Generally speaking, investment companies are exempt from presenting a statement of cash flows in their semi-annual and annual reports, provided they meet three conditions.
Substantially all of the entity’s investments are carried at fair value during the period presented and classified as level 1 or 2 in the fair value hierarchy- The entity had little or no debt outstanding during the period presented
- A statement of changes in net assets is presented
It is important to note that all three of the above criteria must be met in order for an investment company to meet the exemption. Since the language utilized in the first two items listed above might seem vague, let’s look at each of these in further detail.
Substantially all of the entity’s investments are carried at fair value during the period presented. While there is little in terms of authoritative guidance as to what constitutes “substantially,” the standard threshold among the investment company industry is 10%. This threshold was reiterated in the minutes from the AICPA Investment Companies Expert Panel November 2012 conference call. Significant level 3 investments (above 10% of a fund’s securities) would trigger a statement of cash flows requirement.
The entity had little or no debt outstanding during the period presented. Again, there is no set threshold as to the definition of “little or no debt,” but the industry practice is also 10% as discussed in the November 2012 Investment Companies Expert Panel meeting. This is calculated using the ratio of average debt outstanding during the period presented relative to average gross assets. For the purpose of this calculation, debt includes, but is not limited to, draws on a line of credit arrangement with a custodian, margin borrowings from a broker, and bank overdrafts. Short sales and written options are not considered debt as long as they are fully collateralized by cash or cash equivalents.
It’s possible to have a scenario in which an investment company has a net positive cash position at a broker, but still has margin borrowings for the purpose of determining average debt outstanding as mentioned above. For example, assume the investment company has both a short account and a margin account at the broker with the following balances:
- Short account cash balance +$200,000
- Margin account cash balance -$100,000
- Market value of short positions -$175,000
The $200,000 cash balance in the short account fully collateralizes the short positions with an excess of $25,000. The result is a net borrowing of $75,000 ($100,000 negative balance in the margin account, less $25,000 excess in the short account) which would be used in the calculation of average debt outstanding during the period, despite the investment company having a cash balance at the broker of positive $100,000.