1. Assessment of Investment Company & Practical Expedient (US GAAP)
July 3, 2017
Pankaj Kothari
July 3, 2017

2. What is an Investment Company?
An entity regulated under the Investment Company Act of 1940 is an investment company.
Section 3(a)(1)(A) of the Investment Company Act defines an investment company as an issuer which is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in “securities.”
Section 3(a)(1)(C) of the Investment Company Act defines an investment company as an issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire “investment securities” having a value exceeding 40 percent of the value of its total assets (exclusive of government securities and cash items) on an unconsolidated basis.

3. What is an Investment Company? (Continue)
Generally, an "investment company" is a company (corporation, business trust, partnership, or LLC) that issues securities and is primarily engaged in the business of investing in securities. An investment company invests the money it receives from investors on a collective basis, and each investor shares in the profits and losses in proportion to the investor's interest in the investment company. The performance of the investment company will be based on (but it won't be identical to) the performance of the securities and other assets that the investment company owns.
For eg. Mutual Funds, UIT’s Closed-end fund

4. What is Not Regulated Investment Company?
An entity that is not regulated under the Investment Company Act of 1940 should assess all the characteristics of an investment company to determine whether it is an investment company, considering its purpose and design when making that assessment. The initial determination of whether an entity is an investment company should be made up on formation of the entity.
To be an investment company, an entity should possess few fundamental characteristics.
An investment company also has few typical characteristics.

5. Fundamental Characteristics
It is an entity that obtains funds from one or more investors and provides the investor(s) with investment management services.
It is an entity that commits to its investor(s) that its business purpose and only substantive activities are investing the funds solely for returns from capital appreciation, investment income, or both.
The entity or its affiliates do not obtain or have the objective of obtaining returns or benefits from an investee or its affiliates that are not normally attributable to ownership interests or that are other than capital appreciation or investment income.

6. Typical Characteristics
It has more than one investment
It has more than one investor
It has investors that are not related parties of the parent (if there is a parent) or the investment manager;
It has ownership interests in the form of equity or partnership interests; and
It manages substantially all of its investments on a fair value basis.
An investment company should meet all of the typical characteristics. The absence of one or more of those typical characteristics, however, does not necessarily preclude an entity from being an investment company. If an entity does not possess one or more of the typical characteristics, it should apply judgment and determine, considering all facts and circumstances, how its activities continue to be consistent (or are not consistent) with those of an investment company.

7. Disclosure
An investment company should disclose that it is an investment company following the investment company guidance. A change in status should be disclosed along with the reasons for that change. An entity that was not an investment company that becomes an investment company should disclose the effect of the change in status on the reported amounts of investments as of the date of the change in status.

8. Types of Investment Companies
Several types of entities may meet the afore mentioned investment company scope criteria, including but not limited to management investment companies registered under or otherwise regulated by the 1940 Act; 
Unit investment trusts (UITs);
Common (collective) trust funds;
Investment partnerships;
Special purpose funds;
Venture capital investment companies, private equity funds, hedge funds;
Certain separate accounts of life insurance companies; and
Offshore funds.

9. Regulation:
Generally, an investment company is required to register with the SEC under the 1940 Act if one of the following is true:
Its outstanding securities, other than short-term paper, are beneficially owned by more than 100 persons (including the number of beneficial security holders of a company owning 10 percent or more of the voting securities of the investment company).
It is offering or proposing to offer its securities to the public.
The Investment Company Act also exempts from regulation under the Investment Company Act a number of investment pools and entities. If an issuer falls within one of these exclusions or exemptions, it may not register as an investment company with the Commission.

10. Exemptions
Section 2(b) of the Investment Company Act exempts certain governments, government agencies, and instrumentalities from the provisions of the Investment Company Act.
Section 3(b)(1) of the Investment Company Act excludes some issuers from the definition of investment company if they are primarily engaged in a business other than investing, reinvesting, holding or trading securities.
Section 3(b)(2) of the Investment Company Act provides that the Commission may exclude some issuers from the definition of investment company if the Commission, upon application by the issuer, finds and by order declares the issuer to be primarily engaged in a business other than that of investing, reinvesting, owning, holding, or trading in securities either directly or through majority-owned subsidiaries or through controlled companies conducting similar businesses.

11. Exemptions (Continue)
Section 3(c) of the Investment Company Act excludes certain other issuers from the definition of investment company. These issuers include, for example, broker-dealers, charitable organizations, pension plans, church plans and certain Private Investment Companies. (Two exceptions under Section 3(c) of the Investment Company Act are discussed in more detail below under “Private Investment Companies.”).
Section 6 of the Investment Company Act exempts certain investment companies from the provisions of the Investment Company Act, such as investment companies organized or otherwise created under the laws of, and having their principal office and place of business in Puerto Rico, the Virgin Islands, or any other possession of the United States, whose securities are not offered or sold except in the jurisdiction in which the investment company is organized.

12. Exemptions (Continue)
Further, Section 6(c) of the Investment Company Act provides the Commission with broad authority to exempt persons, securities or transactions from any provision of the Investment Company Act, or the regulations thereunder, if and to the extent that such exemption is in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Investment Company Act.

13. Private Investment Companies
Private Funds are excluded from the definition of an investment company and are, therefore, not registered under the US Investment Company Act of 1940 (“1940 Act” or “’40 Act”). Private funds may not make a public offering of their shares and, as a result, are limited to "accredited investors" in order to allow for a private offering complying with Regulation D.
A section 3(c)(1) fund may not be beneficially owned by more than 100 shareholders.
A section 3(c)(7) fund must be owned by "qualified purchasers“. Section 3(c)(7) funds may have more than 100 investors, but typically limit the number of investors to 499, so as to avoid registration under the Securities Exchange Act of 1934 (“1934 Act”).
Section 3(c)(1) funds and Section 3(c)(7) funds offer their interests in private offerings limited to "accredited investors" as defined by rule 501 under the Securities Act of 1933.

14. Private Investment Companies (Continue)
In the United States, to be considered an accredited investor, one must have a net worth of at least $1,000,000, excluding the value of one's primary residence, or have income at least $200,000 each year for the last two years (or $300,000 combined income if married) and have the expectation to make the same amount this year. The term "accredited investor" is defined in Rule 501 of Regulation D of the U.S. Securities and Exchange Commission (SEC). Section 3(c)(7) funds may be purchased only by people who are considered "qualified purchasers," which generally includes a married couple or an individual with over $5 million in investments and owned by 2 or more related natural persons (a family company); a person (such as an institutional investor) who owns and invests (on a discretionary basis) at least $25 million in investments; or a trust not formed for the specific purpose of acquiring securities.

15. Organizations/Entities/Person Providing Services to Investment Companies:
Chief Compliance Officer (CEO)
Investment Advisor
Transfer Agent
Administrator
Attorney
Custodian
Distributor (also known as an underwriter of the fund’s shares, acts as an agent or a principal and sells the fund's shares as a wholesaler through independent dealers or as a retailer through its own sales network)

16. Valuation
In the United States, FASB ASC Topic 946, Investment Companies requires assets of Investment Companies to be reported at Fair Value.
Fair Value :
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
The measurement of Fair Value under US GAAP and IFRS is dictated by Accounting Standards Codification (ASC) Topic 820, Fair Value Measurement as issued by the Financial Accounting Standards Board (FASB), and IFRS 13, Fair Value Measurement as issued by the International Accounting Standards Board (IASB). Other accounting standards dictate when Fair Value is required or permitted. Various IFRS require or permit certain financial instruments to be reported at Fair Value.

17. Valuation (Continue) In determining fair value;
The valuer should use valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs.
The valuation techniques used to determine fair value are consistent with the market or income approaches.
Fair value should be determine based on assumptions that market participants would use in pricing an asset or liability in the principal or most advantageous market.
Fair value is a market-based measure, based on assumptions of prices and inputs considered from the perspective of a market participant that are current as of the measurement date, rather than an entity specific measure.

18. Valuation (Continue)
(For Unquoted Investments, the measurement of Fair Value requires the Valuer to assume the Underlying Business or instrument is realized or sold at the Measurement Date, appropriately allocated to the various interests, regardless of whether the Underlying Business is prepared for sale or whether its shareholders intend to sell in the near future.) Therefore, even when observable inputs are not readily available, the Fund’s own assumptions are set to reflect those that market participants would use in pricing the asset or liability at the measurement date.
Fair Value should be estimated using consistent valuation techniques from Measurement Date to Measurement Date unless there is a change in market conditions or Investment specific factors which would modify how a Market Participant would determine value.

19. Fair Value Hierarchy
When considering market participant assumptions in fair value measurements, the following fair value hierarchy distinguishes between observable and unobservable inputs, which are categorized in one of the following levels: 
Level 1 – Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Fund has the ability to access.
Level 2 – Valuations based on inputs other than quoted prices included in Level 1 that are observable, either directly or indirectly. These inputs may include: (a) quoted prices for similar assets in active markets; (b) quoted prices for identical or similar assets in markets that are not active; (c) inputs other than quoted prices that are observable for the asset; or (d) inputs that are derived principally from or corroborated by observable market data by correlation or other means.

20. Fair Value Hierarchy (Continue)
Level 3 – Valuations based on inputs that are unobservable and significant to the overall fair value measurement.
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an investment’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The General Partner’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the investments.
In determining the Fair Value of an Investment, the Valuer should use judgement. This includes consideration of those specific terms of the Investment which may impact its Fair Value. In this regard, the Valuer should consider the economic substance of the Investment, which may take precedence over the strict legal form.

21. Valuation Technique
The Valuer should exercise their judgment to select the valuation technique or techniques most appropriate for a particular Investment. The Valuer should use one or more of the following Valuation Techniques, taking into account Market Participant assumptions as to how Value would be determined:
Market Approach
Price of Recent Investment
Multiples
Industry Valuation Benchmarks
Available Market Prices
Income Approach
Discounted Cash Flows
Replacement Cost Approach
Net Assets

22. Practical Expedient
ASC 820, Fair Value Measurement, requires reporting entities to categorize investments measured at fair value in one of three levels in the fair value hierarchy. This categorization is based on the observability of the inputs used in valuing the investment. ASC 820 also allows the use of NAV as a practical expedient for fair value for certain investments, to the extent that NAV is calculated consistent with the guidance in ASC 946, Financial Services−Investment Companies. In order to use the stated NAV as the investment’s fair value, the underlying hedge fund must meet certain requirements including: a) the NAV fair value must be an estimate as of the reporting day of the Partnership; b) the Partnership is not likely to sell the investment at an amount different to the NAV; c) the investment is not readily marketable, and so does not have an accessible market value such as a quoted price; and d) the hedge fund meets the criteria of an investment company as defined in Topic 946, Financial Services – Investment Companies. The practical expedient is applied on an investment-by-investment basis.

23. Practical Expedient (Continue)
ASC 820, Fair Value Measurement, requires reporting entities to categorize investments measured at fair value in one of three levels in the fair value hierarchy. This categorization is based on the observability of the inputs used in valuing the investment. ASC 820 also allows the use of NAV as a practical expedient for fair value for certain investments, to the extent that NAV is calculated consistent with the guidance in ASC 946, Financial Services−Investment Companies. In order to use the stated NAV as the investment’s fair value, the underlying hedge fund must meet certain requirements including: a) the NAV fair value must be an estimate as of the reporting day of the Partnership; b) the Partnership is not likely to sell the investment at an amount different to the NAV; c) the investment is not readily marketable, and so does not have an accessible market value such as a quoted price; and d) the hedge fund meets the criteria of an investment company as defined in Topic 946, Financial Services – Investment Companies. The practical expedient is applied on an investment-by-investment basis.

24. Accounting Standards Update No. 2015-07 (“ASU 2015-07”)
In May, 2015, the FASB issued Accounting Standards Update No (“ASU ”), “Fair Value Measurement (Topic 820): Disclosures for Investments in Certain Entities that Calculate Net Asset Value per Share (or its Equivalent).” ASU removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using net asset value per share as a practical expedient.
Removing investments measured using the practical expedient from the fair value hierarchy is intended to eliminate the diversity in practice with respect to the categorization of these investments. The only criterion for categorizing investments in the fair value hierarchy will be the observability of the inputs.
Because a reporting entity’s investments measured at NAV as a practical expedient for fair value will no longer be categorized in the fair value hierarchy, the total of the fair value hierarchy disclosure will not agree to the total investments at fair value on the balance sheet. Therefore, the new guidance requires reporting entities to reconcile the fair value hierarchy disclosure to the balance sheet by disclosing the amount of investments measured using the practical expedient.

25. Accounting Standards Update No. 2015-07 (“ASU 2015-07”) (Continue)
Although removed from the fair value hierarchy, the new guidance still requires reporting entities that elect the practical expedient to make certain disclosures about the nature and risks of the investments (Information that helps users to understand the nature, characteristics and risks of the investments by class and whether the investments, if sold, are probable of being sold at amounts different from net asset value per share). However, the disclosures are no longer required for investments that are eligible to be measured using the practical expedient, but for which the practical expedient was not elected.

26. Accounting Standards Update No. 2015-07 (“ASU 2015-07”) (Continue)
As a result of the changes made to ASC 820 by the new guidance, the FASB amended two other areas of GAAP.
ASC 230, Statement of Cash Flows, currently provides an exemption for investment companies and similar entities from preparing a statement of cash flows. One of the criteria for the exemption requires that “substantially all” of the investments held during the period be categorized as Level 1 or Level 2 within the fair value hierarchy. Without the amendment to ASC 230, reporting entities with significant investments measured at NAV as a practical expedient would not have met the criteria and would have been required to present a statement of cash flows. The new guidance amends ASC 230 to include investments measured using the practical expedient in the “substantially all” test if they are redeemable in the near term at all times.
The FASB also amended ASC 715, Compensation—Retirement Benefits, to clarify that a plan sponsor’s pension assets are eligible to be measured at NAV as a practical expedient and that those investments are not required to be categorized in the fair value hierarchy.

27. Source Investment company Guide 2016
International Private Equity and Venture Capital Valuation Guidelines