EC is advised not to grant IAS 27 exemption

Private equity firms in Europe will probably have to supply consolidated accounts to their investors after accounting standard IAS 27 looked set to be applied to them.

The European Private Equity and Venture Capital Association (EVCA) is attempting to look on the bright side after an exemption for private equity firms from International Accounting Standard 27 (IAS 27) looked increasingly unlikely.

IAS 27 forms part of the ‘Improvements to International Accounting Standards’ being drawn up by the London-based International Accounting Standards Board (IASB). It stipulates that companies prepare consolidated accounts, meaning that financial information relating to a parent company and all its subsidiaries will have to be presented as if the group were one single entity.

The EVCA had lobbied for an exemption for private equity firms on the basis that meshing together the accounts of private equity funds’ underlying portfolio companies into a homogeneous entity would be misleading for investors in those funds. It argued that such accounting would fail to reflect that companies in a private equity portfolio of direct investments are typically at different stages of development.

The European Financial Reporting Advisory Group (EFRAG), a group of financial reporting experts that interprets IASB standards for application in Europe, has advised the European Commission to adopt IAS 27 with no exemption at this stage. This means IAS 27 will be applied to private equity firms unless the Commission rejects EFRAG's advice.   

However, IAS 27 demands consolidated accounts only be produced where ‘control rights’ are exercised. In an endorsement letter to the Commission sent earlier this month, EFRAG stated that ‘concerns with IAS 27 and consolidation might be significantly reduced if the issue of control were to be clarified’.

This appears to potentially benefit private equity firms in cases where they can demonstrate that they do not exert control over portfolio companies. One interpretation is that control rights do not exist where a private equity firm has only a minority interest in a portfolio company – this could mean IAS 27 would not apply to investors happy to retain only minority stakes in portfolio companies.

However, EVCA has a concern that there may in fact be more to the concept of control than simply how large a stake is being taken in a target company. For example, it is concerned regulators may take the view that control is also being exercised if general partners of a private equity fund are appointed non-executive directors to a portfolio company’s board.

In its letter to the Commission, EFRAG said that it was seeking to clarify this point. The IASB is currently working on 'new rules for consolidation' which are expected to be published in late 2004 and which cover the definition of control – these rules will need to be endorsed by the Commission to become mandatory.    

While it now seems as though consolidated accounting of some kind at the portfolio level is increasingly likely, EVCA chairman Jean-Bernard Schmidt said in a recent interview he was pleased that the rules would at least continue to make a distinction between the management company of a private equity firm and its funds under management.

Schmidt also said he anticipated that the planned global harmonisation of accounting standards could eventually lead to the adoption in Europe of US GAAP standards, which are expected to grant an exemption from consolidated accounting to investment companies.

Nevertheless, IAS consolidation rules are due to be applied in January 2005, at which point it appears private equity firms will be confronted with an unwanted administrative burden that GPs will argue does nothing to meet their investors’ demands for greater transparency.