Cash Flow Reporting: Key Criteria for Investment Companies
For investment companies, the Statement of Cash Flows is not always a requirement in financial reporting, however there are situations and conditions, when it becomes a crucial component of their semi-annual and annual reports. Statement of Cashflows, tracks the movement of cash within a company across operating, investing, and financing activities, it also provides essential insights into a company’s liquidity, financial health, and ability to generate cash.
While many businesses must regularly present a cash flow statement, investment companies do enjoy an exemption, under specific (limited) circumstances. In order for an investment company to qualify for this exemption, an investment company must meet three important criteria that are often open to interpretation.
This article will explore these conditions and criteria’s in detail to understand when the exemption applies and when the statement of cash flow is required.
1. Substantially All Investments Are Carried at Fair Value
The first condition for the cash flow statement exemption involves the valuation of an investment company’s holdings. To be specific, the company must ensure as well as guarantee that almost all of its investments are carried at fair value during the period presented.
Fair value is a pricing method which describes the present market valuation of an asset as opposed to its previous price or book valuation. Also as investments, they are divided into a fair value hierarchy that has three levels (Level 1, 2, and 3) according to the reliability of the data to estimate the value: investments.
To satisfy the exemption criteria as an investment company, the largest proportion of investments- most of the time 90% or more- must be classified as either Level 1 or Level 2 of the fair value hierarchy. Investments that constitute Level 3, which are usually more difficult to value and require significant judgment or estimates within the cash flow statement to trigger, are classified as such. If the Level 3 investments exceed 10% of total portfolio investment of the company, then it gets triggered for a requirement of cash flow statement. This ensures that only companies with highly liquid, market-based investments (i.e., those with more reliable valuation metrics) are eligible for the exemption.
2. Limited or No Debt Outstanding
The second exemption criterion is with respect to the level of debt in an investment company. More particularly, the company should have virtually no outstanding debt during the period reported. Unlike other businesses perhaps very much reliant on debt, an investment company functions with relatively low borrowings. By this, we mean borrowings from all forms, such as line of credit draws, margin borrowings, and bank overdrafts. However, it is worth noting that certain other financial instruments, such as collateralized short sales and written options (if stand-alone outstanding), do not count against this calculation of debt. An amount of 10% is set aside as the threshold for determining whether an enterprise has "little or no debt". This means that on average, the amount of debt outstanding during the period must be less than 10% of the company's average gross assets. At a point of debt exceeding this limit, a cash flow statement is required from the company.
3. Statement of Changes in Net Assets is Presented
The final condition for such exemption is a relatively simple one, in that the investment company has to show a Statement of Changes in Net Assets. Such a statement gives an analysis of what differences have taken place in the net assets of the company over time due to investment gains, distributions, and any other new funds raised. This document essentially holds the position of a cash flow statement by clearly indicating with respect to what has changed within the investment company's financial position for the time period in question.
The Practical Implications of These Exemptions The cash flow statement exemption for investment companies has been placed in financial reporting facilities for firms only with simple financial structures. These exemptions, however, have definite definitions and thresholds that must be duly qualified.
Let us, for example, consider a real-life situation regarding the qualifications above. An investment company keeps a positive cash position at a broker, and at the same time has a margin. In a case when the investment company has a short account (with cash collateralizing short positions) and a margin account, the resulting net debt must be accounted for in calculating average debt outstanding. This may lead to the company exceeding the 10% threshold, making a statement of cash flows necessary despite having what appears to be a "positive" cash balance.
This indeed plays a significant role for the investors and analyst. The statement of cash flows can tell how much the investment company has managed its liquidity, how much debt it is maintaining, how funds are allocated, etc. In its absence, it reduces the level of information about the cash flow operations to affect investor decisions.
Conclusion
Investment companies need to recognize the tests that trigger the need for a Statement of Cash Flows in order for an investment company to comply with regulatory requirements and be transparent. The company with all the three conditions - significant fair value investments, low debt, and Statement of Changes in Net Assets - can qualify to be exempted from the cash flow statement requirement. On the other hand, companies above these limits must ensure the provision of full cash flow reporting as one of the documents that help in communicating the financial health and stability of a business.
As the investment companies continue to move on further concerning the intricate requirements, it is necessary for an investor, analyst, or stake-holder to be aware of these conditions as they will help in evaluating a company with respect to its liquidity and financial performance in general. Contact info@aifundservices.com for more details about the exemption.
