Click here for printer friendly page

International accounting standards: impact on private equity

Preparations continue apace for the introduction of International Accounting Standards, which will apply to the consolidated accounts of European listed companies from January 2005, says Victoria Kershaw at SJ Berwin. And two aspects of the consolidation requirements in IAS 27 cause concern to the private equity industry.

Since we last reported on the issue in the Spring, the EVCA, BVCA and other industry organisations have continued to lobby to secure amendments to IAS 27 (Consolidated and Separate Financial Statements).

IAS 27 requires a parent company to consolidate its investments in subsidiaries (broadly, those entitles which it controls) unless certain conditions are met which allow it not to prepare consolidated accounts. The standard makes it clear that the requirement to consolidate applies to venture capital organisations, mutual funds, unit trusts and similar entitles. The only exemption permitted is where the investment is to be disposed of in the near future; in practice, this is unlikely to extend beyond a one year time horizon.

Two aspects of the consolidation requirements in IAS 27 cause concern to the private equity industry. The first issue concerns the accounts of manager companies and general partners who have nominal interests in the funds, but have extensive powers of control to manage the investment portfolio on behalf of the fund. The definition of control in IAS 27 might require these companies to consolidate the entire investment portfolio (where the fund has majority holdings) into their own accounts.

The second issue concerns the accounts of the funds themselves. As it currently stands, the funds may be required to consolidate their investment portfolio of majority holdings. The industry believes that the fund’s accounts will be much more meaningful if they reflect the fair value of the fund’s investments in portfolio companies (as is the current practice).

The good news is that changes to IAS 27 are part of the formal agenda of the International Accounting Standards Board and are being considered in their monthly meetings. IFRIC (the International Financial Reporting Interpretations Committee) has been asked to look at the detailed definition of control in IAS 27, and the IASB and IFRIC have concluded that powers of control in a fiduciary capacity should not satisfy the control definition, even if they can direct the underlying investment's strategic financial and operating policy. This is positive news as far as the accounts of general partners and managers are concerned.

The IASB is currently developing the criteria which will be applied in determining whether a fiduciary will meet the control test. For more information see the June 2004 edition of IASB Update and the Observer Notes on Consolidation prepared for the World Standard - Setters’ Meeting in September 2004, both available at www.iasb.org.

Regarding the second issue (fund accounts), there is a similar debate in progress in the United States. With this in mind, the IASB is reported to have decided to defer consideration of the issue until the US Financial Accounting Standards Board (FASB) has reached its own conclusion. The early signs are that the US will favour a fair value approach for investment companies, which would include private equity funds. So this should also be good news, as it is the IASB's intention to avoid major US/international GAAP differences where possible.

An exposure draft on changes to IAS 27 is due out in the final quarter of 2004, and it is to be hoped that it will address these issues.

Companies that are not listed are under no compulsion to adopt the standards, although they may have the option to do so under national implementing legislation. Whilst the benefits of uniform reporting standards across Europe are expected to result in many unlisted companies choosing to voluntarily adopt the standards, the private equity industry may, unless IAS 27 is amended, buck this trend in order to be able to fair value account for their investments in portfolio companies.

Status of endorsement process
Meanwhile, the banking sector has been campaigning hard for changes to IAS 39 (Financial Instruments), which has attracted the bulk of the press coverage on IAS.

The European Union Regulation that implements IFRS in Europe requires the application of international accounting standards that have been adopted for use in the EU. A standard issued by the IASB must be adopted by the European Commission before it becomes part of the mandatory requirements of the IAS Regulation. Currently, the only standards that remain outstanding for approval are IAS 32 and IAS 39. On 8 July of this year, the European Financial Reporting Advisory Group (EFRAG) – the technical advisory group that advises the EC on the suitability of standards for adoption -published the conclusions of its review on the standards.

It recommended that the EC adopt IAS 32, but did not have the necessary majority to recommend adoption of IAS 39. Since then, certain deletions have been proposed to IAS 39 that would apply for a transitional period, which might prove to be an acceptable political compromise. Once the EFRAG has made its recommendation on IAS 39, the Commission itself has until late October to approve the new rules.

Assuming that an amended IAS 39 is the outcome, European listed companies will therefore have the choice of adopting the full standard or “IAS 39-lite” approved by the EC. Those which also have listings in the US are likely to comply with the full standard, as it is based on US reporting rules. Although it is unfortunate that there is divergence between the US and international standards on disclosure of derivatives – given that one of the aims of the project was to achieve a set of standards that would be acceptable in the US – it at least achieves a degree of certainty that should be welcomed.

Further changes have also been proposed to the standard by the IASB in its recently issued Exposure Draft 7, although if approved these would not take effect until January 2007.

For more information on the impact of international accounting standards on private equity please email the author, Victoria Kershaw (victoria.kershaw@sjberwin.com).

SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris and Brussels. If you would like further information on its services to the private equity industry please contact Jonathan Blake or Simon Witney in its London office +44 (0)20 7533 2222 or visit our website at www.sjberwin.com