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Accounting challenges

In a dynamic environment stemming from changes in international accounting standards, hedge fund administrators, investors and managers all need to understand that the accounting challenges hedge funds can pose should not be underestimated.

This is especially true for a jurisdiction such as Guernsey, which allows funds to used any recognised form of Generally Accepted Accounting Principles, at a time when UK accounting standards are evolving toward the international (IFRS) principles, which themselves have changed, and when hedge funds are also facing new accounting requirements in the United States.
The main issue affecting funds is a change in the way the fair value of investments should be determined. Under the UK and IFRS accounting principles, the fair value of a listed investment is its bid price, and for non-listed investments there is a requirement to use some kind of accepted valuation techniques.

Before this new approach, the accounting rules simply required administrators to determine the market value of an investment. For listed instruments this allowed a midprice to be used, while the administrator of a fund of hedge funds could take prices from the administrator of the underlying fund. This has major implications in particular for administrators of funds of funds, which in valuing underlying investments must now consider the structure of the fund in question, whether it is open- or closedended, how instruments within the fund should be priced, and what is a realistic expectation of the price that could be obtained on exiting the underlying fund.

Another issue involves hedge funds that use derivatives. Managers of such funds that use synthetic positions involving perhaps four or five options would price the position as a whole, since that is the way their strategy works. However, the accounting rules now require a bid value to be placed on each option separately, which could lead to volatility in the fund's financial statements.  This may also result in a discontinuity between the regular periodic valuations provided by the manager and the fund's annual accounts, because the regular valuations - daily, weekly or monthly - are liable to be carried out under a different set of principles from those that govern the annual financial statements.

For investors, this may mean that monthly valuations use mid-prices or whatever technique is set out in the fund's prospectus, while the year-end accounts use the new accounting standards, resulting effectively in a different NAV per share.
Eventually it may become best practice for administrators to use the same accounting basis for monthly valuations and annual financial statements, but there's no move towards this visible at present, and in the meantime it remains acceptable to reconcile the divergence between the two in the annual financial statements.

There's also the issue of whether it is practicable for a fund of funds administrator to do anything apart from accepting the estimated price from the administrator of an underlying fund at month-end in order to calculate their own NAV for the purposes of dealing.

Meanwhile, in the US, auditors of some funds are now required by the SEC as part of their audit to obtain independent price quotes from third parties for all investments where a quoted price is available. While this goes against the traditional audit method of testing on a sample basis, it is designed to capture a situation where a manager is pricing investments with no reference to the market. This may be relevant to simple hedge funds, but for the more complex sectors this could have a huge impact as no two people are likely to price a complex strategy in the same way. Fortunately there's no sign at present of this approach being applied by regulators on this side of the Atlantic.

By Neale Jehan - Neale Jehan is an executive director with KPMG Channel Islands in Guernsey

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