Investment entity assessment for a development finance institution

Whether a development finance institution (DFI) is an investment entity changes the whole shape of its financial statements. If it qualifies, it must not consolidate the portfolio companies and holding vehicles it controls; it measures them at fair value through profit or loss and consolidates only subsidiaries that provide investment-related services to it. If it does not qualify, every controlled investee, including an operating company in which it took a majority stake to rescue it, is consolidated line by line, with goodwill, non-controlling interests and the investee's revenue and debt on the group's face. DFIs are borderline cases: a single sovereign shareholder, a development mandate alongside the return objective, and often a large book of senior loans that management evaluates on yield and credit quality rather than on fair value. A wrong conclusion misstates total assets, profit, leverage and every capital ratio the shareholder and rating agencies read.

Does the DFI obtain funds from one or more investors (including a single government shareholder) and provide them with investment management services? Is its business purpose, as documented in its charter, strategy and communications to the shareholder, to invest solely for capital appreciation, investment income or both, and is the development mandate a criterion for selecting investments rather than a source of other benefits (such as strategic access to resources or below-market supply) for the DFI or its shareholder? Are substantially all investments, including debt investments, measured and evaluated by management and the board on a fair value basis, or is a large senior loan book managed on yield, impairment and credit metrics? Are there documented exit strategies for equity investments? Which typical characteristics are absent (more than one investment, more than one investor, unrelated investors, ownership interests in the form of equity) and how is the conclusion supported despite their absence? Which subsidiaries provide investment-related services (advisory, monitoring, fund management) and are not themselves investment entities?

1. Test the three elements of the definition: funds obtained from investors to provide investment management services; a business purpose of investing solely for capital appreciation, investment income or both; and measurement and evaluation of substantially all investments on a fair value basis.
2. Analyse the development mandate: identify whether the DFI or its shareholder obtains benefits from investees other than capital appreciation or investment income, and whether investments are held for strategic or policy reasons that are inconsistent with the business purpose test.
3. Assess the fair value element against how the board and management actually monitor performance; a senior loan book managed on amortised cost, yield and impairment, if significant, usually prevents the DFI from meeting the definition.
4. Assess the typical characteristics; their absence (common for a DFI with one sovereign shareholder) does not disqualify the entity but requires a reasoned conclusion and disclosure.
5. If the DFI is an investment entity, measure all subsidiaries at fair value through profit or loss under IFRS 9, without applying IFRS 3, and do not present consolidated financial statements if all subsidiaries are fair-valued.
6. Consolidate only those subsidiaries that are not investment entities themselves and whose main purpose is to provide investment-related services or activities to the DFI.
7. Reassess the status when facts change and account for any change prospectively from the date of change.

Fair-valued subsidiaries are measured under IFRS 13, with changes in profit or loss. The unit of account is the DFI's investment in the subsidiary; shareholder loans to the subsidiary are separate financial assets under IFRS 9, normally also at fair value through profit or loss given the fair value management basis, although in practice they are often valued together with the equity and the combined value allocated between them. Intermediate holding vehicles that do not provide services are themselves fair-valued, so their underlying portfolio is captured through the holding vehicle's fair value rather than looked through. Service subsidiaries are consolidated at their carrying amounts with intragroup balances and fees eliminated. Investments in associates and joint ventures are measured at fair value through profit or loss using the IAS 28 election, consistent with the fair value element of the definition.

Disclose: (1) the significant judgments and assumptions made in concluding that the DFI is (or is not) an investment entity, including how the development mandate was assessed; (2) where one or more typical characteristics are absent, the reasons for concluding that the DFI is nevertheless an investment entity; (3) the fact that the consolidation exception is applied; (4) for each unconsolidated subsidiary, its name, principal place of business and ownership interest; (5) significant restrictions on the ability of unconsolidated subsidiaries to transfer funds (for example foreign exchange controls in the investee's country), commitments and intentions to provide financial or other support, and any support provided without a contractual obligation; (6) the effect of any change in investment entity status on the financial statements; (7) the IFRS 13 disclosures for the fair-valued subsidiaries.

• Concluding that a DFI cannot be an investment entity simply because it has a single government shareholder
• concluding that it is one without evidence that the board actually evaluates performance on fair value
• ignoring a significant senior loan book that is managed on an amortised cost and credit basis
• fair-valuing a subsidiary whose main purpose is to provide advisory or monitoring services to the DFI
• consolidating the investees of an intermediate holding vehicle instead of fair-valuing the vehicle
• applying IFRS 3 and recognising goodwill on acquiring control of a portfolio company
• applying the equity method to associates while claiming investment entity status
• omitting the disclosure of reasons where typical characteristics are absent