market or geographic area
  • other intercompany transactions that:
    • are on terms that would be available to parties unrelated to the entity, another group member or the investee
    • are at fair value
    • do not represent a substantial portion of the investee’s or the entity’s business activity, including business activities of other group entities.

The following benefits gained from investees are prohibited for an investment entity:

  • the acquisition, use, exchange or exploitation of the processes, assets or technology of an investee
  • disproportionate, or exclusive rights to acquire assets, technology, products or services of any investee (for example, holding an option to purchase an asset from an investee if development is deemed successful)
  • joint or other arrangements between the investee and another group member to develop, produce, market or provide products or services
  • provision by investee of financial guarantees or assets to serve as collateral for another group member’s borrowings
  • an option held by a related party of the entity to purchase an ownership interest in an investee
  • intercompany transactions other than those in the ‘permitted’ column.

The following other involvement with investees is permitted for an investment entity:

  • providing investees (directly or through a subsidiary) with:

    • management and strategic services

    • financial support such as a loan, capital commitment or guarantee

      if such activities are undertaken to maximise returns from investments rather than being a separate business activity or income stream.

The following other involvement with investees is prohibited for an investment entity:

  • provision of services to investees that represent a separate business activity or income stream.

In some cases meeting the business purpose element of the definition will be straight forward; ie. if the entity does not provide any additional services or gain any additional benefits other than those of capital appreciation and investment income. Others will be less so, for example, when the entity provides both investing activities, investment related services and has an involvement in the management or the financial support of the entity. The extent to which each of these activities are provided will vary entity by entity and therefore careful consideration of individual facts and circumstances will be needed. This is discussed further in the practical insight box below.

Extent of involvement in the investees’ activities Assessment of investment entities

As noted above, management services, strategic advice to investees and financial support to investees are only permitted by an investment entity if they do not represent a separate substantial business activity or separate substantial source of income to the investment entity. What represents “substantial” and the extent of services provided will vary and judgement will be required to determine whether the entity is an investment entity or not. When the required judgement is considered significant, it should be disclosed in the financial statements as a critical accounting judgement.

It is important to consider the reason for the entity providing services other than investing activities as well as the quantum. Management should be questioning whether:

  • the entity is likely to gain any other benefits other than capital appreciation and investment income
  • how it presents itself to third parties. If the entity is a genuine investment entity, they will more likely discuss levels of investment returns rather than how the investment is performing in the other activities the entity is involved in.

In general it is considered acceptable that the level of involvement can be high as long as it is done with the aim to maximise the investees overall value in order to maximise capital appreciation. If there are other reasons for the involvement then this could result in the entity not being an investment entity.

As well as the above, entities must also remember to consider other prohibited activities, for example, having investments without exit strategies, and gaining significant benefits other than capital appreciation and investment income, as noted above.

Specialised IT Fund (based on illustrative example 2 accompanying IFRS 10)

Specialised Research Ltd formed Specialised IT Fund, with the aim being to invest in IT start-up companies for capital appreciation. The group structure is as follows:

Assessment of investment entitiesSpecialised Research Ltd holds options to acquire investments held by Specialised IT Fund, at their fair value, which would be exercised if the IT systems produced by the investees would benefit the operations of Specialised Research Ltd.

Specialised IT Fund has not identified any exit plans with regards to its investments. An investment adviser manages Specialised IT fund, acting as an agent on behalf of the investors of the fund.

Is the fund an investment entity?


Conclusion

Specialised IT Fund is not an investment entity, despite its business purpose being investing for capital appreciation and the potential for investment income, because:

  • Specialised Research Ltd could obtain additional benefits (as well as the capital appreciation and investment income), if the IT assets developed by the investees benefit the operations of Specialised Research Ltd (through the options exercisable by Specialised Research Ltd)
  • Specialised IT Fund hold equity investments, which do not include exit strategies. Specialised IT Fund do not control the options held by Specialised Research Ltd and these are therefore not considered to be an exit strategy.

Real estate investment entities Assessment of investment entities

Real estate entities that own or lease investment property directly (ie that have no subsidiaries) are not affected by this exception. However, many real estate investment entities hold properties in separate legal entities (sometimes referred to as ‘corporate wrappers’). These separate entities may include borrowings used to finance the property purchase. In such cases consolidation versus fair value measurement has a significant impact on the parent entity’s reported financial position, even if the IAS 40 fair value model is used. Fair valuing the various separate legal entities will result in a net rather than gross balance sheet position and will also change reported net assets (due to the entities’ debt being fair valued among other factors).

Determining whether a real estate entity meets the investment entity definition is therefore critical and has to be done on a case-by-case basis. In many cases it is readily apparent that a real estate entity fails the definition – for example, because it undertakes property development activities that are distinct from its investment activities. IFRS 10’s illustrative examples include a case in which an entity is not considered an investment entity for various reasons including that it ‘has a separate substantial business activity that involves the active management of its property portfolio, including lease negotiations, refurbishments and development activities, and marketing of properties to provide benefits other than capital appreciation, investment income, or both’.

Other factors to consider include:

  • whether or not the real estate entity has an exit strategy for its properties or portfolios of properties, including a substantive time frame for exit
  • the extent to which the real estate entity uses fair value as its primary performance measure. Even if an entity applies the IAS 40 fair value model, it may use other measures to assess performance and to make investment decisions, such as information about expected cash flows, rental revenues and expenses.

3. Fair value condition Assessment of investment entities Assessment of investment entities

The last element of the definition is that an investment entity measures and evaluates the performance of substantially all of its investments on a fair value basis. This is because using fair value results in more relevant information than, for example, consolidating its subsidiaries or using the equity method for its interests in associates or joint ventures. In order to demonstrate that it meets this element of the definition, an investment entity:

  • provides investors with fair value information Assessment of investment entities
  • measures substantially all of its investments at fair value in its financial statements whenever fair value is required or permitted in accordance with IFRSs (for example, uses fair value alternatives in IAS 28, IAS 40, IFRS 9)
  • uses fair value as the primary basis for reporting internally to key management personnel [IFRS 10 B85K].

‘Substantially all’

IFRS 10 does not define ‘substantially all’. Therefore assessing whether an entity meets this element will require judgement. The IASB does not provide any bright lines (for example, a level or a percentage). In our view if an entity genuinely considers itself to be an investment entity then it would have selected the fair value option for their investments, as the fair value option provides more meaningful information to investors. If the entity has a significant investment measured at cost then it is unlikely to meet the fair value element of the definition.

An investment entity may have some non-investment assets, such as a head office property and related equipment, and may also have financial liabilities. The fair value measurement element of the definition of an investment entity in IFRS 10 27(c) applies to an investment entity’s investments. Therefore, an investment entity need not measure its non-investment assets or liabilities at fair value.

See also: The IFRS Foundation

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