Finance That Matters Summer 2015
New Consolidation Standard and the Investment Company Industry
[author-style]By Frank R. Boutillette – CPA/ABV, CGMA, Partner[/author-style]
In February 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2015-02, Consolidation – Amendments to the Consolidation Analysis. This guidance was issued in response to concerns about current accounting for consolidation of certain legal entities which may have unintended consequences where generally accepted accounting principles (GAAP) might require a reporting entity to consolidate another legal entity in specific situations. This includes cases where the contractual rights do not give the reporting entity the ability to act primarily on its own behalf; the reporting entity does not hold a majority of the legal entity’s voting rights; or the reporting entity is not exposed to a majority of the legal entity’s economic benefits or obligations.
The main provisions in this update affect limited partnerships and similar entities such as limited liability entities (hereafter referred to as limited partnerships).In addition, entities that need to evaluate whether fees paid to a decision maker or a service provider represent a variable interest will also be impacted. Some of the most significant changes related to limited partnerships include the following:
- There is no longer a presumption that a general partner should consolidate a limited partnership.
- In order for a limited partnership to be considered for consolidation under the voting interest model, the limited partners at a minimum require either substantive kick-out rights or substantive participating rights over the general partner. However, limited partnerships could still be subject to evaluation under the variable interest entity consolidation if they contain another characteristic of a variable interest entity.
- Under the voting interest entity consolidation model, a limited partnership would be consolidated by a limited partner with a controlling interest achieved through substantive kick-out rights and only if there are no other limited partners that have substantive participating rights.
One effect of the above changes is that the general partner in a limited partnership that is evaluated for consolidation under the voting interest model will not consolidate the limited partnership.
With respect to fees paid to a reporting entity who is a decision maker by an entity (including limited partnerships), ASU 2015-02 reduces the number of criteria that decision maker must evaluate to determine if those fees represent a variable interest in the entity. The effect of this change may make it easier for certain decision makers to conclude that fees received from an entity do not constitute a variable interest in the entity.
If the reporting entity determines the fees paid to it do represent a variable interest and the entity (limited partnership) is considered a variable interest entity, then the reporting entity must evaluate if the variable interests represent a controlling financial interest. This would most likely require the reporting entity to consolidate the entity (limited partnership).
Under this update, some decision-maker fee arrangements with a limited partnership are excluded from the evaluation of the economics criterion to determine if they represent a variable interest. For example, if the fee arrangement is both customary and commensurate with the level of effort required for services provided, it can be excluded from the determination of whether a variable interest exists.
In determining whether an asset manager needs to consolidate a fund, the guidance set forth in this updated literature needs to be read carefully.
What follows is a very simple example taken from the guidance:
A limited partnership (Fund) is formed to invest in securities. The general partner is the asset manager and owns a 70% interest in the Fund. There are 3 other independent limited partners each owning 10%. The limited partners have kick-out rights through voting interests, and a vote of a simple majority of the kick-out rights through voting interests to remove the general partner is required.
The general partner is paid a fee of 2% based on the total assets of the Fund plus a 20% performance fee.
Since the fee paid to the general partner are customary and commensurate with the level of service provided, the arrangement would not be considered a variable interest; and therefore, assuming the limited partnership is not a variable interest entity under any of the other criteria, the limited partnership would be deemed to be a voting interest entity. As a voting interest entity, where the limited partners have substantive kick-out rights to remove the general partner, no partner would be deemed to have a controlling financial interest in the Fund on the basis of the guidance in paragraph 810-10-25-1A of the standard, because no single limited partner owns a majority of the fund’s kick-out rights through voting interests. Therefore, no partner consolidates the Fund.
The standard should be read carefully in determining whether the reporting entity should consolidate the limited partnership. This guidance is effective for public business entities for years beginning after December 15, 2015, and other entities for years beginning after December 15, 2016.
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Frank Boutillette, CPA, Partner 212-751-9100 [email protected] View Experience
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Ponzi Scheme Losses
[author-style]By Robert Schachter, CPA, Partner[/author-style]
It is important to note that Revenue Rule 2009-14 and Rev. Proc. 2009-20 & 2011-58 provided safe harbor loss deductions from criminal fraud or embezzlement from transactions entered into for profit. Such losses are deductible as theft losses are not capital losses. Ponzi scheme losses not reimbursed by insurance or having a reasonable prospect of recovery may be taken as theft losses not subject to personal loss limitations or limits on itemized deductions. In addition, the theft loss can create or increase a net operating loss.
The Chief Counsel’s Office has recently advised in CCA 201445009 that an Investor was entitled to safe harbor treatment for losses not specifically identified in the previous Revenue Ruling and Revenue Procedures. While the facts were similar to other investor thefts with a couple of wrinkles, Rev. Proc. 2009-20 provides an optional safe-harbor provision that a qualified investor does not include a person that invested solely in a fund or other entity that, in turn, invested in the specified fraudulent arrangement, and that the fund or other entity itself may be a qualified investor. This provision potentially negated the ability for the Investor to utilize the benefits of Rev. Proc. 2009-20. In addition, Rev. Proc. 2011-58 recognized deaths of lead Ponzi scheme figures, which prevented governmental authorities from charging the lead figure and did not jeopardize the theft loss deduction.
The Chief Counsel’s office was required to consider whether to bar the Investor’s theft loss deduction because it is a third party and would not be deemed a qualified investor under Rev. Proc. 2009-20 because Investor did not invest the funds directly into the investment itself. Not investing directly in the investment vehicle negated the benefits of the Rev. Proc. 2009-20. The Chief Counsel’s Office determined that the Investor’s advisor was acting as an agent of the Investor and therefore the Investor was deemed to have invested the funds directly into the fraudulent arrangement and has set a precedent that Rev. Proc. 2009-20 was not intended to preclude investors from taking a theft loss deduction that would otherwise qualify as a theft loss deduction.
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By Robert Schachter, CPA, Partner 212-751-9100 [email protected] View Experience |
The Basics of Net Capital
[author-style]By Malia Mon[/author-style]
The uniform net capital rule, 15c3-1, is a unique set of guidelines set forth by the US Securities and Exchange Commission (“SEC”) that serves as a liquidity test requiring broker-dealers to maintain a certain percentage or dollar amount (whichever is greater) of net capital in relation to their aggregate indebtedness. This calculation is used to ensure that a broker-dealer has sufficient liquid assets to satisfy their liabilities whether they are to customers or other creditors, and to provide a cushion of liquid assets in excess of their liabilities to protect them against certain risks if they are required to liquidate.
The first step in calculating net capital is determining the amount of assets the broker-dealer maintains. Rule 15c3-1 complicates this by requiring broker-dealers to deduct assets that are not readily convertible to cash, commonly known as non-allowable assets. Non-allowable assets include intangible assets, fixed assets, prepaid expenses, unsecured receivables, real estate and other assets that would be viewed as illiquid to the entity. Non-allowable assets must be excluded for net capital purposes because these assets are not seen as assets that a broker-dealer could use to pay for their financial obligations to their customers or other creditors. So, what assets does this leave broker-dealers with that are includible for net capital purposes? Cash in the bank, clearing deposits, customer debit balances, secured notes receivable, stock borrowed, mortgaged real estate and any other assets a broker-dealer has that are considered to be highly liquid are includible as part of the net capital computation.
Once the allowable and non-allowable assets have been distinguished from one another, a broker-dealer must maintain a 15:1 aggregate indebtedness to the net capital ratio (8:1 for the first year broker-dealers). This ratio compares the company’s net liquid assets to their liabilities to ensure the liquid assets exceed the liabilities by the required ratio. The aggregate indebtedness of a broker-dealer includes the unsecured liabilities of the entity along with all customer related liabilities; generally it is all of the liabilities of a broker-dealer. The net capital requirement is the greater of a dollar amount or a percentage of their aggregate indebtedness, but these amounts will vary based on the type of broker-dealer and the nature of their business.
The complexity of the net capital rule varies based on the type of broker-dealer and how much activity they have. Other factors to be considered include haircuts on securities, mark-to-market value of securities, subordinated debt, and other items that would be deductions from net worth based on the risk of activities performed by a broker-dealer.
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Malia Mon 732-828-1614 [email protected] |
Implication of SEC’s 2015 Examination Priorities to Private Equity Firms
[author-style]By Phyllis Tsai, CPA[/author-style]
One of the areas which SEC’s Office of Compliance Inspections and Examinations (“OCIE”) will focus on is protecting retail investors. OCIE is interested in issues which are important to the retail investors, especially those investors who are saving for or already in retirement. Based on a speech given by Andrew J. Bowden, prior Director of OCIE in May 2014, OCIE has been focusing their efforts in private equity industry to fulfil their mission of protecting the investors and the integrity of the financial market. SEC’s examination findings, publicized by this speech, emphasized on fees and expenses charged by the private equity advisers and interim valuation in fund marketing. SEC’s 2015 examination priorities indicated that SEC will continue their scrutiny in private equity firms’ compliance obligations, marketing materials, and performance reporting.
Based on SEC’s past examinations, SEC have identified issues related to adviser’s collection of fees and allocation of expenses which they believed to be violations of law or material weaknesses in internal controls. SEC also found improper or lack of disclosure to the investors related to shifting expenses to portfolio companies and hidden fees. Given the high rate of deficiencies that SEC found in prior examinations, fees and expenses charge by the private equity advisers will remain a focus for 2015’s examinations. The private equity firms should review their internal controls and policies and procedures related to fees and expenses to determine if their fees and expenses are properly allocated and disclosed.
The retail investors of all ages face the challenges of understanding their investment options and determining how to invest their money. They may rely on private equity’s marking materials and investment valuation to consider whether to invest in a current offering. SEC noted that the private equity firms may use a different valuation method than the method disclosed to investors. Therefore, OCIE’s examiners will be looking out for any incidents that the advisers cherry-picking comparables or adding back inappropriate items to EBITDA and changing the valuation methodology from period to period without additional disclosure to the investors. They will also be reviewing the internal rate of return disclosed in fund marketing materials and evaluating any calculations impacting the historical performance reporting. As a result, more private equity firms engage external and independent parties to review their valuations or to assist in improving their valuation process and procedures because they believe that independent review of their investment valuation methodology or calculation may increase transparency and investors’ and regulators’ confidence.
In addition, OCIE will be assessing cybersecurity compliance and controls during 2015’s examinations. SEC is concerned with investment managers’ ability to protect the safety and confidentiality of customer information. In February 2015, OCIE issued the results of its Cybersecurity Examination Sweep Summary highlighting the compliance issues which the broker-dealers and investment advisers are facing with respect to cybersecurity issues. OCIE examiners will likely focus on the adequacy of the policies and procedures discovered during the sweep and assessing the firms’ governance and supervision of their information system to address cybersecurity risks.
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Phyllis Tsai, CPA 609-520-1188 [email protected] |