Author: Elizabeth Lewis, CPA | Business Assurance & Advisory Services Supervisor | Real Estate & Construction Industry Team
As the real estate market continues its turnaround, savvy investors are increasingly taking advantage of the upside using pooled funds. Many of these funds are managed by real estate experts who may be novices to accounting standards and the specific regulations surrounding the investment company industry. The following list highlights a few items impacted by the specialized guidance that must be considered in the planning and early phases of the fund life to maximize returns for the manager and the investors.
Specialized Accounting Rules for Investment Companies:
- Investments – Investment companies are prohibited from consolidating controlling financial interests in operating entities and from using the equity method of accounting for investments. Operational results from the underlying properties are not included directly in the financial statement of the fund. Instead, the investments (along with all other assets and liabilities) should be presented at fair value. See further discussion on this topic under “Other considerations” below.
- Organization costs – All costs incurred for the start up of the fund should be expensed as incurred (ex: one time registration fees, legal consultation).
- Syndication costs – All costs incurred in connection with the syndication of investor interests are shown as a reduction of equity (capital). This can include costs associated with development of a Private Placement Memorandum or third party broker-dealer costs.
- Schedule of investments – An additional schedule disclosing each investment that constitutes more than 5 percent of net assets must be presented. The schedule should note specific details about each investment, including type, geographic region, and industry.
- Financial Highlights – Specific performance indicators are required to be disclosed depending on the nature of the fund. These financial highlights may include: Internal Rate of Return (IRR) since inception, total return, expense ratios, and net investment income ratios. The Accounting Standards Codification details which expenses should be included or annualized, and how carried interest may impact these calculations.
- Disclosure of accrued preferred returns and carried interest – Accrued preferred return and carried interest do not need to be recognized until it is reasonably assured to be paid. Therefore in the early years of a fund, and especially in cases where a clawback applies, disclosure in the notes is considered sufficient. See further discussion on this topic under “Other considerations” below.
- Distributions to investors – Investment fund operating agreements typically include preferred return and carried interest clauses in the methodology for distributing proceeds to investors. However, depending on the language included, tracking these returns can become a cumbersome exercise. When developing the operating agreement, consider the priority of distributions and the frequency of compounding the returns. The nature of a distribution (income or return of capital) will be determined at the time of payment based on these waterfall provisions and the nature of historical payments.
- In cases where the returns compound on a frequent basis, determining this nature can be a recordkeeping nightmare! Ensure the manager has proper systems in place to accurately account for this activity.
- If the preferred return is noted to be paid first before any return of capital, excess payments cannot be considered “pre-paid” preferred payments. They are instead applied as return of capital at the point in time when the preferred hurdle is met. In practice, this means capital value for future accruals must be re-calculated at the time of each payment, and an annualized IRR will not necessarily produce the same result. This is important to consider for recordkeeping purposes if excess payments are expected in the early years of the fund.
- Fair value reporting – The fair value conversation warrants an article of its own. The guidance requires managers to perform annual analysis to determine the exit value of each investment using an income, cost, or market approach. Most commonly for real estate, this takes the form of an independent appraisal, broker opinion of value, or subsequent sale data. Internal cash flow models may also substantiate a valuation for the real estate held. Subsequent to determining a value of the underlying real estate asset, adjustments must be made for other assets and liabilities held at the investment entity level. Furthermore, for joint ventures, it is imperative that all distribution waterfalls are clearly described and understood by all parties to calculate the residual value for the fund investors. This area of financial reporting requires significant estimates in many cases and poses substantial audit risk when the underlying investment is unaudited.
Although financial reporting implications alone should rarely drive operational decisions, managers must consider how investors and other users of the financial statements will react to the reported information. Establish an understanding of the specialized guidance early to ensure accurate and transparent financial reporting.
Questions on this topic? Contact your Keiter representative or firstname.lastname@example.org | 804.747.0000.
About the Author
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.