Other Consolidation Considerations

7.12 Public investment companies organized pursuant to master-feeder arrangements, as defined by the SEC,⁸ must provide master financial statements with each feeder financial statement, pursuant to SEC requirements.⁹ Nonpublic investment companies should follow the applicable provisions of subtopics 205, 210, 220, 230, and 235 of FASB ASC 946. (See also footnote 5 to paragraph 5.56 of this guide discussing the SEC’s regulations which require public investment companies that are regulated under the 1940 Act meeting certain criteria to file financial statements or include summarized financial information in the notes to the financial statements, as appropriate, for investments in unconsolidated majority-owned subsidiaries or other unconsolidated subsidiaries.)

7.13 FASB ASC 946-205-45-6 states that nonpublic investment companies may also present a complete set of master financial statements with each feeder financial statement in a manner that is consistent with the requirements for public investment companies.

7.14 FASB ASC 810-10-40 discusses when deconsolidation of a subsidiary or derecognition of a group of assets is appropriate and the applicable accounting guidance. FASB ASC 810-10-45 provides accounting and reporting guidance related to the consolidated financial statement presentation of parent and subsidiary financial statements and combined financial statements.

7.15 FASB ASC 810-10-45-15 states that the ownership interests in the subsidiary that are held by owners other than the parent are noncontrolling interests. The noncontrolling interest in a subsidiary is part of the equity of the consolidated group. Further, FASB ASC 810-10-45-16 explains that the noncontrolling interest should be reported in the consolidated statement of financial position within equity and separately from the parent’s equity (or net assets). That amount should be clearly identified and labeled (for example, as noncontrolling interest in subsidiaries). An entity with noncontrolling interests in more than one subsidiary may present those interests in aggregate in the consolidated financial statements. FASB ASC 810-10-55-4I illustrates the application of this guidance.

7.16 According to paragraphs 18–21 of FASB ASC 810-10-45, the amount of intraentity income or loss eliminated in the preparation of consolidated financial statements is not affected by the existence of a noncontrolling interest. The complete elimination of the intraentity income or loss is consistent with the underlying assumption that consolidated financial statements represent the financial position and operating results of a single economic entity. The elimination of the intraentity income or loss may be allocated between the parent and noncontrolling interests. Revenues, expenses, gains, losses, and net income or loss should be reported in the consolidated financial statements at the consolidated amounts, which include amounts attributable to the owners of the parent and noncontrolling interest. Net income or loss should be attributed to the parent and noncontrolling interest. Losses attributable to the parent and noncontrolling interest in a subsidiary may exceed their interests in the subsidiary’s equity. The excess and any further losses attributable to the parent and noncontrolling interest should be attributed to those interests. That is, the noncontrolling interest should continue to be attributed its share of losses even if that attribution results in a deficit noncontrolling interest balance.

7.17 Commodity pool operators (CPOs) of registered investment companies (registered funds) that trade in commodity interests through wholly-owned subsidiaries (known as controlled foreign corporations or CFCs) that are consolidated with such registered funds for financial reporting purposes may rely on no-action relief to permit CPOs of registered funds that consolidate their CFCs for financial reporting purposes to file with the National Futures Association an annual report for the CFC, to the extent required by Commodities Futures Trading Commission (CFTC) Regulation 4.22(c), that contains audited consolidated financial statements of the registered fund, in lieu of a separate annual report for the CFC. In instances where the CPO prepares an annual report of the registered fund that contains consolidated audited financial statements for the registered fund, such financial statements must include the holdings, gains and losses, and other financial statement amounts attributable to the CFC. Paragraph 7.239 provides an illustrative example of this disclosure.

Reporting of Fully Benefit-Responsive Investment Contracts

7.23 FASB ASC 946-210 describes the limited circumstances in which the net assets of investment companies should reflect their net asset value using the contract value of investments attributable to fully benefit-responsive investment contracts (as defined by the FASB ASC glossary). Specifically, FASB ASC 946-210-45-11 states that contract value is the relevant measurement attribute for the portion of net assets attributable to fully benefit-responsive investment contracts, provided that the investment company is established under a trust whereby the trust itself is adopted as part of one or more qualified employer-sponsored defined contribution plans (including both health and welfare and pension plans). A qualified plan refers to a plan that qualifies under the IRC by allowing full or partial tax-deferred contributions and tax-deferred investment gains on those contributions. Further, FASB ASC 946-210-50-14 requires disclosure (among other disclosures) of a reconciliation between the beginning and ending balance of the amount presented on the statement of assets and liabilities that represents the difference between net assets reflecting all investments at fair value and net assets for each period in which a statement of changes in net assets is presented.

7.24 FASB ASC 946-210-45-15 requires that the following line items should be separately reported on the statement of assets and liabilities, with a parenthetical reference that such amounts are being reported at fair value:

a.     Investments (including traditional guaranteed investment contracts)

b.     Wrapper contracts

7.25 As further stated in FASB ASC 946-210-45-16, the statement of assets and liabilities should present amounts for all the following:

a.     Total assets

b.     Total liabilities

c.     Net assets reflecting all investments at fair value

d.     Net assets

The net assets amount represents the amount at which participants can transact with the fund and should be used for purposes of preparing per share disclosures required by FASB ASC 946-205-50-7 through FASB ASC 946-205-50-9 (see paragraph 7.229) and as the beginning and ending balance in the statement of changes in net assets of the fund. The difference between net assets reflecting all investments at fair value and net assets should be presented as a single amount on the face of the statement of assets and liabilities, calculated as the sum of the amounts necessary to adjust the portion of net assets attributable to each fully benefit-responsive investment contract from fair value to contract value. Additional financial statement presentation and disclosure requirements for fully benefit-responsive investment contracts are discussed in paragraphs 17–18 of FASB ASC 946-210-45 and FASB ASC 946-210-50-14 (see paragraphs 7.23, 7.146, and 7.190).

7.26 FASB ASC 946-210-45-18A explains that to be considered within the scope of paragraphs 15–18 of FASB ASC 946-210-45 (as previously discussed), any portion of the net assets of the investment company attributable to a particular plan investee that is not held in trust for the benefit of participants in a qualified employer-sponsored defined contribution plan is not permitted to increase, except for reinvestment of income earned.

Schedule of Investments

Assets

7.47 Following are the major asset categories reported in a statement of assets and liabilities and statement of net assets.

7.48 Investments in securities. The general practice in the investment company industry is to report investments in securities as the first asset because of their relative importance to total assets. Securities, as used in this guide, include but are not limited to stocks, bonds, debentures, notes, rights, warrants, certificates of interest or participation in equity or debt instruments, U.S. government securities, bank certificates of deposit, banker’s acceptances, commercial paper, repurchase agreements, purchased options, and tranches of fixed income securities (such as interest-only and principal-only investments). Rule 6.04 of Regulation S-X contains guidance for balance sheets of registered investment companies regarding how to present different types of investments, including those of unaffiliated issuers, investments in and advances to affiliates, and other investments. For investments in and advances to affiliates, controlled companies and other affiliates, amounts should be separately stated; for other investments, amounts of assets related to variation margin receivable on futures contracts, forward foreign currency contracts, swap contracts, and investments other than those presented in §§210.12-12, 12-12A, 12-12B, 12-13, 12-13A, 12-13B, and 12-13C should be separately stated.

7.49 As discussed in FASB ASC 946-320-35, investment companies should measure their investments in debt and equity securities subsequently at fair value. Paragraph 4 of that FASB ASC subtopic indicates that its general discussion also applies to investments in foreign securities. Portfolio securities that are traded primarily on foreign securities exchanges should be valued at the functional currency (usually the U.S. dollar equivalent) values for such securities on their exchanges. For presentation of investments in debt and equity securities as part of reporting financial position, see FASB ASC 946-210-45.

7.50 Cash. As described in paragraphs 20–21 of FASB ASC 946-210-45, cash on hand and demand deposits are included under the general caption “Cash.” Amounts held in foreign currencies should be disclosed separately at value, with acquisition cost shown parenthetically.

7.51 Time deposits and other funds subject to withdrawal or usage restrictions should be presented separately from other cash amounts.²⁵ Applicable interest rates and maturity dates should be disclosed.

7.52 Receivables. As paragraphs 1–2 of FASB ASC 946-310-45 explain, receivables are listed separately at net realizable value for each of the following categories, among others:

•     Dividends and interest

•     Investment securities sold

•     Capital stock sold

•     Other accounts receivable, such as receivables from related parties, including expense reimbursement receivables from affiliates, and variation margin on open futures contracts

7.53 Receivables denominated in foreign currencies should be converted into the functional currency at current exchange rates and may be categorized with the corresponding functional currency receivables.

7.54 Rule 6.04 of Regulation S-X also contains guidance related to receivables of investment companies which is consistent with the guidance described in the previous paragraph. Rule 6.04 of Regulation S-X also requires separate presentation, either in the balance sheet or a note thereto, if the aggregate amount of notes receivable exceeds ten percent of the aggregate amount of receivables.

7.55 Deferred offering costs, prepaid taxes, and prepaid insurance are normally included under the “Other Assets” caption. Separate amounts are usually not reported unless significant. For public registrants, deposits for securities sold short and other investments are separately stated; these include amounts held by others in connection with short sales, open option contracts, futures contracts, forward foreign currency contracts, swap contracts, other investments, and collateral received for securities loaned.²⁶

7.56 Derivatives. As explained in FASB ASC 815-10-25-1, an entity should recognize all its derivative instruments in its statement of financial position as either assets or liabilities, depending on the rights or obligations under the contracts. In accordance with FASB ASC 815-10-50-1, an entity with derivative instruments should disclose information to enable users of the financial statements to understand all of the following:

•     How and why an entity uses derivative instruments

•     How derivative instruments and related hedged items are accounted for under FASB ASC 815, Derivatives and Hedging

•     How derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows

7.57 Further, as discussed in paragraphs 1A–1B of FASB ASC 815-10-50, an entity with derivative instruments should disclose its objective for holding or issuing those instruments, the context needed to understand those objectives, its strategies for achieving those objectives, and information that would enable users of its financial statements to understand the volume of its activity in those instruments for every annual and interim reporting period for which a statement of financial position and statement of financial performance are presented. Regarding the disclosure that would enable users to understand the volume of the entity’s activity in those instruments, an entity should select the format and specifics of disclosures relating to its volume of such activity that are the most relevant and practicable for its individual facts and circumstances. Regarding the disclosures of the entity’s objectives, context, and strategies, they should be disclosed in the context of each instrument’s primary underlying risk exposure (that is, interest rate, credit, foreign exchange rate, interest rate and foreign exchange rate, or overall price). Moreover, those instruments should be distinguished between those used for risk management purposes and those used for other purposes. FASB ASC 815-10-50-4 adds that for derivative instruments not designated as hedging instruments, the description should indicate the purpose of the derivative activity.

7.58 FASB ASC 815-10-50-4A states that an entity that holds or issues derivative instruments should disclose all of the following for every annual and interim reporting period for which a statement of financial position and statement of financial performance are presented:

•     The location and fair value amounts of derivative instruments reported in the statement of financial position

•     The location and amount of the gains and losses on derivative instruments reported in either the statement of financial performance or statement of financial position (note that investment companies generally report all gains and losses in the statement of operations)

7.59 Paragraphs 4D–4E of FASB ASC 815-10-50 add that this information should be presented separately by type of contract (for example, interest rate contracts, foreign exchange contracts, equity contracts, commodity contracts, credit contracts, and other contracts). The line item(s) in the statement of financial performance in which the gains and losses for these categories of derivative instruments are included should also be disclosed. Further, these disclosures should be presented in tabular format. Additional related disclosure requirements for derivative instruments are provided in paragraphs 4B–4C of FASB ASC 815-10-50. More specific information related to the disclosure of derivatives in prospectuses and shareholder reports is available in the July 2010 SEC letter to the Investment Company Institute. This letter can be accessed from the SEC’s website at www.sec.gov under “Division of Investment Management,” “Staff Guidance and Studies.”

7.60 FASB ASC 815-10-50-4F discusses the disclosure requirements when the entity’s policy is to include derivative instruments not designated or qualifying as hedging instruments under FASB ASC 815-20 in its trading activities (for example, as part of its trading portfolio that includes both derivative instruments and nonderivative or cash instruments). For those derivative instruments, the entity can elect to not separately disclose gains and losses, as required by FASB ASC 815-10-50-4C(e), provided that the entity discloses all of the following:

a.     The gains and losses on its trading activities (including both derivative instruments and nonderivative instruments) recognized in the statement of financial performance separately by major types of items (for example, fixed income interest rates, foreign exchange, equity, commodity, and credit)

b.     The line items in the statement of financial performance in which trading activities gains and losses are included

c.     A description of the nature of its trading activities and related risks and how the entity manages those risks

If this disclosure option is elected, the entity should include a footnote in the required tables referencing the use of alternative disclosures for trading activities. FASB ASC 815-10-55-184 and 815-10-55-182 illustrate a footnote referencing the use of alternative disclosures for trading activities and the disclosure of information required in items a and b, respectively.

7.61 According to FASB ASC 815-10-50-4H, an entity that holds or issues derivative instruments should make the following disclosures for every annual and interim reporting period for which a statement of financial position is presented:

a.     The existence and nature of credit-risk-related contingent features

b.     The circumstances in which credit-risk-related contingent features could be triggered in derivative instruments (or such nonderivative instruments) that are in a net liability position at the end of the reporting period

c.     The aggregate fair value amounts of derivative instruments (or such nonderivative instruments) that contain credit-risk-related contingent features that are in a net liability position at the end of the reporting period

d.     The aggregate fair value of assets that are already posted as collateral at the end of the reporting period

e.     The aggregate fair value of additional assets that would be required to be posted as collateral if the credit-risk-related contingent features were triggered at the end of the reporting period

f.     The aggregate fair value of assets needed to settle the instrument immediately if the credit-risk-related contingent features were triggered at the end of the reporting period

FASB ASC 815-10-55-185 illustrates a credit-risk-related contingent feature disclosure.

7.62 FASB ASC 815-10-50-4I states that if information on derivative instruments is disclosed in more than a single footnote, an entity should cross-reference from the derivative instruments footnote to other footnotes in which derivative-instrument-related information is disclosed. FASB ASC 815-10-55-182 illustrates the disclosure of fair value amounts of derivative instruments and gains and losses on derivative instruments in tabular format.

7.63 The FASB ASC glossary defines a credit derivative as a derivative instrument that has both of the following characteristics: one or more of its underlyings are related to the credit risk of a specified entity (or a group of entities) or an index based on the credit risk of a group of entities; and it exposes the seller to potential loss from credit-risk-related events specified in the contract. Examples of credit derivatives include, but are not limited to, credit default swaps, credit spread options, and credit index products.

7.64 Paragraphs 4J–4K of FASB ASC 815-10-50 specify that the use of the term seller refers to the party that assumes the credit risk, which could be either a guarantor in a guarantee-type contract or any party that provides the credit protection in an option-type contract, a credit default swap, or any other credit derivative contract. A seller of credit derivatives should disclose information about its credit derivatives and hybrid instruments (for example, a credit-linked note) that have embedded credit derivatives to enable users of financial statements to assess their potential effect on the seller’s financial position, financial performance, and cash flows. Paragraphs 4K–4L of FASB ASC 815-10-50 discuss the specific required disclosures and a method of presentation.

7.65 FASB ASC 815-10-45-4 states that, with respect to derivative instruments, unless the specified conditions in FASB ASC 210-20-45-1 for a right to offset are met, the fair value of derivatives in loss positions should not be offset against the fair value of derivatives in gain positions. Similarly, amounts recognized as accrued receivables shall not be offset against amounts recognized as accrued payables unless a right of setoff exists.

7.66 As further discussed in FASB ASC 815-10-45-5, without regard to the condition in FASB ASC 210-20-45-1(c) (when the reporting party intends to set off), a reporting entity may offset fair value amounts recognized for derivative instruments and fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) arising from a derivative instrument or instruments recognized at fair value executed with the same counterparty under a master netting arrangement. Solely as they relate to the right to reclaim cash collateral or the obligation to return cash collateral, fair value amounts include amounts that approximate fair value. The preceding sentence should not be analogized to for any other asset or liability. The fair value recognized for some contracts may include an accrual component for the periodic unconditional receivables and payables that result from the contract; the accrual component included therein may also be offset for contracts executed with the same counterparty under a master netting arrangement. A master netting arrangement exists if the reporting entity has multiple contracts, whether for the same type of derivative instrument or different types of derivative instruments, with a single counterparty that are subject to a contractual agreement that provides for the net settlement of all contracts through a single payment in a single currency in the event of default on, or termination of, any one contract.

7.67 FASB ASC 815-10-45-6 notes that a reporting entity should make an accounting policy decision to offset fair value amounts, pursuant to the preceding paragraph. The reporting entity’s choice to offset must be applied consistently. A reporting entity should not offset fair value amounts recognized for derivative instruments without offsetting fair value amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral. A reporting entity that makes an accounting policy decision to offset fair value amounts recognized for derivative instruments, pursuant to the preceding paragraph but determines that the amount recognized for the right to reclaim cash collateral or the obligation to return cash collateral is not a fair value amount should continue to offset the derivative instruments.

7.68 FASB ASC 815-10-45-7 explains that a reporting entity that has made an accounting policy decision to offset fair value amounts is not permitted to offset amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral against net derivative instrument positions if those amounts either were not fair value amounts or arose from instruments in a master netting arrangement that are not eligible to be offset.

Liabilities

7.69 The following categories of liabilities are reported in the statement of assets and liabilities.

7.70 Accounts payable. FASB ASC 946-405-45-1 states that accounts payable should be listed separately for investment securities purchased and capital stock reacquired.

7.71 Call or put options written, futures contracts, securities sold short, forward foreign currency contracts, swap contracts and other investments. Call or put options written, and securities sold short at the close of the period should be presented separately at fair value in the statement of assets and liabilities, with premiums received on written options and proceeds from short sales disclosed parenthetically. Variation margin due to a broker on futures contracts should be disclosed separately, if significant. Public registrants should also state separately amounts of liabilities related to forward foreign currency contracts, swap contracts, and other investments. Details of the securities sold short, options written, and futures contracts should include information about quantities, fair values, and proceeds and should be presented within the schedule of investments, as discussed in paragraphs 7.27–.46. Information presented for options written should include the number of shares or principal amount, the fair value of each option, the strike price, and the exercise date.

7.72 Accrued liabilities. Accrued liabilities include liabilities for management fees, performance fees, distribution fees, interest, compensation, taxes, and other expenses incurred in the normal course of operations.

7.73 Notes payable and other debt. Notes payable to banks, including bank overdrafts, and other debt should be reported separately at amounts payable, net of unamortized premium or discount, and net of unamortized debt insurance costs, unless the fair value option that is permitted under FASB ASC 825, Financial Instruments, is elected. Public companies should also state separately amounts payable to controlled companies and other affiliates, showing for each category amounts payable within one year and amounts payable after one year. Information relating to unused lines of credit, conditions of credit agreements, and long term debt maturities should be disclosed in the notes to the financial statements. If the fair value option is not elected, the investment company should also disclose the fair value of liabilities, in accordance with the disclosure requirements of FASB ASC 825-10-50. The fair value option is discussed further in paragraphs 7.99–.102.

7.74 On November 5, 2007, the SEC released Staff Accounting Bulletin (SAB) No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings, which expresses the views of the staff regarding written loan commitments that are accounted for at fair value through earnings under GAAP. Previously, SAB No. 105, Application of Accounting Principles to Loan Commitments, stated that in measuring the fair value of a derivative loan commitment, it would be inappropriate to incorporate the expected net future cash flows related to the associated servicing of the loan. SAB No. 109 supersedes SAB No. 105 and expresses the current view of the SEC staff that is consistent with the guidance in FASB ASC 860-50 and 825. Both topics express the view that the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings.

7.75 Reverse repurchase agreements. According to Q&A section 6910.22, “Presentation of Reverse Repurchase Agreements,”²⁷ reverse repurchases agreements are defined as the sale of a security at a specified price with an agreement to purchase the same or substantially the same security from the same counterparty at a fixed or determinable price at a future date.²⁸ Because reverse repurchase agreements represent a fixed, determinable obligation of the investment company, such agreements should also be presented at amounts payable, unless the fair value option that is permitted under FASB ASC 825 is elected. A reverse repurchase agreement denominated in a currency that differs from the reporting currency should be translated at the current exchange rate.

7.76 Deferred fees. According to Q&A section 6910.27, “Treatment of Deferred Fees,”²⁹ the governing documents of some offshore funds may provide that the investment adviser may elect to defer payment of its management fee, incentive fee, or both. Based on the documents, the deferred fees that are payable to the investment adviser do not take the form of a legal capital account and are settled exclusively in cash. Under this arrangement, the fund retains the fee amount and is obligated to pay the investment adviser the deferred fees at a later date, adjusted for the fund’s rate of return (whether positive or negative). In accordance with guidance from paragraph 35 of FASB Concept Statement No. 6, Elements of Financial Statements—a replacement of FASB Concepts Statement No. 3 (incorporating an amendment of FASB Concepts Statement No. 2), the fund should record the cumulative deferred fees as a liability. The indexing of this liability to the fund’s rate of return represents a hybrid instrument that has a host debt instrument with an embedded derivative, which has attributes of a total return contract. Although FASB ASC 815-15-25-1 and 815-15-55-190 require the embedded total return contract to be bifurcated from the host debt instrument, the SEC staff has previously indicated³⁰ that the bifurcation requirements of FASB ASC 815 do not extend beyond measurement to financial statement presentation if the embedded derivative and host debt instrument, together, represent the principal and interest obligations of a debt instrument. Although the fund should fair value the embedded return component of the deferral arrangement, according to the guidance from FASB ASC 815-10-25-1, 815-10-30-1, and 815-10-35-1, generally, the fair value of such return component would be the same as the appreciated or depreciated return of the fund because (a) the fund fair values all its investments, whether assets or liabilities, which generally represent substantially all its net assets, and (b) if the deferred fee liability was transferred, the transfer would likely be transacted at the current net asset value.³¹ The deferred fees and embedded total return contracts associated with deferred fees that are at an appreciated or depreciated position as of the reporting date may be presented as one amount titled “Deferred incentive fees payable” on the statement of assets and liabilities.

7.77 Other liabilities. As stated by FASB ASC 946-405-45-2, other liabilities include amounts due to counterparties for collateral on the return of securities loaned, deferred income, and dividends and distributions payable. Payables denominated in foreign currencies should be converted into the functional currency at current exchange rates and may be categorized within the corresponding functional currency payables. For public registrants, the separate statement of any other liabilities which are material is required by Rule 6.04 of Regulation S-X.

7.78 Rule 6.04 of Regulation S-X contains guidance for balance sheets of registered investment companies regarding how to present other liabilities. It requires the following items to be stated separately on the balance sheet: amounts payable for investment advisory, management, and service fees and the total amount payable to officers and directors or trustees, controlled companies, and other affiliates, excluding any amounts owing to noncontrolled affiliates that arose in the ordinary course of business and that are subject to usual trade terms.

7.79 FASB ASC 860-30-25-5 describes the accounting for noncash collateral by the debtor (obligor) and secured party, which depends on whether the secured party has the right to sell or repledge the collateral and whether the debtor has defaulted. FASB ASC 860-30-25-4 explains that cash collateral used in securities lending transactions should be derecognized by the debtor and recognized by the secured party, not as collateral, but, rather, as proceeds of either a sale or borrowing. FASB ASC 860-30-25-7 explains that many securities lending transactions (including those of many investment companies) often both entitle and obligate the transferor to repurchase or redeem the transferred financial assets before their maturity. In such a transaction, the transferor maintains effective control over those assets when all the following conditions in FASB ASC 860-10-40-24 are met:

•     The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred. To be substantially the same, the financial asset that was transferred and the financial asset that is to be repurchased or redeemed need to have all of the following characteristics:

—     The same primary obligor (except for debt guaranteed by a sovereign government, central bank, government-sponsored enterprise or agency thereof, in which circumstance the guarantor and the terms of the guarantee must be the same)

—     Identical form and type so as to provide the same risks and rights

—     The same maturity (or in the circumstance of mortgage-backed pass-through and pay-through securities, similar remaining weighted-average maturities that result in approximately the same market yield)

—     Identical contractual interest rates

—     Similar assets as collateral

—     The same aggregate unpaid principal amount or principal amounts within accepted good delivery standards for the type of security involved. Participants in the mortgage-backed securities market have established parameters for what is considered acceptable delivery. These specific standards are defined by the Securities Industry and Financial Markets Association and can be found in Uniform Practices for the Clearance and Settlement of Mortgage-Backed Securities and Other Related Securities, which is published by the Securities Industry and Financial Markets Association.

See FASB ASC 860-10-55-35 for implementation guidance related to these conditions.

•     The agreement is to repurchase or redeem them before maturity at a fixed or determinable price.

•     The agreement is entered into contemporaneously with, or in contemplation of, the transfer.

     [Note that neither the transferor’s ability to repurchase or redeem the financial assets at substantially the same agreed terms, nor the transferor’s maintenance of sufficient collateral, are considered during the assessment of effective control.]

FASB ASC 860-30-25-7 continues to explain that those transactions should be accounted for as secured borrowings, in which (a) cash (or other securities that the holder is permitted by contract or custom to sell or repledge) received as collateral is considered the amount borrowed, (b) the securities loaned are considered pledged as collateral against the cash borrowed and reclassified as set forth in FASB ASC 860-30-25-5(a), and (c) any rebate paid to the transferee of securities is interest on the cash that the transferor is considered to have borrowed.

7.80 FASB ASC 860-10-50 discusses required disclosures for transfers and servicing for all entities. FASB ASC 860-10-50-3 explains that the principal objectives of these disclosures are to provide financial statement users with an understanding of the following:

•     A transferor’s continuing involvement, if any, with transferred financial assets

•     The nature of any restrictions on assets reported by an entity in its statement of financial position that relate to a transferred financial asset, including the carrying amounts of those assets

•     How servicing assets and servicing liabilities are reported under FASB ASC 860-50

•     For transfers accounted for as sales, if a transferor has continuing involvement with the transferred financial assets, how the transfer of financial assets affects an entity’s financial position, financial performance, and cash flows

•     For transfers of financial assets accounted for as secured borrowings, how the transfer of financial assets affects an entity’s financial position, financial performance, and cash flows

7.81 Under FASB ASC 480-10-25-4, mandatorily redeemable financial instruments, such as mandatorily redeemable preferred stock, should be classified as a liability, unless the redemption is required to occur only upon the liquidation or termination of the reporting entity. Although mutual fund shares are not mandatorily redeemable, other types of equity instruments should be considered under FASB ASC 480, Distinguishing Liabilities from Equity. Paragraphs 7.108–.109 provide further discussion regarding the various effective dates and deferrals related to FASB ASC 480-10-25-4.

Disclosures Related to Transfers of Financial Assets, Including Repurchase Agreements

7.82 FASB ASC 860-20-50 discusses the disclosures required for transfers of financial assets. To provide an understanding of the nature of the transactions, the transferor’s continuing exposure to the transferred financial assets, and the presentation of the components of the transaction in the financial statements, FASB ASC 860-20-50-4D states that an entity should disclose the following for outstanding transactions at the reporting date that meet the scope guidance in paragraphs 4A–4B of FASB ASC 860-20-50 by type of transaction (for example, repurchase agreements, securities lending transactions, and other transactions economically similar to these), with the exception of those transactions excluded from the scope, as described in FASB ASC 860-20-50-4C:

a.     The carrying amount of assets derecognized as of the date of derecognition

i.     If the amounts that have been derecognized have changed significantly from the amounts that have been derecognized in prior periods or are not representative of the activity throughout the period, a discussion of the reasons for the change should be disclosed.

b.     The amount of gross cash proceeds received by the transferor for the assets derecognized as of the date of derecognition

c.     Information about the transferor’s ongoing exposure to the economic return on the transferred financial assets

i.     As of the reporting date, the fair value of assets derecognized by the transferor

ii.     Amounts reported in the statement of financial position arising from the transaction (for example, the carrying value or fair value of forward repurchase agreements or swap contracts). To the extent that those amounts are captured in the derivative disclosures presented in accordance with FASB ASC 815-10-50-4B, an entity should provide a cross-reference to the appropriate line item in that disclosure.

iii.     A description of the arrangements that result in the transferor retaining substantially all of the exposure to the economic return on the transferred financial assets and the risks related to those arrangements

FASB ASC 860-20-55-108 provides an illustration of one approach for satisfying the quantitative disclosure requirements discussed in the preceding paragraph.

7.83 To provide transparency about the types of collateral pledged in agreements and the associated liabilities, FASB ASC 860-30-50-7 requires the following disclosures for repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions that are accounted for as secured borrowings:

a.     A disaggregation of the gross obligation by the class of collateral pledged, which should be determined by the reporting entity based on the nature, characteristics, and risks of the collateral pledged

b.     The remaining contractual tenor of the agreements, which should be disclosed in maturity intervals determined by the reporting entity to convey an understanding of the overall maturity profile of the entity’s financing agreements

c.     A discussion of the potential risks associated with the agreements and the related collateral pledged, including obligations arising from a decline in the fair value of the collateral pledged and how those risks are managed

Additionally, FASB ASC 860-30-50-8 requires disclosure in accordance with paragraphs 1–6 of FASB ASC 210-20-50 for both of the following that are either offset in accordance with FASB ASC 210-20-45 or subject to an enforceable master netting arrangement or similar agreement:

a.     Recognized repurchase agreements accounted for as a collateralized borrowing and reverse repurchase agreements accounted for as a collateralized borrowing

b.     Recognized securities borrowing and securities lending transactions

Fair Value Disclosures

7.84 FASB ASC 820-10-50 discusses the disclosures required for assets and liabilities measured at fair value. FASB ASC 820-10-50-1 explains that for assets and liabilities that are measured at fair value on a recurring or nonrecurring basis in the statement of financial position after initial recognition, the reporting entity is required to disclose certain information that enables users of its financial statements to assess the valuation techniques and inputs used to develop those measurements. For recurring fair value measurements using significant unobservable inputs (level 3), the reporting entity is required to disclose certain information to help users assess the effect of the measurements on earnings (or changes in net assets) for the period.

7.85 Professional judgment may need to be applied as reporting entities implement and address the broad disclosure objectives summarized in the preceding paragraph. FASB ASC 820-10-50-1A lists the following items that are required to be considered when addressing disclosure objectives in FASB ASC 820-10-50-1:

a.     The level of detail necessary to satisfy the disclosure requirements

b.     How much emphasis to place on each of the various requirements

c.     How much aggregation or disaggregation to undertake

d.     Whether users of financial statements need additional information to evaluate the quantitative information disclosed

7.86 FASB ASC 820-10-55-104 builds on this guidance, adding that a reporting entity might disclose some or all of the following:

a.     The nature of the item being measured at fair value, including the characteristics of the item being measured that are taken into account in the determination of relevant inputs

b.     How third-party information such as broker quotes, pricing services, net asset values, and relevant market data was taken into account when measuring fair value

7.87 FASB ASC 820-10-50-2 requires a reporting entity to disclose, at a minimum, the following information for each class of assets and liabilities measured at fair value in the statement of financial position after initial recognition:

a.     For recurring fair value measurements, the fair value measurement at the end of the reporting period, and for nonrecurring fair value measurements, the fair value measurement at the relevant measurement date and the reasons for the measurement. Recurring fair value measurements of assets or liabilities are those that other FASB ASC topics require or permit in the statement of financial position at the end of each reporting period. Nonrecurring fair value measurements of assets or liabilities are those that other FASB ASC topics require or permit in the statement of financial position in particular circumstances (for example, when a reporting entity measures a long-lived asset or disposal group classified as held for sale at fair value less costs to sell in accordance with FASB ASC 360, Property, Plant and Equipment, because the asset’s fair value less costs to sell is lower than its carrying value). For nonrecurring measurements estimated at a date during the reporting period other than the end of the reporting period, a reporting entity should clearly indicate that the fair value information presented is not as of the period’s end as well as the date or period that the measurement was taken.

b.     For recurring and nonrecurring fair value measurements, the level within the fair value hierarchy in which the fair value measurements are categorized in their entirety (level 1, 2, or 3).

c.     For assets and liabilities held at the end of the reporting period that are measured at fair value on a recurring basis, the amounts of any transfers between level 1 and level 2 of the fair value hierarchy, the reasons for the transfers, and the reporting entity’s policy for determining when transfers between levels are deemed to have occurred. Transfers into each level should be disclosed separately from transfers out of each level. FASB ASC 820-10-50-2C explains that a reporting entity should disclose and consistently follow its policy for determining when transfers between levels of the fair value hierarchy are deemed to have occurred. The policy about the timing of recognizing transfers should be the same for transfers into the levels as that for transfers out of the levels. Examples of policies for determining the timing of transfers include the following: the date of the event or change in circumstances that caused the transfer, the beginning of the reporting period, and the end of the reporting period.

d.     For recurring and nonrecurring fair value measurements categorized within level 2 and level 3 of the fair value hierarchy, a description of the valuation technique(s) and the inputs used in the fair value measurement. If there has been a change in either or both a valuation approach and a valuation technique (for example, changing from a matrix pricing to the binomial model or the use of an additional valuation technique), the reporting entity should disclose that change and the reason(s) for making it.

e.     For fair value measurements categorized within level 3 of the fair value hierarchy, a reporting entity should provide quantitative information about the significant unobservable inputs used in the fair value measurement. A reporting entity is not required to create quantitative information to comply with this disclosure requirement if quantitative unobservable inputs are not developed by the reporting entity when measuring fair value (for example, when a reporting entity uses prices from prior transactions or third-party pricing information without adjustment). However, when providing this disclosure, a reporting entity cannot ignore quantitative unobservable inputs that are significant to the fair value measurement and are reasonably available to the reporting entity.

f.     For recurring fair value measurements categorized within level 3 of the fair value hierarchy, a reconciliation from the opening balances to the closing balances, disclosing separately changes during the period attributable to any of the following:

i.     Total gains or losses for the period recognized in earnings (or changes in net assets), and the line items(s) in the statement of income (or activities) in which those gains or losses are recognized.

ii.     Total gains or losses recognized in other comprehensive income, and the line item(s) in other comprehensive income in which those gains or losses are recognized.

iii.     Purchases, sales, issuances, and settlements (each of those types of changes disclosed separately).

iv.     The amounts of any transfers into or out of level 3 of the fair value hierarchy, the reasons for those transfers, and the reporting entity’s policy for determining when transfers between levels are deemed to have occurred. Transfers into level 3 should be disclosed and discussed separately from transfers out of level 3.

g.     For recurring fair value measurements categorized within level 3 of the fair value hierarchy, the amount of the total gains or losses for the period in item f(i) included in earnings (or changes in net assets) that is attributable to the change in unrealized gains or losses relating to those assets and liabilities still held at the end of the reporting period, and the line item(s) in the statement of income (or activities) in which those unrealized gains or losses are recognized.

h.     For recurring and nonrecurring fair value measurements categorized within level 3 of the fair value hierarchy, a description of the valuation processes used by the reporting entity (including, for example, how an entity determines its valuation policies and procedures and analyzes changes in fair value measurements from period to period).

i.     For recurring fair value measurements categorized within level 3 of the fair value hierarchy, a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs if a change in those inputs to a different amount might result in a significantly higher or lower fair value measurement. If there are interrelationships between those inputs and other unobservable inputs used in the fair value measurement, a reporting entity should also provide a description of those interrelationships and how they magnify or mitigate the effect of changes in the unobservable inputs of the fair value measurement. To comply with that disclosure requirement, the narrative description of the sensitivity to changes in unobservable inputs should include, at a minimum, the unobservable inputs disclosed when complying with items d–e.

j.     For recurring and nonrecurring fair value measurements, if the highest and best use of a nonfinancial asset differs from its current use, a reporting entity should disclose that fact and why the nonfinancial asset is being used in a manner that differs from its highest and best use.

Paragraph 7.228 provides an illustrative example of the disclosures required by FASB ASC 820-10-50-2.

7.88 FASB ASC 820-10-50-2F states that a nonpublic entity is not required to disclose the information required by FASB ASC 820-10-50-2(bb) and (g) and FASB ASC 820-10-50-2E (discussed in paragraphs 7.87c, 7.87i, and 7.97 of this guide) unless required by another FASB ASC topic. A nonpublic entity is defined by the FASB ASC glossary as an entity that does not meet any of the following conditions:

a.     Its debt or equity securities trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally.

b.     It is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).

c.     It files with a regulatory agency in preparation for the sale of any class of debt or equity securities in a public market.

d.     It is required to file or furnish financial statements with the SEC.

e.     It is controlled by an entity covered by items a–d.

FASB ASC 820-10-50-2F includes the phrase “unless required by another FASB ASC Topic.” This phrase requires nonregistered investment companies to consider whether other applicable FASB ASC topics (for example, FASB ASC 825, which is discussed in further detail in paragraph 7.102) require any of the disclosures referenced in FASB ASC 820-10-50-2F.

7.89 When implementing the quantitative information disclosure requirement in paragraph 7.87e, investment companies may consider the following:

•     Disaggregation. Determining the appropriate level of disaggregation may require professional judgment. FASB ASC 820 does not specify what level of disaggregation is required for quantitative disclosures, but the illustrative example in FASB ASC 820-10-55-100 presents disclosures that an entity might provide to comply with the requirements in FASB ASC 820-10-50-2. However, some reporting entities may find that further disaggregation is necessary, in order to provide financial statement users with the ability to evaluate and sufficiently understand the quantitative information (see considerations listed in paragraphs 7.85–.86). When determining whether further disaggregation is necessary, an entity may consider the results of its fair value hierarchy classification analysis, and the inputs evaluated during such analysis. The same inputs that were identified as relevant during the fair value hierarchy classification analysis may also be considered significant enough to warrant disclosure in the quantitative disclosure about significant unobservable inputs. Further, when multiple types of fair value measurement approaches are used to value individual assets (or liabilities) or groups of assets (or liabilities) within an individual class of assets (or liabilities), disaggregation below the asset class level may be necessary in order to sufficiently address the objectives in paragraphs 7.85–.86. If a wide range of quantitative data occurs at a certain disaggregation level, it may be an indicator that the level of disaggregation is not appropriate. Generally, the disaggregation level depends on the nature and risks of the investment.

•     Quantitative information types. Professional judgment may be required when determining what quantitative information is relevant and should be disclosed. Reporting entities may consider the overall objectives of paragraphs 7.84–.86 when applying such judgment in this area, including determining what type of information is most meaningful to the users of the financial statements. FASB ASC 820 does not specify what type of quantitative information is required to be disclosed. However, the illustrative disclosure example in FASB ASC 820-10-55-103 indicates that the high and low end range values and the weighted average of the range may be disclosed.³²

     The following comments provided in paragraph BC86 of Accounting Standards Update (ASU) No. 2011-04, Fair Value (Topic 820)—Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, may also be helpful in understanding the objective of the quantitative information disclosure:

     The Boards concluded that the information required by the disclosure will facilitate comparisons of the inputs used over time, providing users with information about changes in management’s views about particular unobservable inputs and about changes in the market for the assets and liabilities within a particular class. In addition, that disclosure might facilitate comparison between reporting entities with similar assets and liabilities categorized within level 3 of the fair value hierarchy.

     The Boards noted that the objective of the disclosure is not to enable users of the financial statements to replicate the reporting entity’s pricing models but to provide enough information for users to assess whether the reporting entity’s views about individual inputs differed from their own and, if so, to decide how to incorporate the reporting entity’s fair value measurement in their decisions.

•     Exceptions to the disclosure requirement in paragraph 7.87e:

—     As discussed in paragraph 7.87e, the reporting entity does not have to create quantitative information to comply with disclosure requirements, if inputs are not developed by the entity when measuring fair value. However, the same paragraph states that a company cannot ignore quantitative information that is significant and is reasonably available to the entity. Investment companies may consider whether they have obtained and evaluated the third party’s price (or inputs to the price) during due diligence. FASB ASC 820-10-35-54K allows reporting entities to use quoted prices from third parties to determine fair value measurements if those prices were developed in accordance with FASB ASC 820. When performing such due diligence, an investment company may consider the following procedures: gain an understanding of the techniques and models used by the third party, compare valuations received to market information and information received from other vendors, if available, and perform back testing.

—     The reporting entity does not have to disclose quantitative information if the net asset value is used as a practical expedient to determine fair value of the investment (see paragraph 7.94 for discussion of disclosure requirements for investments in companies that calculate net asset value per share, regardless of whether the practical expedient has been applied). Paragraph BC89 of ASU No. 2011-04 supports this by stating “...disclosures about the fair value of those assets and liabilities that are subject to the practical expedient and categorized within level 3 of the fair value hierarchy would not be meaningful for such instruments because the determination of the level in the hierarchy is made on the basis of the reporting entity’s ability to redeem its investment, rather than on the basis of whether the inputs used in the measurement are observable or unobservable.” However, when an adjustment to the practical expedient value is necessary, the adjustment may need to be considered for the level 3 input table disclosure.

—     FASB ASC 820-10-35-54B provides that an investment measured using net asset value per share (or its equivalent) as a practical expedient should not be categorized within the fair value hierarchy and the disclosure requirements in FASB ASC 820-10-50-2 do not apply to that investment. Applicable disclosures are described in FASB ASC 820-10-50-6A. Although the investment is not categorized within the fair value hierarchy, a reporting entity should provide the amount measured using the net asset value per share (or its equivalent) practical expedient to permit reconciliation of the fair value of investments included in the fair value hierarchy to the line items presented in the statement of financial position in accordance with FASB ASC 820-10-50-2B. (See chapter 2.)

•     Presentation of disclosed quantitative information. FASB ASC 820-10-50-8 requires quantitative information to be disclosed in a tabular format.

7.90 When applying the disclosure requirement related to valuation processes in paragraph 7.87h, investment companies may consider disclosing the following items listed in FASB ASC 820-10-55-105:

•     For the group within the reporting entity that decides the reporting entity’s valuation policies and procedures, (a) its description, (b) to whom that group reports, and (c) the internal reporting procedures in place (for example, whether and, if so, how pricing, risk management, or audit committees discuss and assess the fair value measurements)

•     The frequency and methods for calibration, back testing, and other testing procedures of pricing models

•     The process for analyzing changes in fair value measurements from period to period

•     How the reporting entity determined that third-party information, such as broker quotes or pricing services, used in the fair value measurement was developed in accordance with FASB ASC 820

•     The methods used to develop and substantiate the unobservable inputs used in a fair value measurement

7.91 When applying the narrative description of sensitivity disclosure requirement in paragraph 7.87i, investment companies may consider paragraph BC96 of ASU No. 2011-04, which explains that “the Boards expect that the narrative description will focus on the unobservable inputs for which quantitative information is disclosed because those are the unobservable inputs that the entity has determined are most significant to the fair value measurement.” Further, investment companies may consider the example provided in FASB ASC 820-10-55-106:

The significant unobservable inputs used in the fair value measurement of the reporting entity’s residential mortgage-backed securities are prepayment rates, probability of default, and loss severity in the event of default. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.

7.92 FASB ASC 820-10-50-2B explains that a reporting entity should determine appropriate classes of assets and liabilities on the basis of the nature, characteristics, and risks of the asset or liability, and the level of the fair value hierarchy within which the fair value measurement is categorized. Further, the number of classes may need to be greater for fair value measurements within level 3 of the fair value hierarchy because those measurements have a greater degree of uncertainty and subjectivity. A class of assets and liabilities will often require greater disaggregation than the line items presented in the statement of financial position.

7.93 FASB ASC 820-10-50-3 states that, for derivative assets and liabilities, the reporting entity should present both the fair value disclosures discussed in paragraph 7.87a–c on a gross basis (which is consistent with the requirements in FASB ASC 815-10-50-4B[a]) and the reconciliation disclosures discussed in paragraph 7.87f–g on either a gross or net basis.

7.94 FASB ASC 820-10-50-6A states that for investments in certain entities that calculate net asset value per share (investments that are within the scope of paragraphs 4–5 of FASB ASC 820-10-15) and measured at fair value on a recurring or nonrecurring basis during the period, a reporting entity should disclose information that helps users of financial statements to understand the nature and risks of the investments and whether the investments, if sold, are probable of being sold at amounts different from net asset value per share (or its equivalent).

7.95 FASB ASC 820-10-50-6A provides for the following required minimum disclosures, to the extent applicable, for each class of investments:³³

a.     The fair value measurement (as determined by applying paragraphs 59–62 of FASB ASC 820-10-35) of the investments in the class at the reporting date and a description of the significant investment strategies of the investee(s) in the class.

b.     For each class of investment that includes investments that can never be redeemed with the investees, but the reporting entity receives distributions through the liquidation of the underlying assets of the investees, the reporting entity’s estimate of the period of time over which the underlying assets are expected to be liquidated by the investees.

c.     The amount of the reporting entity’s unfunded commitments related to investments in the class.

d.     A general description of the terms and conditions upon which the investor may redeem investments in the class (for example, quarterly redemption with 60 days’ notice).

e.     The circumstances in which an otherwise redeemable investment in the class (or a portion thereof) might not be redeemable (for example, investments subject to a lockup or gate). Also, for those otherwise redeemable investments that are restricted from redemption as of the reporting entity’s measurement date, the reporting entity should disclose its estimate of when the restriction from redemption might lapse. If an estimate cannot be made, the reporting entity should disclose that fact and how long the restriction has been in effect.

f.     Any other significant restriction on the ability to sell investments in the class at the measurement date.

g.     Subparagraph superseded by ASU No. 2015-07.

h.     If a group of investments would otherwise meet the criteria in FASB ASC 820-10-35-62, but the individual investments to be sold have not been identified (for example, if a reporting entity decides to sell 20 percent of its investments in private equity funds, but the individual investments to be sold have not been identified), so the investments continue to qualify for the practical expedient in FASB ASC 820-10-35-59, the reporting entity should disclose its plans to sell and any remaining actions required to complete the sale(s).

7.96 Paragraph 7.233, from FASB ASC 820-10-55-107, provides an example of the disclosures required by FASB ASC 820-10-50-6A.

7.97 FASB ASC 820-10-50-2E provides disclosure requirements for those classes of assets and liabilities not measured at fair value in the statement of financial position but for which the fair value is disclosed. Specifically, for those classes of assets and liabilities, a reporting entity should disclose the information required by paragraph 7.87b, d, and h. No other disclosures in FASB ASC 820-10-50 (summarized in paragraphs 7.82–.96) are required for those classes of assets and liabilities. Paragraphs 3–4 of FASB ASC 825-10-55 list examples of financial instruments that a financial entity and nonfinancial entity, respectively, would include in their disclosures about the fair value of financial instruments, including the following:

•     Cash and short-term investments

•     Investment securities and trading account assets

•     Long-term investments

•     Loan receivables

•     Long-term debt

•     Commitments to extend credit

•     Standby letters of credit

•     Written financial guarantees

Other examples may include, but would not be limited to, the following: tender option bonds, reverse repurchase agreements, lines of credit, and (when accounted for as liabilities) variable-rate demand preferred shares.

7.98 Q&A section 2220.26, “Categorization of Investments for Disclosure Purposes,”³⁴ explains that certain entities that specialize in one particular investment category or have a significant investment in one such category should categorize investments and tailor disclosures to address the concentrations of risk that are specifically attributable to the investments. For example, a private equity fund of funds should not simply categorize its investments as “private equity” because this categorization is not specific enough to address the nature and risks of the investee funds. More specific categorization, perhaps relating to industry; geography; vintage year; or the strategy of the investees (venture, buyout, mezzanine), may be more appropriate and useful to the reader.

Fair Value Option

7.99 FASB ASC 825 creates a fair value option under which an entity may irrevocably elect fair value as the initial and subsequent measure for many financial instruments and certain other items, with changes in fair value recognized in earnings as those changes occur. FASB ASC 825-10-35-4 explains that a business entity should report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. An election is made on an instrument-by-instrument basis (with certain exceptions), generally when an instrument is initially recognized in the financial statements. The fair value option need not be applied to all identical items, except as required by FASB ASC 825-10-25-7. Most financial assets and liabilities are eligible to be recognized using the fair value option, as are firm commitments for financial instruments and certain nonfinancial contracts.

7.100 As explained by FASB ASC 825-10-15-5, specifically excluded from eligibility of the fair value option are

•     an investment in a subsidiary that the entity is required to consolidate.

•     an interest in a VIE that the entity is required to consolidate.

•     an employer’s and a plan’s obligations for pension benefits, other postretirement benefits (including health care and life insurance benefits), postemployment benefits, employee stock option and stock purchase plans, and other deferred compensation arrangements (or assets representing net overfunded positions in those plans).

•     financial assets and liabilities recognized under leases (this does not apply to a guarantee of a third-party lease obligation or contingent obligation arising from a cancelled lease).

•     deposit liabilities of depository institutions.

•     financial instruments that are, in whole or in part, classified by the issuer as a component of shareholder’s equity (including temporary equity) (for example, a convertible debt security with a noncontingent beneficial conversion feature).

7.101 FASB ASC 825-10-45 and 825-10-50 also include presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. Paragraphs 1–2 of FASB ASC 825-10-45 state that entities should report assets and liabilities that are measured at fair value in a manner that separates those reported fair values from the carrying amounts of similar assets and liabilities measured using another measurement attribute. To accomplish that, an entity should either (a) report the aggregate of both fair value and non-fair-value items on a single line, with the fair value amount parenthetically disclosed or (b) present separate lines for the fair value carrying amounts and the non-fair-value carrying amounts. As discussed in FASB ASC 825-10-25-3, upfront costs and fees related to items for which the fair value option is elected should be recognized in earnings as incurred and not deferred.

7.102 Nonregistered investment companies may consider the provisions in FASB ASC 825-10-50-3, which provides an exception from the disclosure requirements in paragraphs 10–19 of FASB ASC 825-10-50 for entities that meet all of the following criteria:

a.     The entity is a nonpublic entity (see paragraph 7.88 for definition of nonpublic entity).

b.     The entity’s total assets are less than $100 million on the date of the financial statements.

c.     The entity has no instrument that, in whole or in part, is accounted for as a derivative instrument under FASB ASC 815 other than commitments related to the origination of mortgage loans to be held for sale during the reporting period. For purposes of this disclosure guidance, a receive-variable, pay-fixed interest rate swap for which the simplified hedge accounting approach (see FASB ASC 815-20) is applied should not be considered an instrument that is accounted for as a derivative instrument under FASB ASC 815.

Further, pursuant to FASB ASC 825-10-50-3A, a reporting entity that is a nonpublic entity is not required to disclose the level of the fair value hierarchy within which the fair value measurements are categorized in their entirety (level 1, 2, or 3) (disclosure requirement in FASB ASC 825-10-50-10(d)) for items disclosed at fair value but not measured at fair value in the statement of financial position.

Net Assets

7.103 FASB ASC 946-20-50-11 requires all investment companies to disclose only two components of capital on the balance sheet: shareholder capital and distributable earnings. The components of distributable earnings, on a tax basis, should be disclosed in a note to the financial statements. This information enables investors to determine the amount of accumulated and undistributed earnings that they potentially could receive in the future and on which they could be taxed. Additionally, as stated by FASB 946-20-50-12, the notes should disclose the tax-basis components of distributable earnings as of the most recent tax year-end, including undistributed ordinary income, undistributed long term capital gains, capital loss carryforwards, and unrealized appreciation (depreciation). FASB ASC 946-20-50-14 notes that investment partnerships and other pass-through entities should aggregate all elements of equity into partners’ capital because the results from operations are deemed distributed to each partner.

7.104 The statement or the notes should also disclose information about the following:³⁵

a.     Units of capital, including the title of each class of capital shares or other capital units, the number authorized, the number outstanding, and the dollar amount.

b.     Paid-in capital, which includes the net proceeds received on the sale of capital shares less the cost of reacquired shares and the return of capital distributions (that is, the tax return of capital distributions [see paragraphs 7.147–.148]). In addition, certain differences between GAAP-basis income or gain amounts and tax-basis amounts distributed from income or gain are reclassified to paid-in capital in the period in which such differences become permanent differences (see paragraphs 7.147–.148).

7.105 As further explained by FASB ASC 946-20-50-13, if a provision for deferred income taxes on unrealized appreciation exists, it should be charged against the unrealized gains account and disclosed as such in the statement of operations. Explanations should be provided for the differences between the total of these amounts and distributable earnings (accumulated losses).

7.106 Net asset value per share should be disclosed for each class of shares, as explained by FASB ASC 946-505-50-1. Net asset value per share is defined by the FASB ASC glossary as the amount of net assets attributable to each share of capital stock (other than senior equity securities [that is, preferred stock]) outstanding at the close of the period. It excludes the effects of assuming conversion of outstanding convertible securities, regardless of whether their conversion would have a diluting effect.

7.107 Consistent with SEC Staff Announcement “Classification and Measurement of Redeemable Securities,”³⁶ (codified as FASB ASC 480-10-S99-3A), a registered investment company should classify preferred securities that are redeemable for cash or other assets outside of permanent equity if they are redeemable at a fixed or determinable price on a fixed or determinable date; at the option of the holder; or upon the occurrence of an event that is not solely within the control of the issuer. The Chief Accountant’s Office of the Division of Investment Management released more guidance specific to the application of the “Pending Content” guidance in FASB ASC 480-10 to closed-end funds. Of most significance, the staff indicated that distributions to preferred stockholders should be presented below net investment income on the statement of operations, the statement of changes in net assets, and financial highlights as a component of the net increase (decrease) in net assets resulting from investment operations. The staff indicated that the “Pending Content” in FASB ASC 480-10 provides guidance on preferred stock arrangements that are redeemable on a fixed or determinable date.

7.108 FASB ASC 480-10-65-1 describes the effective date and transition information for all “Pending Content” guidance in FASB ASC 480-10 that is linked to that paragraph. For instruments issued by nonpublic entities that are not SEC registrants and that are mandatorily redeemable on fixed dates for amounts that are either fixed or determined by reference to an interest rate index, a currency index, or another external index, the classification, measurement, and disclosure provisions of FASB ASC 480-10 were effective for fiscal years beginning after December 15, 2004. The guidance in FASB ASC 480-10 is indefinitely deferred pending further FASB action for mandatorily redeemable financial instruments issued by nonpublic entities that are not SEC registrants, other than those mandatorily redeemable instruments described previously. During the indefinite deferral, FASB plans to reconsider implementation issues and, perhaps, classification or measurement guidance for those instruments in conjunction with FASB’s ongoing project on liabilities and equity. Mandatorily redeemable financial instruments issued by SEC registrants are not eligible for that deferral, even if the entity meets the definition of a nonpublic entity in FASB ASC 480-10. Those entities should follow the effective dates required by FASB ASC 480-10 and related guidance, including the deferral for certain mandatorily redeemable noncontrolling interests, as appropriate. If an entity that is not an SEC registrant and (a) has issued shares that are required to be redeemed under related agreements, and (b) if the shares are issued with the redemption agreement and the required redemption relates to those specific underlying shares, then the shares are mandatorily redeemable and fall under the deferral stated previously.

7.109 FASB ASC 480-10-65-1 also explains that the effective date of FASB ASC 480-10 is deferred for certain mandatorily redeemable noncontrolling interests (of all entities, public and nonpublic) as follows:

a.     For mandatorily redeemable noncontrolling interests that would not have to be classified as liabilities by the subsidiary under the liquidation exception in paragraphs 4 and 6 of FASB ASC 480-10-25 but would be classified as liabilities by the parent in consolidated financial statements, the classification and measurement provisions of FASB ASC 480-10 are deferred indefinitely pending further FASB action.

b.     For other mandatorily redeemable noncontrolling interests that were issued before November 5, 2003, the measurement provisions of FASB ASC 480-10 are deferred indefinitely, both for the parent in consolidated financial statements and for the subsidiary that issued the instruments that result in the mandatorily redeemable noncontrolling interest, pending further FASB action. For those instruments, the measurement guidance for redeemable shares and noncontrolling interests in other predecessor literature (for example, in EITF Topic No. D-98) continues to apply during the deferral period. However, the classification provisions of FASB ASC 480-10 are not deferred.

FASB plans to reconsider implementation issues and, perhaps, classification or measurement guidance for those noncontrolling interests during the deferral period, in conjunction with FASB’s ongoing projects. During the deferral period for certain mandatorily redeemable noncontrolling interests, all public entities as well as nonpublic entities that are SEC registrants are required to follow the disclosure requirements in paragraphs 1–3 of FASB ASC 480-10-50, as well as disclosures required by other applicable guidance. Further, this project is a joint project between FASB and the International Accounting Standards Board.

7.110 Under “Pending Content” in FASB ASC 480-10-25, financial instruments that are mandatorily redeemable on a fixed date or upon the occurrence of an event certain to occur should be classified initially as liabilities. Contingently redeemable securities, such as those described in paragraph 7.107, are not within the scope of FASB ASC 480-10-25 unless and until the contingency occurs, at which time the instruments should be reclassified as liabilities. “Pending Content” in FASB ASC 480-10-25-7 explains that a financial instrument that will be redeemed only upon the occurrence of a conditional event would be assessed at each reporting period to determine whether circumstances have changed such that the instrument now meets the definition of a mandatorily redeemable instrument (that is, the event is no longer conditional). If the event has occurred, the condition is resolved, or the event has become certain to occur, the financial instrument is reclassified as a liability. Therefore, with respect to contingently redeemable securities for which the contingency has not occurred, the guidance discussed in paragraph 7.107 should continue to be followed by registered investment companies.

Investment Income

7.112 Dividend income. FASB ASC 946-320-25-4 states that dividend income is recorded on the ex-dividend date, not the declaration, record, or payable date, because on the ex-dividend date, the quoted market price of listed securities and other market-traded securities tends to be affected by the exclusion of the dividend declared. As noted by FASB ASC 946-20-50-9, dividends from affiliates and controlled companies should be disclosed.

7.113 Rule 6.07.1 of Regulation S-X for SEC registrants also requires that income from affiliates and controlled companies be disclosed. Investment companies are also required to comply with FASB ASC 850, Related Party Disclosures. (Chapter 2 of this guide discusses noncash dividends, dividends in arrears on preferred stocks, and dividends from other than distributable earnings.)

7.114 Interest income. Interest income (including amortization of premiums and accretion of discounts) is generally accrued on all debt securities. However, chapter 2 discusses special reporting requirements for interest on high-yield debt securities, bonds in default, and other kinds of securities such as payment-in-kind bonds and step bonds. Interest earned on securities of affiliates and controlled companies should be disclosed separately.

7.115 Other income. Other income includes fee income from securities loaned and miscellaneous sources. Individual items, if material, should be disclosed separately. Rule 6.07 of Regulation S-X requires the separate disclosure of any category of income that exceeds 5 percent of the total investment income (for example, income from non-cash dividends and income from payment-in-kind interest).

Expenses

7.116 As stated in FASB ASC 946-220-45-3, all of the following expenses are commonly reported separately:

a.     Investment advisory (management) fees (or compensation).

b.     Administration fees payable to an affiliate (if accrued under a separate agreement).

c.     Shareholder service costs, including fees and expenses for the transfer agent and dividend disbursing agent.

d.     Distribution (12b-1) expenses (discussed in chapter 8, “Other Accounts and Considerations,” of this guide).

e.     Custodian fees.

f.     Cost of reports to shareholders.

g.     Federal and state income taxes. These expenses should be shown separately after the income category to which they apply, such as investment income and realized or unrealized gains. (Chapter 6, “Taxes,” of this guide discusses the provision for taxes for entities that do not meet the requirements necessary to qualify as a regulated investment company [RIC].)

h.     Other taxes. (Foreign withholding taxes should be deducted from the relevant income item and disclosed parenthetically or shown as a separate contra-item in the “Income” section.)

i.     Interest (including interest on debt, bank borrowings, and reverse repurchase agreements).

j.     Dividends on securities sold short.

k.     Professional fees.

l.     Directors’ or trustees’ fees.

m.     Registration fees and expenses (discussed in chapter 8).

7.117 Rule 6.07.2(b) of Regulation S-X requires separate disclosure of each expense exceeding 5 percent of total expenses. Additionally, for brokerage service and expense offset arrangements, the notes to the financial statements should include the total amounts by which expenses are increased and list each category that is increased by at least 5 percent of total expenses.³⁷

7.118 Amounts paid to affiliates or related parties (such as advisory fees, administration fees, distribution fees, brokerage commissions, and sales charges) should be disclosed, in accordance with FASB ASC 850. Significant provisions of related-party agreements, including the basis for determining management, advisory, administration, or distribution fees, and, also, other amounts paid to affiliates or related parties should be described in a note to the financial statements.

7.119 As explained in FASB ASC 946-20-05-11, an adviser or a third party may voluntarily or involuntarily waive its fee and reimburse expenses (waivers). An example of an involuntary waiver is when the advisory agreement (or other regulation or agreements that are either outside the adviser’s control or require shareholder approval) provides that the adviser should reimburse the investment company for expenses in excess of a specified percentage of average net assets. As further described in FASB ASC 946-20-50-7, all voluntary and involuntary waivers should be disclosed on the face of the statement of operations as a reduction of total expenses. The expense ratio in the financial highlights should be shown net of voluntary and involuntary waivers. The effect of only voluntary waivers on the expense ratio should be disclosed (either as the basis point effect on the ratio or as the gross expense ratio) in a note to, or as part of, the financial highlights. In addition, the terms of all voluntary and involuntary waivers should be disclosed in the notes to the financial statements.

7.120 As noted in FASB ASC 946-20-50-4, if a 12b-1 distribution reimbursement plan³⁸ provides for the carryover of unreimbursed costs to subsequent periods, the terms of reimbursement and the unreimbursed amount should be disclosed.

7.121 The disclosure requirements in Section 30(e)(5) of the 1940 Act address aggregate remuneration to directors or trustees and each company of which any officer or director is an affiliated person. The auditor may conclude that the investment company has complied with the requirements by disclosure in the notes to the financial statements or in another manner that the investment company’s management or legal counsel determines to be appropriate.

7.122 As noted in FASB ASC 946-20-05-9, an investment company may have a brokerage service arrangement with a broker-dealer or an affiliate of a broker-dealer under which the broker-dealer (or its affiliate), in connection with the investment company’s brokerage transactions directed to the broker-dealer, provides or pays for services to the investment company (other than brokerage and research services as those terms are used in Section 28(e) of the 1934 Act). As further explained in FASB ASC 946-20-45-3, the relevant expense caption on the statement of operations and the expense ratio in the financial highlights should include the amount that would have been incurred by the investment company for such services had it paid for the services directly in an arm’s length transaction. Such amounts should also be shown as a corresponding reduction in total expenses, captioned as “Fees paid indirectly.”

7.123 As stated in FASB ASC 946-20-45-5, expense offset arrangements under which a third party explicitly reduces its fees by a specified or readily ascertainable amount for services provided to the investment company in exchange for use of the investment company’s assets should be presented in the statement of operations, the expense ratio in the financial highlights, and the notes to the financial statements in the same manner as brokerage service arrangements.

7.124 As discussed in FASB ASC 946-20-05-10, investment companies organized as limited partnerships typically receive advisory services from the general partner. Many partnerships pay fees for such services, chargeable as expenses to the partnership; others allocate net income from the limited partners’ capital accounts to the general partner’s capital account; and still others employ a combination of the two methods. Further, FASB ASC 946-20-45-4 notes that the amounts of any such payments or allocations for advisory services from the general partner should be presented in either the statement of operations or the statement of changes in partners’ capital. FASB ASC 946-20-50-5 states that the method of computing such payments or allocations should be described in the notes to the financial statements.

7.125 According to Q&A section 6910.29, “Allocation of Unrealized Gain (Loss), Recognition of Carried Interest, and Clawback Obligations,”³⁹ the governing documents of some nonregistered investment partnerships may contain provisions that do not allow allocations of unrealized gains or losses or do not require the recognition of carried interest (also referred to as carry, incentive, or performance fees and allocations) and clawback obligations (also referred to as lookback, negative carried interest, or general partner⁴⁰ giveback) until a specified date or time (for example, at the time of the partnership’s liquidation or termination) or the occurrence of a specific event (such as the actual disposition of an investment). Often, in these cases, the partnership’s investments are either not marketable or of such limited liquidity that interim valuations are highly subjective, and the intent of the provision is to delay the general partner’s receipt of incentive allocations in cash until the gains can be measured objectively.

7.126 Q&A section 6910.29 also explains that if a nonregistered investment partnership reports capital by investor class, cumulative unrealized gains (losses), carried interest, and clawback provisions should be reflected in the equity balances of each class of shareholder or partner at the balance sheet date as if the investment company had realized all assets and settled all liabilities at the fair values reported in the financial statements and allocated all gains and losses and distributed the net assets to each class of shareholder or partner at the reporting date consistent with the provisions of the partnership’s governing documents. Further discussion of each of these items follows:

a.     Cumulative unrealized gains (losses). Cumulative unrealized gains (losses) should be included in the ending balances of each class of shareholders’ or partners’ interest in the reporting entity at the reporting date, and the changes in such amounts should be reported in the changes in net asset value and partners’ capital for the reporting period.

b.     Carried interest. The carried interest generally is due to the investment manager, an affiliated entity, or both and is either in the form of a fee (usually for offshore funds) or as an allocation from the limited partners’ capital accounts, pro rata, to the general partner’s capital account (usually for domestic funds). Although many variations exist, the investment manager is often entitled to receive its carry on a deal-by-deal basis. On this basis, as individual investments are sold, the investment proceeds are allocated based on a specific methodology defined in the governing documents to determine the amount of carry, if any, to which the investment manager is entitled. In presenting each class of shareholders’ or partners’ interest in the net assets as of the reporting date, the financial statements should consider the carry formula as if the investment company had realized all assets and settled all liabilities at their reported fair value and allocated all gains and losses and distributed the net assets to each class of shareholder or partner at the reporting date.

c.     Clawback. Although all classes of shareholder or partner may be subject to clawback provisions in the governing documents, a clawback most frequently involves an obligation on the part of the investment manager to return previously received incentive allocations to the investment fund due to subsequent losses. Such clawback amounts, when paid, are typically distributed to other investors. The impact of a clawback should be calculated as of each reporting date under the methodology specified in the fund’s governing documents.

7.127 Q&A section 6910.29 notes that, consistent with FASB ASC 310-10-45-14, such an obligation should not be recognized as an asset (receivable) in the entity’s financial statements unless substantial evidence exists of the ability and intent to pay within a reasonably short period of time. Rather, in most instances, the obligation should be reflected as a deduction from the general partner’s capital account. The specific circumstances, including whether the clawback represents a legal obligation to return or contribute funds to the reporting entity, require consideration before determining whether a clawback, resulting in a negative general partner capital balance (that is, contra-equity), is recognized in the financial statements. Additionally, it may not be appropriate to reflect a negative general partner capital balance (and a corresponding increase to limited partner capital balances) if the general partner does not have the financial resources to make good on its obligation.

7.128 Even if not recognized within the capital accounts, at a minimum, it would be appropriate to disclose the existence of a clawback in the footnotes to the financial statements because in almost all cases, the existence of the clawback would modify the manner in which future distributions are made.

7.129 Deferred fees.⁴¹ According to Q&A section 6910.27, because the fund directly earns or incurs the income, expenses, net realized gains or losses, and unrealized appreciation or depreciation on the deferred fee retained in the fund, such amounts should be presented within their respective line items in the investment company’s statement of operations. The net change in unrealized appreciation or depreciation on the total return contracts associated with the deferred fees should be reported in earnings (that is, reflected as an expense [appreciation of deferred fees] or a negative expense [depreciation of deferred fees] of the fund, rather than an allocation of earnings or losses) and, following the guidance from FASB ASC 850, should be presented separately from the current period management or incentive fee.

Net Investment Income

7.130 As noted in FASB ASC 946-220-45-5, the excess of investment income over total expenses should be shown as net investment income (or loss). Further, as explained in FASB ASC 946-220-50-1, any income tax provision relating to net investment income should be disclosed separately.

Net Realized Gain or Loss From Investments and Foreign Currency Transactions

7.131 Net realized gain or loss from investments. As explained in FASB ASC 946-220-45-6 and 946-220-50-2, the statement of operations should disclose net realized gains or losses. Net realized gains or losses resulting from sales or other disposals should be reported net of brokerage commissions. Gains or losses arising from in-kind redemptions should be disclosed. The net realized gains or losses from investments and net realized gains or losses from foreign currency transactions may be reported separately or combined.

7.132 Registered investment companies should disclose in the statement of operations net realized gains or losses into categories required by Rule 6.07.7 of Regulation S-X. An income tax provision charged against realized gains should also be disclosed separately.

7.133 Net realized gains or losses from foreign currency transactions. As explained in FASB ASC 946-220-45-6 and 946-220-50-2, net gains or losses from assets or liabilities denominated in foreign currencies during the period should be reported separately. If separate reporting of foreign currency effects on realized gains or losses from investments is elected, those effects should be included in this caption. Guidance for computing such amounts appears in chapter 2. The net realized gains or losses on investments resulting from foreign currency changes may be reported separately or combined with net realized gains or losses from investments. Notes to the financial statements should state an entity’s practice of either including or excluding that portion of realized and unrealized gains and losses from investments that result from foreign currency changes with or from other foreign currency gains and losses.

7.134 The 1940 Act requires the disclosure of proceeds from sales of securities and the cost of securities purchased.⁴² The SEC staff permits exclusion of short term securities (those securities with a maturity of one year or less) from this disclosure. Information about common stocks, bonds, and preferred stocks may be combined or disclosed separately.

Net Increase (Decrease) in Unrealized Appreciation or Depreciation on Investments and Translation of Assets and Liabilities in Foreign Currencies

7.135 Net increase (decrease) in unrealized appreciation or depreciation on investments. As discussed in FASB ASC 946-220-45-6, changes in net unrealized appreciation or depreciation during the period should be reported in the statement of operations. The major components of unrealized appreciation or depreciation should be disclosed in a manner that is consistent with the guidance discussed in paragraph 7.131. Either combining the net unrealized gains or losses from investments with net unrealized gains or losses from foreign currency transactions or reporting them separately is permissible. Any provision for deferred taxes should be reported separately.

7.136 Net increase (decrease) in unrealized appreciation or depreciation on translation of assets and liabilities in foreign currencies. As noted in FASB ASC 946-220-45-6, the net change during the period from translating assets and liabilities denominated in foreign currencies should be reported under this caption. Guidance for computing such amounts appears in chapter 2.

Net Increase From Payments by Affiliates and Net Gains (Losses) Realized on the Disposal of Investments in Violation of Restrictions

7.137 As illustrated in FASB ASC 946-20-05-2, affiliates may make payments to a fund related to investment losses for either of the following reasons:

a.     Payments by affiliates. To reimburse the effect of a loss (realized or unrealized) on a portfolio investment, often caused by a situation outside the fund’s or its affiliates’ direct control, such as an issuer default or a decline in fair value.

b.     Investment restriction violations (investments not meeting investment guidelines). Occasionally, a fund adviser may purchase an investment for a fund that violates the fund’s investment restrictions (investment restrictions are described in the prospectus or statement of additional information for registered funds and in partnership agreements or offering memorandums for nonregistered funds). The investment held in violation of the fund’s investment restrictions may appreciate or depreciate in value. In the case in which the investment has depreciated in value and the fund has consequently incurred a loss, the fund adviser may make a payment to the fund in lieu of settlement of a potential claim resulting from the violation of the fund’s investment restrictions. This payment, in effect, makes the fund whole relative to the loss that it has incurred. This type of transaction is, in essence, a payment to put the fund’s shareholders in the position they would have been in had the violation not occurred.

7.138 As explained in FASB ASC 946-20-45-1, payments made by affiliates for those two reasons should be combined and reported as a separate line item entitled “Net increase from payments by affiliates and net gains (losses) realized on the disposal of investments in violation of restrictions” in the statement of operations as part of net realized and unrealized gains (losses) from investments and foreign currency. That separate line item would comprise amounts related to the following:

a.     Voluntary reimbursements by the affiliate for investment transaction losses

b.     Realized and unrealized losses on investments not meeting the investment guidelines of the fund

c.     Reimbursements from the affiliate for losses on investments not meeting the investment guidelines of the fund

d.     Realized and unrealized gains on investments not meeting the investment guidelines of the fund

As further discussed in FASB ASC 946-20-50-2, the amounts and circumstances of payments by affiliates to reimburse the fund for losses on investment transactions should be described in the notes to the financial statements. The gains and losses on investments not meeting investment guidelines of the fund should also be disclosed in the notes to the financial statements. In addition, the effect on total return, which is presented in the financial highlights, of the payments, as well as any gains or losses on investments not meeting investment guidelines of the fund, should be quantified and disclosed in the financial highlights in a manner similar to disclosure of the effect of voluntary waivers of fees and expenses on expense ratios. This is disclosed in accordance with FASB ASC 850-10. Total return should be presented in the financial highlights. The following is an example of total return being presented in a footnote to the financial highlights, as shown in FASB ASC 946-20-55-1:

In 20XX, a.aa% of the fund’s total return consists of a voluntary reimbursement by the adviser for a realized investment loss, and another b.bb% consists of a gain on an investment not meeting the fund’s investment restrictions. Excluding these items, total return would have been c.cc%. Additionally, the adviser fully reimbursed the fund for a loss on a transaction not meeting the fund’s investment guidelines, which otherwise would have reduced total return by d.dd%.

7.139 The Financial Reporting Executive Committee (FinREC) believes that due to the underlying reasons for such payments, the inclusion of the payments in the statement of operations should not be changed if the person making the payment is also a shareholder in the fund. FinREC was able to distinguish these payments from transactions undertaken by an entity’s principal shareholder for the benefit of the entity (see SEC Topic 5T, “Accounting for Expenses or Liabilities Paid by Principal Stockholder[s]” of the SEC’s Codification of Staff Accounting Bulletins), as arising from the person’s service relationship to the fund, not its shareholder relationship. FinREC observed that the payments typically do not enhance the value of the person’s equity investment in the fund beyond a pro rata interest in the payment itself, because the value of investment company shares either equals or is directly related to net asset value per share. Thus, FinREC believes that the payments ordinarily are intended to maintain a person’s service relationship with the fund, rather than enhance or maintain the value of the person’s investment in the fund.

7.140 In considering the presentation of the payments within the statement of operations, FinREC considered the guidance in FASB ASC 220-20-45-1. FinREC recognizes that payments of the type specified in paragraph 7.137a historically have been infrequent, typically occurring when an investment-grade issuer suddenly and unexpectedly defaulted, and that transactions in violation of investment restrictions, whether resulting in gains or losses, and payments of the type described in paragraph 7.137b are inherently infrequent. Thus, FinREC recommends the presentation of such items within a separate component of the statement of operations, as described in paragraph 7.138. FinREC also believes that the inconsistency between these transactions and the operating practices stated in the fund’s governing documents provides further support for such presentation.

7.141 As explained in FASB ASC 946-20-05-3, payments by affiliates may take several forms, such as the following:

•     A direct cash contribution to the fund to offset the effect of a realized loss on a portfolio investment

•     Purchase of securities from the fund at prices in excess of the securities’ current fair value

•     Provision of a credit enhancement to maintain the investment’s value

7.142 Further, FASB ASC 946-20-25-2 notes that a credit enhancement provided by an affiliate to maintain an investment’s value should be recognized when the enhancement becomes available to the fund. FASB ASC 946-20-30-1 adds that the amount of the payment is initially measured by the cost of obtaining a similar enhancement in an arm’s length transaction. Lastly, FASB ASC 946-20-35-1 states that any subsequent change in the value of the enhancement should be accounted for as unrealized appreciation or depreciation.

7.143 A fund may receive other payments from affiliates for reasons other than those described in FASB ASC 946-20-05-2. An evaluation must be made to determine whether to disclose the payments on the statement of operations or statement of changes in net assets. Regardless of the type of payment received, the fund should separately disclose the payments received in the respective financial statement, show the impact on the total return relating to such items in the financial highlights, and provide a narrative disclosure of the reasons why such payments were made.

Net Realized and Unrealized Gain or Loss From Investments and Foreign Currency

7.144 FASB ASC 946-220-45-6(c) states that the sum of the net realized gain or loss and change in unrealized gain or loss on investments and foreign currency-denominated assets and liabilities should be presented in the statement of operations as a net gain or loss on investments and foreign currency.

Net Increase or Decrease in Net Assets From Operations

7.145 As noted in FASB ASC 946-220-45-7, the sum of net investment income or loss and net realized and unrealized gain or loss on investments and foreign currency should be shown as a net increase or decrease in net assets resulting from operations.

Reporting of Fully Benefit-Responsive Investment Contracts

7.146 FASB ASC 946-210-45-17 requires that the statements of operations and changes in net assets be prepared on a basis that reflects income credited to participants in the fund and realized and unrealized gains and losses only on those investment contracts that are not deemed fully benefit-responsive.

Fully Benefit-Responsive Investment Contract Disclosures

7.190 As discussed in FASB ASC 946-210-50-14, investment companies identified in FASB ASC 946-210-45-11 should disclose the following in the aggregate in connection with fully benefit-responsive investment contracts:

a.     A description of the nature of those investment contracts, how they operate, and the methodology for calculating the interest crediting rate, including the key factors that could influence future average interest crediting rates, the basis for and frequency of determining interest crediting rate resets, and any minimum interest crediting rate under the terms of the contracts. This disclosure should explain the relationship between future interest crediting rates and the amount reported on the statement of assets and liabilities representing the adjustment for the portion of net assets attributable to fully benefit-responsive investment contracts from fair value to contract value.

b.     A reconciliation between the beginning and ending balance of the amount presented on the statement of assets and liabilities that represents the difference between net assets reflecting all investments at fair value and net assets for each period in which a statement of changes in net assets is presented. This reconciliation should include

i.     the change in the difference between the fair value and contract value of all fully benefit-responsive investment contracts and

ii.     the increase or decrease due to changes in the fully benefit-responsive status of the fund’s investment contracts.

c.     The average yield earned by the entire fund (which may differ from the interest rate credited to participants in the fund) for each period for which a statement of assets and liabilities is presented. This average yield should be calculated by dividing the annualized earnings of all investments in the fund (irrespective of the interest rate credited to participants in the fund) by the fair value of all investments in the fund.

d.     The average yield earned by the entire fund with an adjustment to reflect the actual interest rate credited to participants in the fund for each period for which a statement of assets and liabilities is presented. This average yield should be calculated by dividing the annualized earnings credited to participants in the fund (irrespective of the actual earnings of the investments in the fund) by the fair value of all investments in the fund.

e.     The following two sensitivity analyses:

i.     The weighted average interest crediting rate (that is, the contract value yield) as of the date of the latest statement of assets and liabilities and the effect on this weighted average interest crediting rate, calculated as of the date of the latest statement of assets and liabilities and the end of the next four quarterly periods, under two or more scenarios in which there is an immediate hypothetical increase or decrease in market yields, with no change to the duration of the underlying investment portfolio and no contributions or withdrawals. Those scenarios should include, at a minimum, immediate hypothetical increases and decreases in market yields equal to one-quarter and one-half of the current yield.

ii.     The effect on the weighted average interest crediting rate calculated as of the date of the latest statement of assets and liabilities and the next four quarterly reset dates, under two or more scenarios in which there are the same immediate hypothetical changes in market yields in the first analysis, combined with an immediate, one-time, hypothetical 10 percent decrease in the net assets of the fund due to participant transfers, with no change to the duration of the portfolio.

f.     A description of the events that limit the ability of the fund to transact at contract value with the issuer (for example, premature termination of the contracts by the fund, plant closings, layoffs, plan termination, bankruptcy, mergers, and early retirement incentives), including a statement about whether the occurrence of those events that would limit the fund’s ability to transact at contract value with the participants in the fund is probable or not probable.

g.     A description of the events and circumstances that would allow issuers to terminate fully benefit-responsive investment contracts with the fund and settle at an amount different from contract value.

Paragraph 7.231, from FASB ASC 946-210-55-2, illustrates the application of this guidance.

Offsetting Assets and Liabilities

7.191 FASB ASC 210-20-50 discusses disclosures about certain financial instruments and derivative instruments that are either (a) offset in accordance with either FASB ASC 210-20-45 or FASB ASC 815-10-45 or (b) are subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either FASB ASC 210-20-45 or FASB ASC 815-10-45.

Auditing Considerations

7.209 AU-C section 930, Interim Financial Information,⁵⁵ addresses the auditor’s responsibilities when engaged to review interim financial information of nonissuers, including nonregistered investment companies, under conditions specified therein (see the section “Applicability of Generally Accepted Auditing Standards and PCAOB Standards” of the preface to this guide for a discussion of the definitions of issuer and nonissuer as used throughout this guide). The term auditor is used throughout AU-C section 930, not because the auditor is performing an audit, but because the scope of AU-C section 930 is limited to a review of interim financial information performed by an auditor of the financial statements of the entity. AU-C section 930 applies to a review of interim financial information when

a.     the entity’s latest annual financial statements have been audited by the auditor or a predecessor auditor;

b.     the auditor either

i.     has been engaged to audit the entity’s current year financial statements, or

ii.     audited the entity’s latest annual financial statements, and in situations in which it is expected that the current year financial statements will be audited, the engagement of another auditor to audit the current year financial statements is not effective prior to the beginning of the period covered by the review;

c.     the entity prepares its interim financial information in accordance with the same financial reporting framework as that used to prepare the annual financial statements; and

d.     all of the following conditions are met if the interim financial information is condensed:

i.     The condensed interim financial information purports to be prepared in accordance with an appropriate financial reporting framework, which includes appropriate form and content of interim financial information.

ii.     The condensed interim financial information includes a note that the financial information does not represent complete financial statements and is to be read in conjunction with the entity’s latest audited annual financial statements.

iii.     The condensed interim financial information accompanies the entity’s latest audited annual financial statements or such audited annual financial statements are made readily available by the entity.

7.210 Paragraphs .A1–.A3 of AU-C section 930 provide application and other explanatory guidance associated with items a–d preceding, as follows:

•     The ability to apply the provisions of AU-C section 930 even when the auditor does not expect to be engaged to audit the current year financial statements provides for appropriate transitions between the predecessor auditor and the auditor of the current year financial statements.

•     Appropriate financial reporting frameworks for condensed interim financial information may include, for example, FASB ASC 270, Interim Reporting, and Article 10 of SEC Regulation S-X with respect to accounting principles generally accepted in the United States of America or International Accounting Standard 34, Interim Financial Reporting, with respect to International Financial Reporting Standards issued by the International Accounting Standards Board. FASB ASC 270 outlines the application of U.S. generally accepted accounting principles (GAAP) to the determination of income when interim financial information is presented, provides for the use of estimated effective income tax rates, and specifies certain disclosure requirements for condensed interim financial information issued by public companies, and may be adapted by nonissuers as a fair presentation framework for condensed interim financial information. In addition to FASB ASC 270, other FASB ASC topics also include disclosure requirements for interim financial information.

•     The meaning of readily available in item d(iii) is provided in paragraph .A3 of AU-C section 930, which states that audited financial statements are deemed to be readily available if a third-party user can obtain the financial statements without any further action by the entity (for example, financial statements on an entity’s website may be considered readily available, but being available upon request is not considered readily available).

7.211 AU-C section 930 defines interim financial information as financial information prepared and presented in accordance with an applicable financial reporting framework that comprises either a complete or condensed set of financial statements covering a period or periods less than 1 full year or covering a 12-month period ending on a date other than the entity’s fiscal year-end.

Considerations for Audits Performed in Accordance With PCAOB Standards

Registered public accounting firms must comply with the standards of the PCAOB in connection with the preparation or issuance of any report on reviews of interim financial information of an issuer (see the section “Applicability of Generally Accepted Auditing Standards and PCAOB Standards” of the preface to this guide for a discussion of the definitions of issuer and nonissuer as used throughout this guide). AS 4105, Reviews of Interim Financial Information,⁵⁶ is the relevant standard for performing reviews of interim financial statements of issuers. Paragraphs .07 and .18g of AS 4105 also provide guidance to auditors with respect to evaluating management’s quarterly certifications about internal control over financial reporting, where applicable. (See the preface of this guide for more information about management’s assessment of the effectiveness of internal control.)

7.212 Q&A section 9170.02, “Supplementary Information That Accompanies Interim Financial Information,”⁵⁷ explains that an auditor is not required to report on supplementary information when an entity presents supplemental information along with interim financial statements (when the auditor is performing an interim review in accordance with AU-C section 930). However, the auditor can report on supplementary information if he or she chooses to do so. If the auditor decides to report on the supplementary information, the auditor may disclaim on the supplementary information or issue a report based on the limited procedures performed as part of the interim review. Q&A section 9170.02 provides an example of a report based on the limited procedures applied in the review.