Investment Advisory (Management) Fee Expense

8.01 As discussed in chapter 1, “Overview of the Investment Company Industry,” of this guide, an investment company usually engages an investment adviser for a fee, which is generally the largest expense incurred by the investment company. This fee is usually reflected in the periodic net asset value calculation (daily, weekly, monthly, quarterly or less frequently) at rates established by the investment advisory agreement. Certain agreements may provide for performance fee adjustments based on a comparison of the investment company’s performance against an index specified in the agreement.

8.02 As stated in FASB Accounting Standards Codification (ASC) 946-20-25-10, performance fees by an investment adviser under an advisory agreement should be accrued by an investment company at interim dates based on actual performance through the accrual date. As discussed in paragraph 7.125 of this guide, Technical Questions and Answers (Q&A) section 6910.29, “Allocation of Unrealized Gain (Loss), Recognition of Carried Interest, and Clawback Obligations,”^1,2 addresses situations in which governing documents contain provisions that do not require the payment of performance fees until a specified date or time.

8.03 However, according to the SEC’s policy, interim payments to the adviser should be based on the minimum fee provided in the agreement because if performance for the year yields a fee that is lower than the interim payments, the excess may represent a loan to the adviser. Performance fees based on a rolling or moving period are discussed in Release No. 7113 of the Investment Company Act of 1940 (the 1940 Act). Investment companies should ensure that their accounting policies do not contradict provisions in the 1940 Act or rules thereunder, as well as relevant SEC releases.

Expenses

8.04 The investment company’s expenses should be inspected for compliance with the provisions of the investment advisory contract, the prospectus, and other relevant agreements. The investment company estimates its other expenses for the year and the period within which it will incur them and allocates them, usually daily, in computing net asset value. Estimated annual expenses should be evaluated continually and accruals adjusted as necessary.

8.05 Asset-based fees are typically recalculated by the auditor for reasonableness, and other expense items are typically reviewed by analytical procedures.

8.06 Some investment company prospectuses, offering memorandums, or agreements between the adviser or other servicer (such as an administrator) and the fund may require the servicer to waive its fee and reimburse or assume certain expenses that exceed stated limitations. If so, the auditor should test the calculations for compliance with the governing document.

8.07 Expense limitation arrangements help new funds with lower asset levels maintain lower expense ratios, which results in a benefit to the shareholder. Typically, one condition attached to these arrangements is that the investment company agrees to repay the service provider (without interest) if, and to the extent that, the investment company’s net assets increase sufficiently to permit such payments without exceeding the stated percentage expense limitation. Also, typically, these agreements (a) are terminable on short notice by either party without a penalty, (b) have a fixed expiration date, and (c) give the service provider no claim against the investment company for any amounts not reimbursed upon termination or expiration. The economic result of these agreements is to defer payment of the expenses until the investment company is financially able to bear them or, upon termination or expiration, to eliminate them entirely.

8.08 As explained in FASB ASC 946-20-05-8, some expense limitation agreements may provide that reimbursements by the fund adviser of expenses incurred by the fund in excess of the maximum permitted by the prospectus or offering document will be carried over to a future period and reimbursed to the fund adviser when, and to the extent that, the total expense ratio falls below the permitted maximum. Such agreements may also provide that reimbursement of excess expenses to the fund adviser is not required after a specified date or upon conclusion of a specified period from the time the fund initially incurred, or the adviser initially reimbursed, the expenses, such as three years.

8.09 According to FASB ASC 946-20-25-4, a liability for such excess expenses should be recognized if, and to the extent that, the expense limitation agreement’s established terms for repayment of the excess expenses to the adviser by the fund and the attendant circumstances meet criteria (a), (b), and (c) of paragraph 36 of FASB Concepts Statement No. 6, Elements of Financial Statements—a replacement of FASB Concepts Statement No. 3 (incorporating an amendment of FASB Concepts Statement No. 2), and the criteria in FASB ASC 450-20-25-2.³ In most instances, a liability will not be recorded because it is not likely that excess expenses under such plans will meet the criteria in those paragraphs before amounts are actually due to the adviser under the reimbursement agreement. If an assessment of the specific circumstances (such as an agreement to reimburse for either an unlimited period or a period substantially greater than that necessary for the fund to demonstrate its economic viability, or an obligation to reimburse the servicer remains even after the cancellation of the fund’s contract with the servicer) indicates that the preceding criteria are met, a liability should be recorded. FASB ASC 946-20-50-6 states that the existence of reimbursement agreements and the carryover of excess expenses potentially reimbursable to the adviser but not recorded as a liability should be disclosed in the notes to the financial statements.

8.10 FASB ASC 946-20-05-8 also explains that, under most excess expense plans, a fund is obligated to repay a servicer for expenses incurred previously only if, during a defined period, the fund retains the service provider and can reduce its expense ratio to a low enough level to permit payment, and the fund maintains that ratio at a sufficiently low level thereafter. Many substantive conditions could cause the fund to have no obligation to the servicer, including failure to attract assets, significant redemptions of shares by investors, market depreciation, and significant increases in other expenses, all of which could drive expenses up to or beyond the maximum under which payment would otherwise be made.

8.11 The AICPA Financial Reporting Executive Committee (FinREC) observed that even actual reimbursement of some expenses does not establish the appropriateness of accrual of additional unreimbursed amounts because these conditions must continually be met for the fund to be further obligated to the servicer.

8.12 Some advisers to nonregistered investment companies, especially those advising funds with significant private investments, will earn transaction related fees and income from investments owned by the funds they advise. In certain cases, the management fee charged to such funds will be reduced by the transaction fees and income earned by the adviser.

8.13 Auditors should examine these arrangements to ascertain that management fee reductions are calculated correctly and that the nature of transaction fees earned by the adviser are considered for presentation and disclosure in accordance with guidance covering related party transactions. See also the “Expenses” section in chapter 7, “Financial Statements of Investment Companies,” of this guide.

Distribution Expenses⁴

8.14 As discussed in FASB ASC 946-20-05-4, open-end investment companies are permitted to finance the distribution of their shares under a plan pursuant to Rule 12b-1 (Rule 12b-1 is one of the regulations implementing the 1940 Act). Under Rule 12b-1, a fund’s board of directors or trustees is required to perform an annual review of the plan and determine whether to continue or terminate it. Under a traditional 12b-1 plan, a fund’s distributor may be compensated or reimbursed for its distribution costs or efforts through any of the following methods:

•     A 12b-1 fee, payable by the fund, based on an annual percentage of the fund’s average net assets (a compensation plan) or based on an annual percentage of the fund’s average net assets limited to actual costs incurred, after deducting contingent deferred sales loads (CDSLs) received by the distributor (a reimbursement plan). Therefore, a compensation plan differs from a reimbursement plan only in that the latter provides for annual or cumulative limits, or both, on fees paid. Fees for both kinds of plans are treated as expenses in a fund’s statement of operations.

•     A front-end load, which is assessed on purchasing shareholders at the time fund shares are sold.

•     A CDSL imposed directly on redeeming shareholders. The CDSL usually is expressed as a percentage, which declines with the passage of time, of the lesser of redemption proceeds or original cost. The CDSL normally ranges from 4 percent to 6 percent and typically is reduced by 1 percent per year (for example, from 6 percent to 5 percent) until the sales charge reaches 0 percent.

8.15 Financial Industry Regulatory Authority (FINRA) rules construe 12b-1 fees to be either asset based sales charges or service fees. These rules (Section 2830 of the National Association of Securities Dealers Rules of Fair Practice, incorporated into the FINRA manual) limit the amount of asset-based sales charges that may be charged in any year to specified percentages of average net assets and provide aggregate limitations on the total amounts of sales charges received through front-end sales loads, deferred sales charges, and asset-based sales charges.

8.16 As noted in FASB ASC 946-20-05-5, Rule 12b-1 plans historically have provided that a fund’s board of directors or trustees may terminate the plan with no penalty to the fund. (Termination of the plan does not necessitate termination of the fund.) Redeeming shareholders still would be subject to the CDSL, which would be paid to the distributor that sold the shares to those shareholders. However, with a traditional 12b-1 plan, the 12b-1 fees normally would be discontinued on plan termination. Some traditional reimbursement 12b-1 plans provide that, when the plan is terminated, the fund’s board of directors or trustees has the option, but not the requirement, to pay the distributor for any costs incurred in excess of the cumulative CDSLs and 12b-1 fees that the distributor has received. Such a plan is referred to as a board-contingent plan. Under traditional reimbursement 12b-1 plans, including board-contingent plans, CDSL payments by shareholders continue to be remitted to the distributor until excess costs are fully recovered, after which the CDSL payments usually are remitted to the fund instead of the distributor. As stated in FASB ASC 946-20-50-4, if a 12b-1 distribution reimbursement plan provides for the carryover of unreimbursed costs to subsequent periods, the terms of reimbursement and the unreimbursed amount should be disclosed.

8.17 Reimbursement to the investment company of expenses incurred under such plan (12b-1 expense reimbursement) should be shown as a negative amount and deducted from current 12b-1 expenses. Distribution expenses paid with an investment company’s assets are accounted for as operating expenses. Under 12b-1 plans, including board-contingent plans, CDSL payments by shareholders are remitted to the distributor until aggregate regulatory limitations on sales charges to be received are met. As explained in FASB ASC 946-20-05-6, with an enhanced 12b-1 plan, the fund is required to continue paying the 12b-1 fee after termination of the plan to the extent that the distributor has excess costs. CDSL payments by shareholders would continue to be remitted to the distributor to further offset excess costs. Thus, the major distinction between traditional and enhanced 12b-1 plans is the requirement for the fund to continue such payments upon plan termination.

8.18 The following table from FASB ASC 946-20-05-7 summarizes the 12b-1 plan attributes enumerated previously.

8.19 FASB ASC 946-20-25-3 states that a liability, with a corresponding charge to expense, should be recognized by a fund with an enhanced 12b-1 plan for excess costs. FASB ASC 946-20-30-3 explains that the initial amount of the liability and expense should equal the cumulative distribution costs incurred by the distributor less the sum of: cumulative 12b-1 fees paid; cumulative CDSL payments; and future cumulative CDSL payments by current shareholders, if reasonably estimable. Paragraphs 3–4 of FASB ASC 946-20-35 note that any future cumulative CDSL payments should be based on: (a) current net asset value per share, (b) the number of shares currently outstanding and the number of years that they have been outstanding, and (c) estimated shareholder persistency based on historical fund data or, if historical fund data are not available, group or industry data for a similar class of shares. Changes in the liability should be recognized in the statement of operations as an expense or a reduction of expense.

8.20 Paragraphs 4–5 of FASB ASC 946-20-30 note that the liability and expense should be measured at its present value, calculated using an appropriate current interest rate, if both (a) the amount and timing of cash flows are reliably determinable and (b) the distribution costs are not subject to a reasonable interest charge. If these conditions are not met, the liability should be calculated without discounting to present value.

8.21 FASB ASC 946-20-25-3 states that a liability for excess costs, computed in the same way as for an enhanced 12b-1 plan, should be recorded by a fund with a board-contingent plan when the fund’s board commits to pay such costs.

8.22 As explained in FASB ASC 946-20-50-3, for both board-contingent plans and enhanced 12b-1 plans, funds should disclose in their interim and annual financial statements the principal terms of such plans and any plan provisions permitting or requiring payments of excess costs after plan termination. For board-contingent and enhanced 12b-1 plans, the aggregate amount of distribution costs subject to recovery through future payments by the fund pursuant to the plan and through future CDSL payments by current shareholders should be disclosed. For enhanced 12b-1 plans, funds should disclose the methodology used to estimate future CDSL payments by current shareholders.

8.23 As stated in FASB ASC 946-20-45-2, an excess of cumulative 12b-1 fees and CDSL payments to date and future CDSL payments by current shareholders over the cumulative costs incurred by the distributor should not be reported as an asset.

Organization and Offering Costs

8.24 A newly formed investment company incurs organization costs unless a sponsoring management company agrees to absorb such costs (see paragraph 8.05). Organization costs consist of costs incurred to establish the company and enable it legally to do business. A newly established series of a previously established investment company may also incur organization costs. In a master-feeder arrangement, these costs may be incurred at the master level, feeder level, or both. Organization costs for an investment company include, among other things, the following:

•     Incorporation fees

•     Legal services pertaining to the organization and incorporation of the business; drafting of bylaws, administration, custody and transfer agent agreements; and performing research and consultation services in connection with the initial meeting of directors or trustees

•     Audit fees relating to the initial registration statement and auditing the initial seed capital statement of assets and liabilities

8.25 In accordance with FASB ASC 720-15-25-1, organization costs should be charged to expense as they are incurred.

8.26 The following chart summarizes those costs that are, or are not, generally treated as organization and offering costs and the accounting required under FASB ASC 720-15 or other U.S. generally accepted accounting principles (GAAP).

8.27 Once an investment company has been organized to do business, it usually engages immediately in its planned principal operations (that is, the sale of capital stock and investment of funds). Employee training, development of markets for the sale of capital stock, and similar activities are usually performed by the investment adviser or other agent, and the costs of these activities are not borne directly by the investment company. However, an investment company, particularly one not engaging an agent to manage its portfolio and perform other essential functions, may engage in such activities and bear those costs directly from inception.

8.28 Offering costs, as defined by the FASB ASC glossary, include the following:

•     Legal fees pertaining to the investment company’s shares offered for sale

•     SEC and state registration fees

•     Underwriting and other similar costs

•     Costs of printing prospectuses for sales purposes

•     Initial fees paid to be listed on an exchange

•     Tax opinion costs related to offering of shares

•     Initial agency fees of securing the rating for bonds or preferred stock issued by closed-end funds

8.29 As discussed in paragraphs 5–6 of FASB ASC 946-20-25 and 946-20-35-5, offering costs of closed-end funds and investment partnerships should be charged to paid-in capital upon sale of the shares or units. Offering costs of open-end investment companies and of closed-end funds with a continuous offering period should be accounted for as a deferred charge until operations begin and thereafter be amortized to expense over 12 months on a straight-line basis.

8.30 Certain kinds of costs incurred from the distribution of shares, such as front-end sales charges and deferred sales charges, are deducted from the proceeds received from shareholders or redemption proceeds paid to shareholders; are not paid by the fund; and are, therefore, outside the scope of offering costs, as defined herein.

8.31 Some closed-end funds and business development companies offer stock through shelf registration statements. According to Q&A section 4110.10, “Costs Incurred in Shelf Registration,”⁶ legal and other fees incurred for a stock issue under a shelf registration should be capitalized as a prepaid expense. When securities are taken off the shelf and sold, a portion of the costs attributable to the securities sold should be charged against paid-in-capital. Any subsequent costs incurred to keep the filing “alive” should be charged to expense as incurred. If the filing is withdrawn, the related capitalized costs should be charged to expense.

8.32 FASB ASC 946-20-35-5 does not indicate whether an investment partnership should apply the same treatment as open-end registered investment companies and closed-end registered investment companies with a continuous offering period. According to Q&A section 6910.23, “Accounting Treatment of Offering Costs Incurred by Investment Partnerships,”⁷ an investment partnership that continually offers its interests should defer offering costs incurred prior to the commencement of operations and then amortize them to expense over the period that it continually offers its interests, up to a maximum of 12 months. The straight-line method of amortization should generally be used. If the offering period terminates earlier than expected, the remaining deferred balance should be charged to expense. Q&A section 6910.24, “Meaning of ’Continually Offer Interests’,”⁸ provides a definition of continually offer interests, which explains that an investment partnership is deemed to continually offer its interests if an eligible, new investor may enter into an agreement to purchase an interest in the partnership on any business day or on a series of specified business days over a continuous period of time. For this purpose, a new investor is one that does not already own any interest in the investment partnership at the time of purchase. Some investment partnerships may offer their interests at a single point in time and require new investors to commit to providing capital contributions over a period of time. In this scenario, because the interests are not available for purchase over a continuous period, such investment partnerships would not be deemed to have a continuous offering period.

8.33 This treatment of offering costs by closed-end funds and investment partnerships results in such costs being borne by the initial shareholders or partners of the closed-end fund or partnership. The treatment of capitalizing offering costs by open-end investment companies and certain investment partnerships that continually offer interests is consistent with their continuous issuances and redemptions of shares.

8.34 Unit investment trusts (UITs)⁹ have characteristics that are similar to both open-end and closed-end investment companies. Some UITs offer shares only at a particular time, but others provide for ongoing sales over a longer offering period. FinREC recognized that requiring a UIT to charge its offering costs to paid-in capital at the commencement of its offering or immediately after its units or shares are sold to the underwriters would require the underwriters, not the shareholders, to bear those costs. The treatment of these offering costs is discussed in the following paragraph and matches those costs with the proceeds received from the sale of the units or shares. FinREC also considered whether these offering costs should be deferred until these units or shares are sold by the underwriters to the public. FinREC concluded that the capital-raising effort of the UIT is completed upon the sale of the units or shares to the underwriters; therefore, support for further deferral does not exist.

8.35 As explained in FASB ASC 946-20-35-6 and 946-20-40-1, offering costs of UITs should be treated as follows:

•     Offering costs should be charged to paid-in capital on a pro rata basis as the units or shares are issued or sold by the trust (when the units are purchased by the underwriters). Units sold to underwriters on a firm basis are considered sold by the trust, and the offering costs associated with those units should be charged to paid-in capital when the units are purchased by the underwriters. Offering costs that remain unamortized at the end of the year should be reviewed for impairment.

•     Offering costs that have not yet been charged to paid-in capital should be written off when it is no longer probable that the shares to which the offering costs relate will be issued in the future. It is presumed that those costs will not have a future benefit one year from the initial offering.

Unusual Income Items

8.36 Unusual income items, such as amounts recovered from the settlement of litigation, are usually recognized in the financial statements when the investment company acquires an enforceable right, in accordance with the gain contingency provisions of FASB ASC 450-30. For items considered payment in lieu of settlement to make whole for violations by an affiliate, refer to paragraph 7.138 of this guide. Items relating to specific portfolio securities are typically recorded as an adjustment to realized or unrealized gains or losses. Otherwise, the item and a subsequent revaluation should be presented as other income, if any, or a separate income item. If the item is sufficiently material in relation to net investment income, it should be presented as a line item immediately before net investment income, unless the item is clearly identifiable with realized or unrealized gains or losses.

Business Combinations¹⁰

8.37 The guidance in FASB ASC 805, Business Combinations, applies to all transactions or other events that meet the definition of a business combination or an acquisition by a not for profit entity. FASB ASC 805-10-15-4 identifies exclusions from the scope of the business combinations topic. One of the exclusions is the acquisition of an asset or group of assets that does not constitute a business. Readers should consider the applicability of guidance appropriate to their individual circumstances.

8.38 According to Q&A section 6910.33, “Certain Financial Reporting, Disclosure, Regulatory, and Tax Considerations When Preparing Financial Statements of Investment Companies Involved in a Business Combination,”¹¹ most mergers of registered investment companies are structured as tax-free reorganizations in which shares of one company typically are exchanged for substantially all the shares or assets of another company (or companies). Following a business combination, portfolios of investment companies are often realigned, subject to tax limitations, to fit the objectives, strategies, and goals of the surviving company. Typically, shares of the acquiring fund are issued at an exchange ratio determined on the acquisition date, essentially equivalent to the acquiring fund’s net asset value per share divided by the net asset value per share of the fund being acquired, both as calculated on the acquisition date. Adjusting the carrying amounts of assets and liabilities is usually unnecessary because virtually all assets of the combining investment companies (investments) are stated at fair value, in accordance with FASB ASC 820, Fair Value Measurement, and liabilities are generally short term so that their carrying values approximate their fair values.¹² However, conforming adjustments may be necessary when funds have different valuation policies (for example, valuing securities at the bid price versus the mean of the bid and asked price) in order to ensure that the exchange ratio is equitable to shareholders of both funds.

8.39 Q&A section 6910.33 also explains that only one of the combining companies can be the legal survivor. In certain instances, it may not be clear which of the two funds constitutes the acquirer for financial reporting purposes. Although the legal survivor would normally be considered the acquirer, continuity and dominance in one or more of the following areas might lead to a determination that the fund legally dissolved should be considered the acquirer for financial reporting purposes:

•     Portfolio management

•     Portfolio composition

•     Investment objectives, policies, and restrictions

•     Expense structures and expense ratios

•     Asset size

8.40 As stated in Q&A section 6910.33, a registration statement on Form N-14 is often filed in connection with a merger of management investment companies registered under the 1940 Act, or of business development companies, as defined by Section 2(a)(48) of the 1940 Act. Form N-14 is both a proxy statement, in that it solicits a vote from the (legally) acquired fund’s shareholders to approve the transaction, and a prospectus, in that it registers the (legally) acquiring fund’s shares that will be issued in the transaction. Form N-14 frequently requires the inclusion of pro forma financial statements reflecting the effect of the merger.¹³

8.41 Q&A section 6910.33 also states that tax implications must be considered and monitored carefully in the planning, execution, and postmerger stages of a business combination. The tax rules that must be considered include those related to the determination that the transaction is tax-free to the funds involved and their shareholders (IRC Section 368(a) and IRS Notice 88-19), the qualification tests affecting regulated investment companies (RICs) (IRC Section 851), and the accounting for tax attributes of specific accounts such as earnings and profits (Section 1.852–12(b) of Title 26, Internal Revenue, of U.S. Code of Federal Regulations), capital loss carryforwards, and methods of tax accounting (IRC Section 381). Management may consider obtaining a private letter ruling from the IRS or an opinion of counsel on the tax-free treatment. Upon completion of the acquisition, the portfolio securities obtained from the acquiree generally should be monitored because substantial turnover of the acquiree’s portfolio securities may jeopardize the tax-free status of the reorganization. There are important differences in the tax rules affecting business combinations of RICs and nonregulated investment companies.

8.42 As further stated by Q&A section 6910.33, merger-related expenses (mainly legal, audit, proxy solicitation, and mailing costs) are addressed in the plan of reorganization and often paid by the fund incurring the expense, although the adviser may waive or reimburse certain merger-related expenses. Numerous factors and circumstances should be considered in determining which entity bears merger-related expenses.

8.43 FASB ASC 805-10-25-23 notes that acquisition-related costs are costs that the acquirer incurs to effect a business combination. Acquisition-related costs include finder’s fees; advisory, legal, accounting, valuation, and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department; and costs of registering and issuing debt and equity securities. The acquirer should account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received. The only exception to this is for costs relating to issuance of debt or equity securities, which should be recognized in accordance with other applicable GAAP.

8.44 Q&A section 6910.33 goes on to state that if the combination is a taxable reorganization, the fair value of the assets acquired on the date of the combination becomes the assets’ new cost basis. For financial reporting purposes, assets acquired in a tax-free reorganization may be accounted for in the same manner as a taxable reorganization. However, investment companies carry substantially all their assets at fair value as an ongoing reporting practice, and cost basis is principally used and presented solely for purposes of determining realized and unrealized gain and loss. Accordingly, an investment company, which is an acquirer in a business combination structured as a tax-free exchange of shares, may make an accounting policy election to carry forward the historical cost basis of the acquiree’s investment securities for purposes of measuring realized and unrealized gain or loss for statement of operations presentation in order to more closely align the subsequent reporting of realized gains by the combined entity with tax-basis gains distributable to shareholders. The basis for such policy election should be disclosed in the notes to the financial statements, if material.

8.45 Q&A section 6910.33 explains that the instructions to Forms N-1A and N-2 state that, for registered investment companies, costs of purchases and proceeds from sales of portfolio securities that occurred in the effort to realign a combined fund’s portfolio after a merger should be excluded in the portfolio turnover calculation. The amount of excluded purchases and sales should be disclosed in a note.¹⁴

8.46 FASB ASC 805-10-50-1 states that disclosures to enable users of the financial statements to evaluate the nature and effect of a business combination are required when business combinations occur during the reporting period or after the reporting date but before the financial statements are issued or available to be issued. FASB ASC 805-10-50-2 explains that disclosures for all business combinations should include the name and description of the acquiree, the acquisition date, the percentage of voting equity interests acquired, and the primary reasons for the business combination and a description of how the acquirer obtained control of the acquiree. Transactions that are recognized separately from the acquisition of assets and assumptions of liabilities in the business combination require additional disclosures. Business combinations achieved in stages also require additional disclosures.

8.47 In addition, FASB ASC 805-10-50-2 discusses that if the acquirer is a public business entity, these additional disclosures are required:

•     The amounts of revenue and earnings of the acquiree since the acquisition date included in the consolidated income statement for the reporting period

•     If comparative financial statements are not presented, the revenue and earnings of the combined entity for the current reporting period as though the acquisition date for all business combinations that occurred during the year had been as of the beginning of the annual reporting period.

•     If comparative financial statements are presented, the revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period (supplemental pro forma information). For example, for a calendar year-end entity, disclosures would be provided for a business combination that occurs in 20X2, as if it occurred on January 2, 20X1. Such disclosures would not be revised if 20X2 is presented for comparative purposes with the 20X3 financial statements (even if 20X2 is the earliest period presented).

•     The nature and amount of any material, nonrecurring pro forma adjustments directly attributable to the business combination(s) included in the reported pro forma revenue and earnings (supplemental pro forma information).

If providing the public entity acquirer disclosures will not be practicable, that fact, along with an explanation of why the disclosure is impracticable, should be disclosed. In this context, impracticable is defined by any of the following conditions existing:

•     After making every reasonable attempt to do so, the entity is unable to apply the requirement.

•     Retrospective application requires assumptions about management’s intent in a prior period that cannot be independently substantiated.

•     Retrospective application requires significant estimates of amounts, and it is impossible to objectively distinguish information about those estimates that both

—     provides evidence of circumstances that existed on the date(s) at which those amounts would be recognized, measured, or disclosed under retrospective application and

—     would have been available when the financial statements for that prior period were issued.

8.48 Q&A section 6910.33 notes that because of the importance of investment company taxation to amounts distributable to shareholders, certain additional disclosures are recommended for combinations of investment companies, including the tax status and attributes of the merger. Additionally, if the merger is a tax-free exchange, separate disclosures of the amount of unrealized appreciation or depreciation and the amount of undistributed investment company income of the acquiree at the date of acquisition, if significant, may provide meaningful information about amounts transferred from the acquiree, which may be distributable by the combined fund in future periods. See appendix E, “Illustrative Financial Statement Presentation for Tax-Free Business Combinations of Investment Companies,” of this guide for an example of the calculation of an exchange ratio in an investment company merger, as well as merger-related financial statement disclosures.

Diversification of Assets

8.49 An investment company may use a worksheet to determine and document that it has complied with the diversification requirements stated in its registration statement.

8.50 The auditor may test that worksheet to become satisfied about the fund’s representations of the diversification of its assets. Those diversification requirements may differ from the requirements under IRC Subchapter M, discussed in chapter 6, “Taxes,” of this guide.

Liquidation Basis of Accounting

8.51 The liquidation basis of accounting, as described in FASB ASC 205-30, is not applicable to investment companies regulated under the 1940 Act. Other entities should not apply this scope exception by analogy. This scope exception does not apply to nonregulated investment companies, such as hedge funds and private equity funds.