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International Financial Reporting Standards for Hedge Funds


Date: Monday, September 15, 2008
Author: Robert Roley, Advent Software

 What about IFRS in the U.S.?

The U.S. is almost the only major capital market that has not yet adopted or committed to adopting IFRS, but it seems that this may be changing soon. In August 2007, the SEC issued a "concept release" soliciting input on whether U.S. registrants should be permitted to have the option to prepare their financial statements using IFRS or GAAP for SEC reporting purposes. The majority of comments received on the concept release expressed support for permitting IFRS for U.S. registrants. In December 2007, the SEC held additional roundtables with similar results. On Aug. 27, 2008, the SEC staff recommended that they adopt a roadmap that could lead to mandatory use of IFRS by U.S. companies beginning in 2014.

But why should U.S.-based hedge fund or fund administrators start considering IFRS now? IFRS provides an opportunity for reduced complexity, greater transparency, increased comparability and improved efficiency to investors, capital markets and companies, which is why many countries, including the U.S. are either considering or are in the process of adopting IFRS. Another important reason to start considering IFRS today is because adoption of IFRS in the U.S. is likely inevitable. On Aug. 27, 2008, SEC Commissioner Elisse Walter said, "The world should make no mistake: The SEC is serious about moving to IFRS as the governing accounting standards."

Is it just accounting policies that need to change?

The adoption of IFRS affects more than a company's accounting policies and financial reporting. Many aspects of an organization's business could be affected, including a transformational impact on financial reporting systems, internal controls, taxes, treasury and cash management with an extended impact on employees, processes and systems.

Accounting Differences between IFRS and U.S. GAAP

The differences outlined below are not intended to be an all inclusive list but highlight significant differences between IFRS and GAAP relevant to hedge funds. Some of the most notable differences include:

  • Industry Specific Guide—In contrast to GAAP which provides industry specific guidance for investments companies1, IFRS does not provide industry specific guidance. In fact, hedge funds use the same financial reporting standards that apply to other companies across all industries.

  • Consolidation—Under IFRS, a fund should be consolidated by its controlling party. The identity of the controlling party will depend on the following factors: (i) the ability of the investment manager to make real investment and other decisions; (ii) the existence of any rights to remove the investment manager; (iii) the existence of any other interest held by the investment manager or its affiliates in the investment entity; and (iv) any other statutory, contractual, legal or regulatory constraints on the power of the investment manager. Therefore, an investment manager with real decision-making powers who cannot be removed immediately and who has a significant economic interest in a fund may have to consolidate that fund under IFRS. The consolidation model under IFRS does not provide exemptions to investment companies. For example, and unlike GAAP, when a feeder fund has control over its master fund, the master fund should be consolidated into the feeder fund.

  • Investments—Unlike GAAP, which requires all investments to be recorded at fair value, IFRS would permit classifying investments as either (i) fair value through profit or loss (held for trading or designated under fair value option); (ii) available-for-sale; (iii) held-to-maturity or (iv) loans and receivables. The subsequent measurement attribute is based on the elected classification. Generally held-to-maturity classification is not possible for hedge funds and in practice hedge funds typically classify their investments as fair value though profit or loss (either held for trading or designated under fair value option).

  • Fair Value—IFRS has not yet adopted fair value measurements guidance similar to FAS 157 and as such GAAP differences still exist2. For example, under IFRS long positions must be valued at the bid price and short positions must be valued at the ask price while assets and liabilities with offsetting market risks may be valued at mid-market prices for the offsetting risk positions and at bid or asking price for net position as appropriate. Under GAAP, the use of mid-price is permitted as a practical expedient.
  • Transitioning to IFRS—Impact to Operations and Technology

    A firm wishing to switch from GAAP to IFRS or to produce reporting under both standards may require changes to their operational and technology environments. In many cases, the requirements for IFRS are less specific than GAAP and as such, in many cases treatment under GAAP will work for IFRS. However, some differences require different accounting treatment or reporting and therefore will impact how firms operate and account for their investment activity. High level considerations include:

  • Pricing—Firms that are currently valuing investments using only the mid or closing price under GAAP will need to accommodate additional bid and ask prices for valuing their assets. Depending on how firms gather prices and value their investments, this may represent a technology change as many firms are using technology to automate the process of price collection and position valuation.

  • Trade vs. Settle Date Representation—Firms moving to IFRS who want to report initial recognition of positions as of settle date will need to ensure they are capturing settlement date information. Firms that are tracking positions for GAAP only based on trade date may not be capturing settle date information today.

  • Transaction Costs—Under GAAP, transaction costs are often recognized as part of an investment's cost basis. As such, firms may not be tracking these separate from investment cost. Under IFRS, transaction costs may need to be expensed. Firms that are not currently differentiating transactions costs from the investment cost will need to identify transaction costs so that different treatments may be applied.
  • Reporting Specifics

  • Statement of Cash Flows—This statement is required for IFRS even for firms that may be exempted under GAAP. For firms that currently provide this under GAAP, the potential exists for classification differences. In both cases, firms will need to capture cash activity with enough detail to generate the Statement of Cash Flows and classify appropriately on statements.

  • Amortization—Premiums and discounts must be amortized under GAAP. With IFRS, there may not be a need to segregate amortization from market gain (or loss) as the investments carried at fair value will show the P&L through the fair value.

  • Classification of Investor Ownership—GAAP classifies owner interest as equity. Under IFRS, ownership may be expressed as equity or as a liability when the interest is redeemable by the investor. In addition, IFRS requires that investor capital be split between share capital, premium, and surplus. Firms who were not previously tracking different types of ownership may need to do so in order to report accurately.

  • Recognition of Unrealized and Realized Price and Currency Gain—Under GAAP, firms should distinguish between realized and unrealized and price and FX gain. IFRS does not require this. This is an example where GAAP is more specific, and while this may not change current operations for a GAAP firm adopting IFRS, it may require technology to report both ways without manual effort to combine gains for IFRS.

  • Functional Currency—It is possible for a fund to have different functional currencies under GAAP vs. IFRS. If this is the case, firms now need to ensure additional FX rates to and from additional functional currencies are captured, and must have the ability to restate in multiple currencies.

  • Segment Reporting—IFRS requires separate sub-reporting for business unit or geographic segments. Firms will need to track and associate all investment activities to the appropriate segments.

  • Risk Reporting—IFRS 7 requires disclosures related to the nature and extent of risk exposure of investments. The types of risk that must be reported include credit risk, liquidity risk, interest rate risk, market risk, and currency risk.
  • System Considerations

    From a financial reporting perspective, firms wanting to provide IFRS reporting in addition to GAAP will want to leverage technology in a number of ways. Ideally, firms should be able to produce compliant statements for both standards from the same system with minimal incremental overhead.

    There are three prominent themes that we see in how an accounting and reporting platform can support these requirements. First, the system must allow firms to capture any required additional data needed to ensure proper treatment and reporting of accounting results. Second, the system must be flexible enough to apply different sets of accounting rules to the same underlying data sets. In the case where a fund may need to report in both standards, this is critical as the alternative is tracking a second complete set of books. And third, the system must be able to present the results in ways that are compliant with both standards without ongoing manual intervention.

    Conclusions

    As long as their remains divergence in the accounting standards, firms wishing to adhere to multiple standards or switch from one to another have several things to consider. First, firms must analyze the accounting differences as they relate to them between the standards. This document attempts to identify those differences specific to hedge funds, at a high level. Second, they must examine how accommodating a new standard will impact their organization, in terms of process and in terms of technology. When technology is a major component of the firm's accounting environment, they must examine how their systems can or cannot meet their needs and what type of configuration or customization is necessary.

    1—AICPA Audit and Accounting Guide, Investment Companies.

    2—The IASB issued a discussion paper on fair value measurements in November 2006 which is based on FAS 157, Fair Value Measurements.

    Robert Roley is a Senior Consultant at Advent Software. Advent's web site can be found at www.advent.com .