As the stock market has shown volatility over the last several years, many high-net worth, sophisticated and institutional investors have used various forms of alternative investments to supplement their portfolios. A popular investment choice has been real estate-related funds.
In today’s regulatory environment – which boasts increased scrutiny and transparency for investors – a common issue for real estate fund managers is how to report the financial results of these funds to investors.
The Financial Accounting Standards Board (the FASB) issued clarified guidance for determining whether an entity is an investment company in accordance with accounting principles generally accepted in the United States of America (GAAP) in June 2013 through the issuance of Accounting Standards Update (ASU) 2013-08, Financial Services-Investment Companies (Topic 946); Amendments to the Scope, Measurement and Disclosure Requirements. Although this guidance has been effective for all interim and annual reporting periods for fiscal years beginning after Dec. 15, 2013, many questions still remain related to what entities meet the criteria of an investment company rather than an operating company.
Real Estate Investment Trusts (REITs) were specifically exempted from the scope of ASU 2013-08. The FASB further indicated that it did not intend for the amendment in the update to change the practice for real estate entities for which it is industry practice to issue financial statements using the measurement principles in Topic 946 (Financial Services-Investment Companies). It elected to address issues related to the applicability of investment company accounting for real estate entities at a later date. Although certain exclusions have been permitted to real estate entities, many real estate entities who issue financial statements as an operating company still question if investment company industry-specific reporting is applicable to them.
The ASU 2013-08 is applicable to both public and private entities. Entities regulated under the Investment Company Act of 1940 is an investment company under the guidance. Entities not regulated under the Investment Company Act of 1940 must apply certain criteria under a two-step approach within the guidance to determine if they are an investment company subject to industry-specific accounting principles under Topic 946. The purpose and design of the entity should be carefully considered when making the following assessment:
Step 1: Fundamental Characteristics
Investment companies have the following fundamental characteristics:
- An entity obtains funds from one or more investors and provides the investor(s) with investment management services. Further, an entity commits to its investor(s) that its business purpose and only substantive activities are investing the funds solely for returns from capital appreciation, investment income, or both.
- The entity or its affiliates do not obtain or have the objective of obtaining returns or benefits from an investee or its affiliates that are not normally attributable to ownership interest or that are other than capital appreciation or investment income.
Real estate entities and private equity companies may have involvement in the operations of an investee and would not preclude them from meeting the above criteria as long as the purpose is to maximize the returns of the entity.
Step 2: Typical Characteristics
An entity that qualifies as an investment company should possess both fundamental characteristics above and also has the following typical characteristics:
- It has more than one investment
- It has more than one investor
- It has investors that are not related parties of the parent or the investment manager
- It has ownership interests in the form of equity or partnership interests
- It manages substantially all of its investments on a fair value basis
An entity does not necessarily need to meet all of the above typical characteristics. For example, investments may only hold one investment if the objective is to pool investors capital to obtain access to an investment its investors would not have access to individually (such as a fund-of-funds). Additionally, ownership interests do not need to be unitized to meet this criteria but could rather be a proportional interest in an investee’s net assets.
The above criteria presents a general fact pattern to determine if an entity would qualify as an investment company; however, entities should consider the purpose and design of the entity and apply judgment to determine if the entity meets the general fact pattern to be reported as an investment company.
About the Author
Scott Price is a partner in Katz, Sapper & Miller’s Audit and Assurance Services Group. Scott’s background includes providing audit, review and attestation services to a diverse clientele in numerous industries, including financial services and real estate. Connect with him on LinkedIn.
About the Author
Brett Breedlove is a director in Katz, Sapper & Miller’s Audit and Assurance Services Group. Brett’s primary responsibilities include auditing and reviewing financial statements and advising clients in accounting, reporting, compliance and internal control matters. Connect with him on LinkedIn.