Currently, there are no specific rules or requirements for investment companies relating to the financial statements of acquired funds. Instead, investment companies apply the general SEC requirements of Rule 3-05 and the pro-forma financial information requirements in Article 11 requiring disclosure and information, which are not always relevant to investment companies.
As it is often unclear how to apply these reporting requirements, much time is spent by registrants and the SEC staff in consultation. The clarifying amendments, proposed by the SEC on May 3, 2019, are in three parts:
This proposal will add a two-part significant subsidiary definition to Reg S-X specifically tailored to investment companies. The definition consists of an investment test and an income test.
- Investment test – Do the value of the investment in and advances to the subsidiary exceed 10% of the total investments of the registrant as of the end of the most recently completed fiscal year?
- Income test – Is the sum of the absolute values of 1) investment income 2) net realized gains (losses) and 3) net change in unrealized gains (losses), divided by the sum of the absolute value of the registrant’s change in net assets resulting from operations, greater than 80% by itself or 10% and the investment test has a result greater than 5% (alternate income test)?
Note: The SEC is proposing the registrant be permitted to use the absolute value of the changes in net assets over the last five years as this might be more representative of the true significance of the acquisition.
Proposed Rule 6-11 of Reg S-X
The SEC is also proposing a new Rule 6-11 which would specifically cover financial reporting in the event of a fund acquisition – defined as the acquisition of all or substantially all portfolio investments. The investment test and alternate income test above should be applied to determine whether an acquired fund’s financial statements are required to be provided under Rule 6-11 but using 20% (instead of 10%).
If the definition of a fund acquisition is met, then the registrant must provide one year of audited financial statements for the acquired fund. Recognizing that certain funds acquired might not have Reg S-X financial statements, the SEC has proposed to allow for GAAP audited financial statements accompanied by schedules that comply with Article 12 of Regulation S-X, meaning that each investment of the acquired fund be listed separately.
The proposal eliminates the need to provide pro-forma financial information for investment companies and instead requires them to provide supplemental data which would be more relevant to investors including:
- Pro-forma fee table (post-transaction fee structure)
- Illustrative post-acquisition portfolio if the acquisition will result in a material change to the portfolio
- Disclosure about material differences in the accounting policies of the acquired fund once combined
Bottom line: From an auditor’s perspective, these proposed amendments are certainly welcome. It is often difficult to juggle the letter of the law in the way of disclosure requirements versus the common sense approach to what makes sense for a given entity when evaluating a client’s financial statements. Acquisitions in the fund business happen often enough, and much time has been spent on how best to disclose fund acquisitions and pro-forma financial information for an investment company when much of the currently required information is irrelevant. The alternative is true as well – it’s difficult to convince a client that they should disclose something in the financial statements that would be of interest to a reader but is not “required” by GAAP.