As investment funds continue to face challenges in meeting performance benchmarks and as investors become less tolerant of paying management fees for underperformance, many fund managers are determining that liquidating their funds is the best course of action. As a result, questions concerning the implementation of  the Financial Accounting Standards Board (FASB)accounting and financial reporting guidance on adopting the liquidation basis of accounting are becoming more frequent. This guidance is a byproduct of the FASB’s going concern project and provides much needed guidance that addresses when to adopt the liquidation basis of accounting and how to report net assets and changes in net assets during the liquidation period.

The Provisions of the Accounting Guidance

The main provisions of the guidance revolve around determining when to apply the liquidation basis of accounting and how to present financial statements and disclosures on that basis. An investment fund should adopt the liquidation basis of accounting when liquidation is imminent or when the likelihood of returning from wind down mode is remote. The likelihood of returning from wind down mode is considered remote when a plan of liquidation is approved by the persons with the authority to make a plan of liquidation effective, and the plan is unable to be blocked by other parties; or when liquidation is imposed by outside parties, for example involuntary bankruptcy.

Once the liquidation basis of accounting is adopted, the assets and liabilities of an investment fund should be measured at estimated collection or settlement amounts (net realizable value). The following financial statements, at a minimum are required to be presented upon adoption of the liquidation basis of accounting:

  • Statement of Net Assets in Liquidation
  • Statement of Changes in Net Assets in Liquidation

Financial statements should disclose the investment fund’s plan of liquidation and its effect on the fund’s financial statements. A condensed schedule of investments, the statement of cash flows and financial highlights of the fund should continue to be presented as long as they remain relevant.

When an investment fund determines that it is appropriate to apply the liquidation basis of accounting, the estimated costs to dispose of assets and the estimated costs and income expected to be incurred or earned during the liquidation period should be accrued if and when the investment fund has a reasonable basis for estimation. Such costs might include legal fees, management and incentive fees and administrative costs. In recognizing income earned during the liquidation period, expected earnings on assets would not be recognized when those earnings are already reflected in the net realizable values of the assets of the investment fund. Accruals for income earned and costs incurred during the liquidation period should not be discounted and estimates of income earned and costs incurred should be reevaluated at each subsequent reporting date.

Challenges for
Investment Funds

Determining the costs incurred during the liquidation period could present challenges because certain costs are dependent on how long the entity will exist under the liquidation basis of accounting. An investment fund should undertake efforts to evaluate how long it will take to liquidate and develop an estimate of future expenses to be incurred during the estimated liquidation period. Depending on facts and circumstances, there may be significant uncertainty, requiring management of the fund to use significant judgment to determine how long it will take to liquidate a fund’s illiquid assets. If a reasonable basis for estimating the costs incurred and income earned during the liquidation period cannot be determined, this should be disclosed in the notes to the financial statements.

In certain cases, liquidation value may not equal fair value. An example of when net realizable value may differ from fair value is when an investment fund determines that it cannot dispose of illiquid investments during the liquidation period in an orderly fashion such as in a distressed or forced sale. Although in some cases fair value may be an approximation of the amount an investment fund expects to collect, an investment fund should not presume this is true for all assets.

The adoption of the liquidation basis of accounting is applied prospectively, which means during that year of adoption, an investment fund could have a period of operations, changes in net assets and cash flows to report on a going concern basis and an additional period of changes in net assets in liquidation to report on the liquidation basis of accounting. While the accounting guidance does not require separate presentation for the period preceding adoption of the liquidation basis of accounting, an investment fund should consider the requirements of its regulator and the needs of any other users of an investment fund’s financial statements. A registered investment adviser is required to prepare financial statements covering an entire annual period for a fund(s) that it advises to comply with the annual audit provision under the SEC’s Custody Rule. These financial statements would, at a minimum, include statements of operations, changes in net assets and cash flows for the period preceding the adoption of the liquidation basis of accounting and a statement of net assets in liquidation as of the measurement date and a statement of changes in net assets in liquidation for the liquidation period.

Exceptions to Applying
the Liquidation Basis
of Accounting

The accounting guidance does not apply to the following investment funds or situations:

  • Funds registered under the Investment Company Act of 1940
  • Funds being merged or acquired
  • Limited life entities; such as private equity funds that are liquidating in accordance with a plan of established at the inception of the fund and that is outlined in its governing documents. Judgment is required as to whether this exception is met when a plan of liquidation deviates slightly from the pre-establish plan.