United States

FASB proposes new requirements for the liquidation basis of accounting. What does this mean for investment companies?

INVESTMENT INDUSTRY INSIGHTS  | 

Background

After determining that current US GAAP provides minimal guidance on the application of the liquidation basis of accounting, the FASB recently issued a proposed Accounting Standards Update (ASU) that would provide clarification and guidance on when and how an entity should apply such basis in the preparation of its financial statements.

The proposed ASU would apply to all entities that issue financial statements which are presented in conformity with US GAAP. The specific provisions would apply when an entity determines that liquidation is imminent. Liquidation is determined to be imminent when either of the following occurs:

  • A plan for liquidation has been approved by the person or persons with the authority to make such a plan effective, and the likelihood is remote that the execution of the plan will be blocked by other parties.
  • A plan for liquidation is being imposed by other forces (for example, involuntary bankruptcy) and the likelihood is remote that the entity will subsequently return from liquidation.

If a plan for liquidation is specified in the entity’s governing documents at inception (for example, limited-life entities like private equity funds), liquidation would be imminent when significant management decisions about furthering the ongoing operations of the entity have ceased or they are substantially limited to those necessary to carry out a plan for liquidation other than the plan specified at inception; in other words, there are substantial changes in the entity’s original limited-life plan. Below is a list of indicators provided in the proposed ASU that implies a plan of liquidation differs from what was originally specified in the governing documents:

  • Liquidation is expected to conclude earlier or later than the specified expiration date of the entity.
  • The entity is forced to dispose of assets that are not orderly or in exchange for consideration that does not equal fair value (e.g., fire sale).
  • The governing documents have been amended since inception.

Liquidation basis presentation

Financial statements prepared under the liquidation basis of accounting would measure and present assets and liabilities at their respective cash values or other consideration that the entity expects to collect or pay as part of the liquidation plan. Any costs and income the entity expects to earn during the liquidation should be accrued and presented separately. Additional disclosures required by the proposed ASU include a statement that the financial statements have been prepared in accordance with the liquidation basis of accounting, including the facts and circumstances leading to its application, and a description of the entity’s liquidation plan. The liquidation plan would include, at a minimum, an explanation of the manner in which the entity expects to dispose of its assets and liabilities and management’s expectation of the duration of the liquidation.

How does the proposed ASU impact investment companies?

For investment companies, liquidation is imminent when:

  • A plan for liquidation has been approved by the management (general partner, managing member or the investment manager). For hedge funds or funds of hedge funds, particularly the ones with significant illiquid investments, when a fund receives an unusually high level of redemption requests and satisfying the redemption requests may not be reasonably practical and may be detrimental to all investors, management often chooses to voluntarily approve a liquidation of the fund. We saw a flurry of fund liquidations after the collapse of Lehman Brothers and Bear Stearns. For private equity funds, liquidation often happens when a fund is past its term of life and it can no longer extend the life of the fund. Essentially, liquidation is a private equity fund’s last option by distributing the interest in the remaining assets to the investors or transferring the remaining assets into a liquidation trust.
  • A plan for liquidation is being imposed by outside forces. Liquidation imposed by outside forces is rare for investment companies as management makes all significant decisions as dictated by the governing documents. It is possible for liquidation to be forced by a court decision or in certain cases, regulatory bodies.

One concern, considering the structure and governance of investment companies, is that a fund entity could continue when a plan of liquidation has not been executed. For example, if a fund holds positions in only illiquid investments, is not accepting any new capital and has suspended redemptions, it could continue to collect a management fee, indefinitely. Should consideration be given to force such an entity to be in a state of liquidation if certain criteria, such as the aforementioned, were present? As of now, this proposed ASU does not provide any guidance specific to investment companies.

Under GAAP, an investment company values its assets and liabilities at fair value. Therefore, one could argue that these items are already indicative of what the cash value would be in a state of liquidation. It is conceivable that an investment company could have large positions that it would not be able to liquidate resulting in a difference between estimated liquidation value and fair value, which could be significant. Another example would be a fund of funds where some of its investments may have suspended redemptions.

The investment company would need to accrue and disclose separately any additional costs it estimates it would incur as a result of the liquidation. This could include legal fees, accounting and administrative fees, and other professional fees. It could also include the accruing of management fees through the estimated date of the liquidation. Since investments are already valued at estimated fair value, it is presumed that there would be no adjustments in anticipation of liquidation.

By Lisa Brock, partner, RSM US LLP, 804.281.6808, Todd Rosen, director, RSM US LLP, 212.372.1715, and Stanley Yu, director, RSM US LLP, 212.372.1260.

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FASB proposes new requirements for the liquidation basis of accounting – What does this mean for investment companies?