To: International Accounting Standards Board
ED 10 Consolidated Financial Statements – Response by the Association of
Investment Companies (‘AIC’)
Introduction
The AIC is the trade body representing some 350 investment companies, managing
assets of approximately £60bn.
Our Members are closed-ended investment
companies whose business is to invest in a diversified portfolio of shares and
securities, property and other assets to provide returns for their shareholders.
Investment companies are one of the main forms of collective investment vehicle
available to UK investors, along with unit trusts and OEICs.
Our Members are domiciled both in the UK (investment trusts, Venture Capital Trusts)
and offshore (predominantly in the Channel Islands); with the vast majority listed on
the London Stock Exchange. Many of our Members either specialise in private equity
investment (or have exposure to this asset class) or the provision of venture capital.
In our experience, the vast majority of investment companies do not produce
consolidated accounts (simply because they have no subsidiary companies). The
minority that do consolidate usually do so because they carry out a secondary aspect
of their business, separate from their pure investment business, through a subsidiary.
Our Members, however, seldom, if ever, consolidate any of the investee companies
held as part of their primary business. This is because an investment company
generally does not seek to control its investee companies. The AIC SORP sets out,
in paragraph 4 and elsewhere, the unique nature of an investment company’s
business.
Notwithstanding that they have the option to produce their company accounts in
accordance with IFRS, most of our Members (we estimate around 70%) continue to
produce their accounts in accordance with UK GAAP. However, as UK GAAP itself is
largely converged with IFRS, and it can be expected that any standard emerging from
this process will be adopted in the UK, ED 10 is as applicable to our Members as it is
for those entities that are reporting directly in accordance with IFRS.
As stated above, many of our Members specialise in private equity investment or the
provision of venture capital. Consequently, such entities would often be much more
closely involved with their investee companies than would ordinarily be the case for
investment companies generally. Even so, it would be most unusual for such entities
to control their investee companies and the production of consolidated accounts
would be rare.
We should make it clear that the following comments apply only to an investment
company’s investments. If an investment company carries out other (non-investment)
activities via entities it controls then we would agree that consolidation is required.
Basis for consolidation
The AIC is pleased to note that the requirement to consolidate an entity continues to
be based on actual control. In our letter of 23 May 2007 addressed to Mr Alan
Teixeira, we set out at length our reservations concerning some of the points raised in
your papers: Information for observers – 20 July 2006 – Consolidation (including
SPEs) and Consolidation (including Special Purpose Entities) 31 August 2006. For
example, the July paper states that control can be presumed:
‘if an entity has the right to cast sufficient votes to constitute a majority
of the votes usually cast at meetings of the entity’s governing body.’
However, we note that ED 10 does envisage situations where an entity has the power
to direct the activities of another entity without a majority of the voting rights. Whilst
this does not seem to go as far as considering votes usually cast at meetings, it does
(in paragraph 28) introduce the concept of a dominant shareholder and compares this
to all the other shareholders ‘whose voting rights are dispersed and are not organised
in such a way that they actively co-operate when they exercise their votes’.
Putting to one side the legal considerations of such organisation (concert parties etc),
we do not agree that, for example, a shareholder owning 40% can be said to be able
to control the outcome of votes simply because the other 60% do not actively cooperate. Provided they are able to exercise their votes, the 60% could vote against
the 40% on any particular issue. Additionally, as far as we are aware, there is
nothing to stop one of these other entities from actually building up a holding in the
‘controlled’ entity of over 50%.
We are not certain what is meant by the phrase ‘whose voting rights are dispersed
and are not organised in such a way that they actively co-operate when they exercise
their votes’. ED 10 seems to be suggesting that consolidation is to be based on
presumptions about circumstances and intentions of third parties that may potentially
be unknown to the investor. We do not see how the ‘dominant shareholder’ would
necessarily know whether or not votes are organised or know the holdings of the
other shareholders (nominee accounts etc). Even if it does know the other holdings,
what is meant by dispersed? If another shareholder increases its holding to, for
example, 5%, 10% or 15%, which of these levels, if any, would mean that the
dominant shareholder is no longer deemed to have control?
In conclusion, we do not understand how a ‘dominant shareholder’ could demonstrate
control in these circumstances and see this aspect of consolidation as a step too far
and recommend that it be dropped from ED 10. If it is retained, much more
guidance is required. It also seems to us that ‘dominant shareholder’ should be a
defined term.
With regard to disclosures, we do not agree with the requirements set out in B32. If
our recommendation, as set out above, that the dominant shareholder test should be
dropped is not accepted then, without further guidance, we cannot see how an entity
can reach conclusions regarding B32a and b. However, if the entity has concluded
that, even though it is the dominant shareholder, it does not control another entity, we
do not agree that the information required by B34 should be shown. If there is no
control then it is inappropriate to be giving information, even in aggregate, that
purports to be showing the position as if control exists.
Investment companies
We note the contents of paragraphs BC22 to BC27 where the position of investment
companies is discussed. In particular, in BC27 you confirm your earlier reasoning
that:
‘The Board concluded that for investments under the control of private equity
entities, users’ information needs are best served by financial statements in
which those investments are consolidated, thus revealing the extent of the
operations of the entities they control. The Board noted that a parent can
either present information about the fair value of those investments in the
notes to the consolidated financial statements or prepare separate financial
statements in addition to its consolidated financial statements, presenting
those investments at cost or at fair value. By contrast, the Board decided that
information needs of users of financial statements would not be well served if
those controlling investments are measured only at fair value. This would
leave unreported the assets and liabilities of a controlled entity. It is
conceivable that an investment in a large, highly geared subsidiary would have
only a small fair value. Reporting that value alone would preclude a user from
being able to assess the financial position, results and cash flows of the
group.’
We believe that this conclusion is wrong for the following reasons.
1. Consolidation is not the better accounting treatment for portfolio investee
companies. In our view, the fact that an investment in a large, highly geared
subsidiary has only a small fair value is a reason not to consolidate as
consolidation would produce misleading results. We do not believe that
consolidation in these circumstances results in greater clarity, rather the
activities of the subsidiaries are mixed-in producing confusing and unhelpful
reporting;
2. Presenting separate financial statements as suggested is not practicable or
desirable and would be confusing to users; and
3. A conclusion is reached about the needs of users which the AIC believes is
unfounded and not supported by any evidence.
We believe that the needs of users are best served by the non-consolidation of
investments by an investment company, even where the investor has more than a
50% economic interest.
The AIC agrees that the desirability for consolidation should be driven by the needs
of users. However, having discussed this matter with representatives of institutional
investors, financial advisers, discretionary managers and private investors, the AIC
has yet to come across any that feel that consolidation provides them with more
useful and relevant information. Some of our Members also invest their assets in the
shares of investment companies and are therefore also users of such accounts.
Again, the AIC has yet to come across any that consider that consolidation provides
them with better quality information.
When assessing an investment company, users will generally consider the asset
allocation of the company and the performance of the portfolio as a whole in terms of
capital appreciation and dividend income etc. This process will not be facilitated by
consolidating the results of investee companies. In fact, consolidation will confuse
this process as the financial statements will not show the market value of the
investments and the dividend income received. Producing separate financial
statements to highlight these figures will confuse users and increase the size and
complexity of what is already likely to be a large and detailed document to what we
believe will be an unacceptable level.
Trading and investment activities are not the same. ED 10 refers to control as being
the power to direct the activities of an entity to generate returns for the reporting
entity. With regard to an investment company, we believe that it invests not to benefit
from the investee’s activities but rather to obtain benefits from an increase in its value
i.e. fair value gains and dividend income. Such an increase could, of course, flow
directly from improved activity, but it could also follow a change in the market’s
perception not directly connected with the investee’s performance. It follows that
consolidation could actually obscure the returns due to the investment company by
showing neither of these.
In addition, an investment company will usually have within its investment plans an
exit strategy; i.e. it will be seeking to maximise its returns by disposing of its
investments at an appropriate time. This again demonstrates that trading and
investment is not the same thing.
We believe that what an investor in an investment company wants to know is the fair
value of its investments and this is certainly what our SORP recommends with regard
to investment holdings generally. Clearly IFRS already accommodates this approach
with regard to associated companies (where such investments held by venture capital
organisations, mutual funds etc are excluded from the requirement to be accounted
for using the equity method).
Consequently, we find it surprising and concerning that the IASB can conclude that
the needs of these users are best served by consolidation. We can see no basis for
such a conclusion, as it does not accord with our experience of how users actually
assess the performance of investment companies or what they are looking for from
the accounts of such companies.
If the IASB has any evidence that users desire consolidation information in the
accounts of investment companies, the AIC would be very interested to see it. If the
IASB does not have any such evidence, then it should not proceed on the basis of a
presumption which we believe is unfounded.
Scope exemption
We note your reference in paragraph BC23 to the US GAAP scope exemption.
Although outside of our area of expertise, we recommend that you investigate this
possibility further with the intention to introduce a similar exemption in IFRS. We do
not believe that the practical challenges (mentioned in BC26) are insurmountable and
do not see why this scope exemption should not be considered as part of the
convergence project with US GAAP.
If such an exemption were to be introduced, then the investments would still fall
within the scope of IAS 39, so it is really a matter of clarifying whether IAS 27 or IAS
39 is the relevant standard.
Associated companies (question 12)
As stated above, the non-application of IAS 28 to investments in associates held by
mutual funds, unit trusts and similar entities is, we believe, most appropriate, and we
would urge you not to disturb this in any consideration of IAS 28.
If you wish to discuss any aspect of this response please do not hesitate to contact
me (Dir tel: 020 7282 5605; e-mail: john.stevens@theaic.co.uk).
Yours sincerely
John Stevens
Finance Director