Investment company technical release Proposed amendments to the AIC SORP

Investment company
technical release
January 2014
Proposed amendments to the AIC SORP
Following the recent finalisation of the new UK financial reporting standards which will
replace the existing UK accounting framework from 2015, the AIC has issued an exposure
draft setting out the proposed amendments to the SORP relating to the financial statements
of Investment Trust Companies and Venture Capital Trusts. The consultation is open until
19 March 2014. The expectation would be that, once finalised, the revised SORP would
be effective for accounting periods beginning on or after 1 January 2015, although early
adoption would be permitted. Boards, managers and administrators are likely to wish to give
early consideration to the potential changes and their implications.
Background
The current SORP was last updated in January 2009. At that
stage, UK GAAP was largely on hold pending the lengthy
deliberations over IFRS convergence and the 2009 update was
largely a question of keeping the SORP up to date in light
of current developments. At the same time, the scope of the
SORP was also expanded to include VCTs.
Five years later, the debate over the accounting framework
has finally reached a conclusion. IFRS remains optional for
non-consolidated financial statements as it is currently; and
SORPs will continue, including the AIC SORP – a welcome
outcome. The recently published exposure draft reflects
the need to align the SORP with the new UK Financial
Reporting Standards, and in particular with FRS 102 which
replaces the body of existing UK GAAP. There have however
also been changes in the regulatory framework particularly
regarding the Companies Act 2006 provisions governing
the distribution of capital profits which involve some
consequential updates to the SORP.
In keeping with the 2009 SORP, the approach to be
taken for the 2014 SORP will be to continue to promote
consistency of information and provide guidance on the
distinction between capital and revenue. The SORP does not
seek to duplicate all the relevant requirements of accounting
standards. The 2014 SORP will be a key component in
making the transition to FRS 102, but investment companies
will need to consider the detailed requirements of the new
body of accounting standards in conjunction with the SORP
in order to identify all the detailed changes that may be
required to their financial statements.
Further discussion of the potential implications of FRS
102 for investment companies is contained in our May 2013
Investment Company Technical Release ‘The reshaping of UK
GAAP’. Some of the key features of the exposure draft for the
2014 SORP are summarised below.
Alterations to the primary statements
FRS 102 introduces the Statement of Comprehensive Income
into UK GAAP, but there is some flexibility as to how this
is presented. It may be presented as a single statement or
as two statements (ie an Income Statement and a Statement
of Comprehensive Income). As it is also permissible to
present only an Income Statement if there are no items
of other comprehensive income, as is typically the case in
an investment trust or VCT, the SORP proposes that this
presentation would generally be the most appropriate. For
the majority of investment companies this will result in an
approach broadly similar to that currently being used by some
of the investment trusts and VCTs which follow IFRS – ie an
Income Statement, typically with an accompanying footnote
explaining that there is no other comprehensive income.
The existing Reconciliation of Movements in Shareholders’
Funds becomes the Statement of Changes in Equity which,
for an investment company, is largely the same in all but
name. This would generally include the existing columnar
analysis of share capital and reserves and the analysis should
indicate whether any dividends paid were met out of revenue
or capital profits.
New cash flow statement exemption
FRS 102 extends the current exemption for open-ended
funds from preparing a cash flow statement to any fund
that can meet the relevant criteria – primarily this requires
substantially all of the entity’s investments to be highly
liquid and carried at market value. The proposed SORP
highlights the availability of the exemption but stresses that
not all investment companies will qualify and they will need
to carefully consider the liquidity profile of their portfolios
in order to determine whether the exemption applies. Our
view would be that investment companies should be cautious
about seeking to take advantage of the exemption if the results
of this evaluation are not clear cut. However for companies
which clearly qualify, the exemption is a tangible benefit.
Investment companies investing in property, unquoted
stocks or quoted stocks with limited liquidity and which do
not qualify for the exemption will find that their cash flow
statements require to be reformatted to comply with FRS
102 and in future these will look more like the cash flow
statements produced under IFRS.
The continued use of fair value through profit or loss
The SORP proposes that investments should generally be
accounted for in accordance with the provisions set out in
Sections 11 and 12 of FRS 102 and measured at fair value with
changes in fair value recognised in profit or loss.
FRS 102 permits the use of the measurement and
recognition provisions of IAS 39 or IFRS 9 as an alternative
and the SORP does not prevent companies from choosing
these options should they be more appropriate in the
circumstances. The SORP proposals are however drafted on
the premise that for the majority of companies, Sections 11
and 12 should prove suitable. Another relevant consideration
here is that by staying within the body of UK GAAP,
investment companies may potentially have greater influence
and less exposure to the uncertainties surrounding IFRS 9 and
what this might look like when it is finally complete.
Revised fair value disclosures
Investment Trusts and VCTs are required currently to provide
a three-level fair value hierarchy analysis under FRS 29. This
hierarchy is however not identical to that prescribed in FRS
102. In order to align with FRS 102, but also to continue to
provide the information on the use of observable and nonobservable data which is presented currently, the SORP
proposes what is, in effect, a four-level categorisation. The
four categories proposed for the analysis and examples of
some of the types of investments which might typically fall
into these are as follows:
• quoted prices for identical instruments in active markets
(eg liquid, exchange traded instruments)
• recent transactions for identical instruments (eg certain
unquoted equities and bonds)
• valuation techniques using observable market data (eg
certain OTC derivatives and bonds)
• valuation techniques using assumptions and nonobservable data (eg other unquoted instruments)
Broadly, the end result of this is that the separate category
for assets valued using the price of a recent transaction will
be new compared to current practice. In valuation parlance,
the price of a recent transaction for an identical asset
provides evidence of fair value as long as there has not been a
significant change in economic circumstances or a significant
lapse of time since the transaction took place.
The fact that the hierarchy is not the same as that for
investment companies following IFRS is perhaps something
which the FRC might have considered more closely when
finalising FRS 102. The AIC proposals do however ensure
direct comparability with the proposed authorised funds
SORP, which is also based on UK GAAP.
Revised guidance on recognition of interest from debt
securities – redemption premiums
An amendment to the SORP is being proposed in relation
to the accounting for returns from shares or debt securities
which are for a fixed amount. The revision emphasises the
need to consider whether the split of returns between revenue
and capital is in line with reasonable commercial expectations.
This would be a welcome refinement to the existing SORP as
it would reduce the risk of investment companies reflecting
returns where the split between revenue and capital appears
inappropriate. The particular example cited in the SORP is
one encountered particularly in VCTs where redemption
premiums attaching to debt securities may be designed to
protect the value of the investor’s equity stake in an investee
company rather than to form part of a commercial rate of
return on a loan investment. Similar considerations can
however also arise with investments in distressed debt.
We particularly welcome the fact that the proposals seek
to address some of the anomalies which have arisen in recent
years in relation to the split between capital and revenue
returns on bonds. Whilst there are many bonds where the
effective interest method has in practice produced a sensible
allocation between revenue and capital there are some where
it has not. Fundamentally, such difficulties largely arise from
the fact that accounting standards are not written with the
aim of distinguishing capital and revenue returns and the
effective interest method is therefore being used indirectly for
a purpose for which it was not originally designed.
Recommended disclosures where there are multiple
share classes each with their own pool of value
In line with the growth in the number of companies
(particularly VCTs) issuing C, D, E shares et al, each with
their own separate pool of investments, the SORP proposals
include recommendations for provision of additional
disclosures at the level of the individual share class.
The proposed recommendation is to provide disclosures
sufficient for each class of shareholders to ascertain its financial
position. The guidance is not prescriptive as to how this is
achieved but the proposals broadly seek to codify current
practice whereby companies typically provide separate income
statements and balance sheets at the share class level, along
with separate NAV and portfolio information.
It is worth noting also that the SORP is not prescriptive
as to the specific location of these disclosures within
the annual report. Boards would be able to choose the
most appropriate positioning of these, as currently. Our
view, however, would be that the provision of these as
supplementary information distinct from the audited
financial statements of the company affords the greatest
flexibility as it potentially avoids them becoming entwined
with legal and accounting standards disclosures particularly
regarding the notes to the financial statements.
Consolidation exclusion for portfolio investments
The SORP revisions highlight the important changes
which will become effective under FRS 102 excluding from
consolidation any investment held as part of an investment
portfolio. Prior to FRS 102 it has not been permissible to
consider a subsidiary company as a portfolio investment.
Under FRS 102 an interest is held as part of an investment
portfolio if its value to the investor is through fair value as
part of a directly or indirectly held basket of investments,
rather than as media through which the investor carries
out business. A basket of investments would be indirectly
held if, for example, an investment company holds a single
investment in a second investment fund which, in turn, holds
a basket of investments.
Both UK GAAP and IFRS therefore now incorporate
consolidation exclusions relevant to investment entities,
although it is important to note that the detailed mechanics of
these are not identical.
Consequential amendments arising from legal changes
governing the distribution of capital profits
Following the recent changes to the Companies Act 2006
removing the restriction on investment companies from
distributing capital profits by way of dividend, there are
proposed SORP amendments which emphasise the need to
provide an indication in the financial statements of which
reserves are distributable. This is important as some companies
may have amended their articles to allow distribution of
capital profits, and some may not. In addition, a number
of investment companies have special reserves arising from
share premium account conversions which may or may not
be subject to Court restrictions. The proposed amendments
should therefore assist with both clarity and comparability.
In keeping with the 2009 SORP there is no requirement to
provide any quantitative analysis of investment holding gains
at the reporting date between those which are realised and
those which are unrealised for legal distribution purposes.
So far as normal dividends received from other investment
trusts are concerned, the SORP revisions indicate that as a
matter of general principle, the fact that these may have been
paid out of capital profits is, on its own, not sufficient reason
to recognise them as capital. Such dividends will therefore
generally be revenue. They may however have other special
characteristics which may need to be considered having
regard to the facts and circumstances – in other words if
they are special dividends, then the usual special dividend
considerations would apply.
Other proposals
Benefits receivable by the manager
In the interests of clarity and consistency of interpretation,
the SORP revisions emphasise that when disclosing any
financial benefits which the manager receives derived from
its relationship with the company, disclosures should include
amounts paid by third parties as well as amounts paid by the
investment company itself. The disclosures also extend to any
indirect benefits which the manager may have received.
IFRS 8 ‘Operating segments’
FRS 102 mandates that entities whose debt or equity is
publicly traded need to comply with IFRS 8. The SORP
revisions therefore reflect this change but do confirm that
where investment companies only carry out investment
activity they will generally only have one segment. Companies
which engage in additional activities or which operate nonstandard business models may however need to consider
whether any segmental information is required according to
their individual circumstances.
Related parties
In line with recent AIC guidance, the SORP takes the position
that, in terms of accounting standards, it would be rare for the
management company to be a related party of the investment
company and thus recommends that companies take care in
their use of terminology when discussing transactions with the
manager etc in the notes to the financial statements. Possibly
the main situation in practice where the manager might
potentially be a related party in accounting standards parlance
would be where the manager is controlled by a director of the
investment company.
Transaction costs
In terms of the interaction of the SORP with FRS 102 there
are no proposed changes to the accounting and disclosure
of transaction costs incurred in acquiring or disposing of
investments. These provisions are the same as in the 2009
SORP. Transaction costs will continue to be disclosed in the
notes to the financial statements.
AIFMD investor disclosures
The SORP does not seek to deal with the additional
transparency requirements imposed by the Alternative
Investment Fund Managers Directive. Also there is some
flexibility as to the location of many of the AIFMD investor
disclosure obligations and it may be that there are alternatives
to including them in the annual report.
Investment companies will need to refer to the FCA’s new
FUND sourcebook and also consider the EU directive and
regulations directly in order to ensure they comply fully with
the detailed disclosure requirements. Inter alia, some of the
main additional disclosure requirements are likely to relate to
the following:
• material changes to certain specified pre sale information
• details of remuneration paid by the AIFM to its staff
• details of leverage
• information about liquidity management
The precise application of the AIFMD disclosure requirements
will vary from company to company according to whether
the company is over the size thresholds or not and on who is
carrying out the role of the AIFM.
Next steps
Consultation on the exposure draft closes on 19 March
2014. It is anticipated that the revised SORP would be
published in final form towards the middle of 2014 with a
view to becoming applicable for accounting periods starting
on or after 1 January 2015 – in line with the timetable for
implementation of FRS 102.
As noted previously, whilst the revised SORP will contain
a large amount of extremely useful signposting to FRS
102 requirements, it will also be necessary to refer to the
detail of FRS 102 itself in order to identify all the detailed
changes which may be required to the financial statements
on transition. Taking into account the need for comparative
information, the date of transition to FRS 102 would, in
effect, be the start of the comparative accounting period.
Thus, for example, if a company’s first FRS 102 annual
financial statements are for the financial year to 31 December
2015, then the date of transition is 1 January 2014.
Whether companies are considering early adoption of
the new accounting regime or are planning to wait until the
mandatory effective date, it is invariably the case that the
more that can be done in advance, the smoother the transition
is likely to be. Thus, for example, a review exercise which
combines both the revised SORP requirements and the FRS
102 changes in conjunction with a rework of the annual report
which will form the comparative information, is likely to be
beneficial. This would also enable boards to have early sight
of the form and content of the financial statements and to
discuss any potential issues which need to be addressed ahead
of the first year end for which the changes are being applied.
Contact us
Alastair Robertson
T +44 (0)20 7865 2275
E [email protected]
Julian Bartlett
T +44 (0)20 7865 2327
E [email protected]
Marcus Swales
T +44 (0)20 7865 2320
E [email protected]
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