Introduction to Investment entities

Introduction to Investment entities is about information provision through financial statements to knowledgeable investors. For many years, preparers and investors in the investment entity industry felt that consolidating the financial statements of an investment entity and its investees does not provide the most useful information. Consolidation made it more difficult for investors to understand what they are most interested in – the value of the entity’s investments.

IFRS 10 provides an exception to consolidating particular subsidiaries for investment entities. The exception requires an investment entity to measure those subsidiaries at fair value through profit or loss in accordance with IFRS 9 in its consolidated and separate financial statements.

What is an investment entity?

The definition of an investment entity is fundamental when determining if the exception should be applied. It has three components, accompanied by four ‘typical characteristics’. Establishing whether an entity meets the definition of an investment entity is the central element to this exception, and could require significant judgement.

The definition, typical characteristics and their interaction are set out below:

Definition of an ‘investment entity’ [IFRS 10 27]

An investment entity is an entity that:

  1. obtains funds from one or more investors for the purpose of providing those investor(s) with investment management services (investment services condition)
  2. commits to its investor(s) that its business purpose is to invest funds solely for returns from capital appreciation, investment income, or both (business purpose condition)
  3. measures and evaluates the performance of substantially all of its investments on a fair value basis (fair value condition).

Typical characteristics [IFRS 10 28]

In assessing whether it meets the definition, an entity shall consider whether it has the following typical characteristics of an investment entity:

  1. it has more than one investment
  2. it has more than one investor
  3. it has investors that are not related parties of the entity
  4. it has ownership interests in the form of equity or similar interests.

1. Introduction to Investment entities

Although the investment entity definition is paramount, most entities that meet that definition are also in general expected to have all four of these typical characteristics. If an entity lacks one or more of the characteristics additional judgement is required to assess whether it meets the definition. It is very unlikely that an entity with none of the typical characteristics would meet the definition of an investment entity.

IFRS 10 provides examples of situations in which the absence of a typical characteristic would not necessarily preclude the entity from being an investment entity. More detail on each of the characteristics together with these examples is provided below:

1. More than one investment

An investment entity typically holds several investments to diversify its risk and maximise its returns. An entity may hold a portfolio of investments directly or indirectly, for example, by holding a single investment in another investment entity that itself holds several investments [IFRS 10 B85O].

Even though having more than one investment is typical of an investment entity, there may, however, be times when the entity has only one investment. This does not necessarily prevent an entity from meeting the definition of an investment entity; all facts and circumstances need to be taken into account. For example, an investment entity may hold only a single investment when the entity:

  1. is in its start-up period and has not yet identified suitable investments and, therefore, has not yet executed its investment plan to acquire several investments
  2. has not yet made other investments to replace those it has disposed of
  3. is established to pool investors’ funds to invest in a single investment when that investment is unobtainable by individual investors (for example, when the required minimum investment is too high for an individual investor)
  4. is in the process of liquidation [IFRS 10 B85P].

The intention of IFRS 10 is that generally an investment entity will have more than one investment and so therefore it is unusual for it to have only one investment for its entire period as an investment entity. Having one investment is typically only temporary.

If the investment entity only has one investment then it can still qualify as an investment entity, however this is not typical of an investment entity. Therefore management will need to apply and disclose their significant judgement made in reaching this conclusion.

2 More than one investor

Usually, an investment entity would have several investors who pool their funds to gain access to investment management services and investment opportunities that they might not have had access to individually. Having several investors would make it less likely that the entity, or other members of the group containing the entity, would obtain benefits other than capital appreciation or investment income [IFRS 10 B85Q].

However, an investment entity may be formed by, or for, a single investor that represents or supports the interests of a wider group of investors (for example, a pension fund, government investment fund or family trust).

There may also be times when the entity temporarily has a single investor. For example, an investment entity may have one investor when the entity:

  1. is within its initial offering period Introduction to Investment entities
  2. has not yet identified suitable investors to replace those that have redeemed their interests
  3. is in the process of liquidation. Introduction to Investment entities

If the entity only has one investor or that investor represents the interests of a wider group of investors then it can still qualify as an investment entity, however this is not typical of an investment entity. Therefore management will need to apply and disclose their significant judgement they make in reaching this conclusion.

In practice – Intermediate Holding Companies

Some group structures are set up for regulatory, tax or similar purposes and are wholly owned subsidiaries that own only one investment. In these cases it may be appropriate to consider the group structure as a whole. For example, this would apply to the following:

1. Introduction to Investment entities

Investment Co is owned by a number of unrelated investors. Entities 1-4 have been set up purely for regulatory purposes and are wholly owned subsidiaries of Investment Co. They control only one investment. Entities 1-4 do not carry out any other activities.

Whilst individually Investment Co and entities 1-4 would be unlikely to qualify as investment entities because they do not display enough of the typical characteristics (only equity ownership interests), as a group however, they have all the typical characteristics of an investment entity. This is because the group has:

  • more than one investment Introduction to Investment entities
  • more than one investor Introduction to Investment entities
  • unrelated investors Introduction to Investment entities
  • equity ownership interests. Introduction to Investment entities

If therefore the group has the three conditions documented in the definition in IFRS 10 27 (investment services, business purpose and fair value) then all of entities 1-4 and Investment Co would be considered investment entities. This is because the purpose and design of the entities is purely to meet the regulatory requirements in the various jurisdictions.

3 Investors that are not related parties

Typically, an investment entity has several investors that are not related parties of either the entity or other members of its group. Having unrelated investors would make it less likely that the entity, or other members of its group, would obtain benefits other than capital appreciation or investment income [IFRS 10 B85T].

However, an entity may still qualify as an investment entity even though its investors are related to the entity. For example, an investment entity may set up a separate ‘parallel’ fund for a group of its employees or other related party investors, which mirrors the investments of the entity’s main investment fund. This ‘parallel’ fund may qualify as an investment entity even though all of its investors are related parties [IFRS 10 B85U].

4 Ownership interests in the form of equity or similar interests

An entity is normally a separate legal entity; however this is not an explicit requirement. Ownership interests in an investment entity typically take the form of equity or similar interests (for example, partnership interests), to which proportionate shares of the net assets of the investment entity are attributed. However, having different classes of investors, some of which have rights only to a specific investment or groups of investments or which have different proportionate shares of the net assets, does not preclude an entity from being an investment entity [IFRS 10 B85V].

In addition, an entity that has significant ownership interests in the form of debt that, in accordance with other applicable IFRSs, does not meet the definition of equity, may still qualify as an investment entity, provided that the debt holders are exposed to variable returns from changes in the fair value of the entity’s net assets [IFRS 10 B85W].

Regulated investment entities

In many countries investment services are subject to specific laws and regulations. Accordingly, certain entities are considered to be ‘investment companies’ or similar for the purpose of local law and regulation. This leads to a question as to whether these regulated entities should automatically be presumed to meet the definition of an investment entity.

The answer is no – the definition does not refer to any local regulatory requirements. The IASB concluded that referring to local legal definitions would not be appropriate in an international standard. Accordingly, an entity is not necessarily an investment entity under IFRS 10 simply because it is regulated. Conversely, an entity can be an investment entity under IFRS 10 even if not considered as such under local requirements. This differs to US GAAP, which specifies that an entity regulated under the SEC’s Investment Company Act of 1940 would be an investment company for accounting purposes.

See also: The IFRS Foundation

Introduction to Investment entities

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