Financial Services Insights – July 2013 – FASB Clarifies the Liquidation Basis of Accounting
In April, 2013, the Financial Accounting Standards Board issued Accounting Standards Update 2013-07, Presentation of Financial Statements (Topic 205): Liquidation Basis of Accounting (the "ASU"). The ASU provides guidance on when and how to apply the liquidation basis of accounting. It also sets forth key principles for the recognition and measurement of assets and liabilities and requirements for financial statements prepared using the liquidation basis of accounting.
Key Takeaways for Investment Funds
- Liquidation basis of accounting is required when liquidation is "imminent."
- At a minimum, statements of net assets in liquidation and changes in net assets in liquidation are required.
- Assets and liabilities are measured based on estimated collection or settlement amounts; estimated costs and liabilities should be accrued through the expected liquidation date.
- New disclosures are required.
- Registered funds (1940 Act Filers) are exempt.
Determination to Begin Using the Liquidation Basis of Accounting
Financial statements should be prepared using the liquidation basis of accounting prospectively from the day liquidation is determined to be imminent. Liquidation is imminent when either of the following occurs:
- A plan for liquidation has been approved by the person(s) with the authority to make such a plan effective, and the likelihood is remote that either the plan will be blocked by another party or the entity will return from liquidation.
- A plan for liquidation is imposed by other forces (i.e., involuntary bankruptcy) and the likelihood is remote that the entity will return from liquidation.
The general partner or the investment manager would typically be responsible for the approval of the liquidation plan for a hedge fund or a private equity fund.
Investment companies that are regulated under the Investment Company Act of 1940 (the "1940 Act") are exempt. In addition, if a plan for liquidation was specified in the governing documents at inception (i.e., a limited-life entity), the liquidation basis of accounting should only be used if the approved plan for liquidation differs from the initially specified plan. Private equity funds are typically limited-life entities, so if the private equity fund follows its governing documents when ceasing its operations, it would be exempt from applying the liquidation basis of accounting.
Application of the Liquidation Basis of Accounting
The general concept underlying the liquidation basis of accounting is to report the amount of cash or other consideration that an investor might reasonably expect to receive after liquidation. As such, assets and liabilities that are recorded on the books in liquidation basis financial statements may differ from assets and liabilities that are recorded under non-liquidation GAAP (going-concern basis).
Assets shall be measured using the estimated amount of cash or other consideration that is expected to be collected in their settlement or disposition, less reasonably predictable costs of completion and disposal. This may differ from fair value as defined by U.S. GAAP. Fund managers evaluating investments under the liquidation basis of accounting should carefully consider whether fair value approximates the consideration expected to be collected as the ASU specifically states that such a presumption shall not be made.
Liabilities shall be recognized and derecognized in accordance with previously issued GAAP and adjusted to reflect changes in assumptions that are the result of the decision to liquidate (i.e., timing of payments). No assumption shall be made of being legally released as the debtor.
Costs that are expected to be incurred and income expected be earned through the end of the liquidation period should be accrued if and when there is a reasonable basis for estimation on a non-discounted basis.
All estimates should be reevaluated to determine whether they are appropriate at each reporting date.
Financial Statements and Related Disclosures
The liquidation basis of accounting requires, at a minimum, the following financial statements:
- Statement of net assets in liquidation
- Statement of changes in net assets in liquidation
Additional statements, such as a statement of cash flows or schedule of investments are not specifically addressed in the ASU. We recommend that investment funds continue to present such financial statements to the extent that they continue to be relevant.
In addition to all the disclosures required by other GAAP, at a minimum, the following should be disclosed:
- The financial statements are prepared using the liquidation basis of accounting, including the facts and circumstances surrounding the adoption of the liquidation basis of accounting and the determination that liquidation is imminent.
- Description of the plans for liquidation, including a description of each of the following:
- The manner in which it expects to dispose of its assets,
- The manner in which it expects to settle its liabilities, and
- The expected date for completion of the liquidation.
- The methods and significant assumptions used to measure assets and liabilities including any subsequent changes to those methods and assumptions.
- The type and amount of costs and income accrued in statement of net assets in liquidation and the period over which those cost are expect to be paid or income earned.
The provisions of the ASU are effective when it is determined that liquidation is imminent during annual reporting periods beginning after December 15, 2013 and any interim reporting periods therein. Early adoption is permitted. The ASU should be applied prospectively.
Financial Services Insights – July 2013