The overriding intention of the fund financial statement – which is delivered to all limited partners – is that it is sufficiently clear and informative to assist investors making decisions about allocations and monitoring their investments.
Unlike International Financial Reporting Standards (IFRS) and UK Generally Accepted Accounting Principles (GAAP), where comparative information is imperative, under US GAAP, comparative financial statements are not required for investment companies.
A set of US GAAP financial statements generally includes the following:
· Statement of assets and liabilities or a statement of net assets;
· Statement of operations;
· Statement of changes in net assets;
· Statement of cash flows (if required);
· Notes to the financial statements.
STATEMENT OF ASSETS AND LIABILITIES/STATEMENT OF NET ASSETS
The statement of assets and liabilities has a non-classified presentation and has requirements for the presentation of specific items with the investments presented first due to their importance considering the nature of an investment company. The schedule of investments could be presented either on the face of the statement of assets and liabilities or as a separate schedule.
CLASSIFICATION OF CAPITAL CONTRIBUTIONS
Under US GAAP, all financial instruments, including issued equity (capital contributions in the context of a private equity fund), require evaluation under FASB ASC 480 Distinguishing Liabilities from Equity for potential liability classification. They should be classified as liabilities if they are unconditionally redeemable by transferring assets at a specified or determinable date (or dates) or when an event is certain to occur (or generally on fixed dates) for amounts that are either fixed or determined by reference to an interest rate index, currency index or another external index. For all other mandatorily redeemable financial instruments the classification, measurement and disclosure provisions of FASB ASC 480 are deferred indefinitely pending further action by the FASB.
Therefore, unlike IFRS, capital contributions (for avoidance of doubt, capital contributions in a US fund would typically include what in a UK fund is structured as both capital and loan contributions) are typically classified as equity, because the amounts to be paid are not fixed or determinable and the dates are not fixed. Therefore, they meet the deferral criteria, unlike IFRS whereby the definition of liabilities is different, contributions (except for the 0.001 percent capital contributions for UK partnerships) are typically classified as liabilities.
If capital contributions (partners’ interests) are classified as equity, then distributions to LPs should be recognized as transactions in equity and presented on the statement of changes in net assets.
Net-assets measurement: the net-assets measurement is similar to IFRS, that is, the residual value of the assets net of liabilities.
STATEMENT OF OPERATIONS
US GAAP requires specific items to be presented and disclosed on the face of the statement of operations. Remember that IFRS does not prescribe a standard format for the statement of comprehensive income/income statement.
Unlike for IFRS, net realized gains (losses) and net change in unrealized appreciation (depreciation) should be disclosed separately.
Realized and unrealized gains or losses on foreign currency transactions also need to be distinguished.
The foreign currency element of gains or losses on investments may be presented either separately or together with the local-currency market gains or losses on investments.
The rules permit either separate or combined reporting of net unrealized gains or losses from investments with net unrealized gains or losses from foreign currency transactions. The same applies to net realized gains (losses) from investments and net realized gains (losses) from foreign currency transactions and they may be reported either separately or may be combined.
Therefore, in drawing a simple conclusion, under US GAAP, compared with IFRS, the distinction between realized and unrealized gains (losses) is more important, while the distinction between net realized and unrealized gains (losses) from investments and net realized and unrealized gains (losses) from foreign currency transactions not so much so and there is an element of choice in the presentation – separately or combined.
In addition, there is a requirement for separating interest income (on investments) from fair-value movements.
At present (before the amendments discussed above in the IFRS section are effective), US GAAP and IFRSs differ on the presentation of other comprehensive income (OCI) items. US GAAP does not require OCI items to be presented in the statement of comprehensive income, but allows them to be incorporated in the statement of changes in equity or in the notes. This makes it difficult to identify and understand the nature of those gains and losses. These different approaches also make it difficult for users to compare financial statements prepared in accordance with US GAAP and those prepared in accordance with IFRSs.
FASB has amended US GAAP to require profit or loss and other comprehensive income to be presented in either one statement or two continuous statements, with profit or loss items presented separately. The changes to IAS 1 and US GAAP will make it easier for users to compare the financial statements prepared in accordance with US GAAP with those prepared in accordance with IFRSs.
STATEMENT OF CHANGES: IN NET ASSETS/IN EQUITY
Unlike IFRS which does not prescribe a specific format, under US GAAP specific items are required to be presented and disclosed on the face of the statement of changes in net assets/statement of changes in equity as the increase and decrease in net assets.
These items are:
· net changes in net assets resulting from operations;
· net equalisation debits and credits;
· distributions to partners;
· capital-share transactions for each class, which can be presented either in the statement itself or in the notes; and
· capital contributions.
For private equity funds organized as limited partnerships, the statement of changes in net assets/equity may be combined with the statement of changes in partners’ capital.
STATEMENT OF CASH FLOWS
Similar to IFRS, there are standard headings required under US GAAP, but unlike under IFRS, specific guidance for items included in each category is provided. Also similar to IFRS, either the direct or indirect method can be used for cash flows from operating activities, but unlike IFRS, preference is given to (and in practice is more commonly used which is similar to the UK application of IFRS) the indirect method.
If certain conditions are met, however, an investment company may be exempted from presenting a statement of cash flows which is another difference to IFRS where all entities prepare the statement of cash flows.
DEFINITION OF CASH AND CASH EQUIVALENTS
As with IFRS, only investments with original maturities of three months or less qualify for cash equivalents; movements in bank overdrafts should be shown as financing activities though.
NOTES TO THE FINANCIAL STATEMENTS
The notes to the financial statements under US GAAP cover a vast topic that would need a whole separate publication to do them justice, as even if I were only scratch the surface of limited amount, I would only leave more questions unanswered. However, one note that I feel that I need to mention, without an equivalent under IFRS and UK GAAP, is the mandatory financial highlights that is a very important part of the disclosures and include useful information such IRRs and a number of ratios such as operating expenses to (average) net assets.
ILPA STANDARDIZED FORMAT
ILPA released the Quarterly Reporting Standards Best Practices that include a standardized template of a quarterly report (including a set of financial statements appended at the back of the report), which is the latest of ILPA’s standardised best-practice templates, which will be very useful. I would strongly recommend that you review the ILPA document and benchmark your quarterly reports (including the financial statements appended at the back taking into consideration the specific GAAP your financial statements are prepared under) against it, as that is probably what your LPs would expect in the future.
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The above article is an edited excerpt from a chapter in PEI’s Private Equity Accounting handbook, available at www.peimedia.com/books.
Mariya Stefanova is a founder partner of PE Accounting Insights, a private equity accounting training and consultancy firm, providing specialist training and technical advice for private equity houses, fund administrators and individual fund accountants.
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