JFA Accounting Update 29 March 2011
Your presenters Andrew Quinn Over 13 years experience within the financial services sector Has extensive experience across a whole range of offshore financial services including banking, funds, trust companies, investment companies and special purpose vehicles and currently acts as engagement director responsible for the delivery of audit and other assurance services to subsidiaries and affiliates of KPMG s major local and global clients. Member of the Jersey Society of Chartered and Certified Accountants Executive Committee 1
Your presenters Nick Stevens 10 years experience within the financial services sector of KPMG, involving two years with KPMG in London working on various alternative investment clients. Acts as engagement director for a number of alternative ti investment clients, mainly private equity, mezzanine funds and hedge funds. A member of KPMG s Private Equity Group 2
Agenda Let s put things in context A basic GAAP comparison for funds Of increasing importance: Investment Company accounting A classic problem area: fair value and 1-3 level hierarchy Forthcoming developments: IFRS9 Leasing rules for property funds The demise of UK GAAP? Investment Company rules for IFRS Qualifying Limited Partnerships SEC registration (Dodd-Frank) Audits of funds: what we look for 3
Let s put things in context
Let s put things in context LEGAL STRUCTURES Company (including PCCs and ICCs) Unit Trust Limited Partnership p LLP REGULATORY STATUS COBO only / private Expert Fund (CIF) Recognised Fund (CIF) Listed Fund (CIF) Unregulated Fund Unclassified Fund ASSET CLASSES Retail / long only Private equity Hedge Real estate Infrastructure I f t t Hybrid / other LIQUIDITY ARRANGEMENTS Closed ended Open ended lock ins, side pockets Gates, lock-ins, 5
A basic GAAP comparison for funds
Key trends Convergence between IFRS and US GAAP Global GAAP convergence Phasing out of UK GAAP in favour of IFRS UK managed funds continue to favour UK GAAP Rest-of-world except US managed funds tend to expect IFRS Generally, US GAAP increasingly seen depends on the investors 7
Fund accounts US, IFRS and UK GAAP US GAAP Rule driven focus Investment Company accounting rules Can be painful, particularly if only one investor wants it Dominates US based funds industry, increasingly seen in the Channel Islands 8
Fund accounts US, IFRS and UK GAAP UK GAAP UK accounting standards, not UK Companies Act type provisions Relatively simple in content compared with US GAAP or IFRS SORPs IMA, rarely seen in Jersey funds 9
Fund accounts US, IFRS and UK GAAP IFRS Less common among PE and other alternative funds Continually changing g (IFRS7, IFRS8 and now IFRS9) A long set of accounts with arguably unnecessary disclosures No consolidation exemption for majority owned investments BUT: new Investment Company rules on the horizon 10
What is LP GAAP? Choose your own accounting policies (within reason) Does not work for statutory vehicles those that require a true and fair view Commonly used where funds cash account for investment income want to minimise impact due to changes in standards year after year avoid other issues such as consolidation do not want to include extensive disclosure requirements (e.g. IFRS7) But must be flexibility in LPA Audit opinion prepared in accordance with the accounting policies 11
A basic GAAP comparison for funds UK GAAP IFRS US GAAP LP GAAP Format Balance Sheet Statement of Financial Position Statement of Position What you want (within reason) Profit and Loss FV gains/ losses to STRGL (unless listed or adopting FRS26/29 optionally) Some Cash Flow Statement exemptions Statement of Comprehensive income FV gains/ losses to Statement of Comprehensive income No exemption Statement of Operations FV gains/ losses to Statement of Operations No exemption 12
A basic GAAP comparison for funds UK GAAP IFRS US GAAP LP GAAP Investment valuation Fair value Fair value Fair value What you want (within reason) Risk disclosures Cost less impairment Optional for nonlisted funds Generally not available Extensive risk disclosures required (IFRS7) inc fair value level 1-3 disclosures Not available financial highlights + fair value level 1-3 disclosures Schedule of Not required Not required Required investments 13
A basic GAAP comparison for funds UK GAAP IFRS US GAAP LP GAAP Fund consolidation True and fair override Not available Investment Company rules What you want (within reason) Held for resale Not available if held over 12 months No consolidation policy = qualification Avoid IFRS if you do not want to consolidate 14
A basic GAAP comparison for funds UK GAAP IFRS US GAAP LP GAAP GP consolidation True and fair override Not available Not available What you want (within reason) Proportional consolidation Substantive kick-out rights Not available Substantive kick-out rights Not available Substantive kick-out rights & Participating rights 15
Of increasing importance: Investment Company accounting
Of increasing importance: Investment Company accounting A purpose-built set of accounting rules for funds under US GAAP Offers several exemptions from other standards, notably consolidation Primary US GAAP source: AICPA Audit and Accounting Guide, Investment Companies What is an Investment Company? An entity that pools funds to provide shareholders with professional investment management Is a legal entity Undertakes investment t activity it Has unit ownership (e.g. partnership interests) has to be multiple investors Covers all forms legal entities set up as funds, such as a limited partnership. Covers all types of PE funds, hedge funds, ETFs, offshore/onshore funds etc Soon to become an important t part of IFRS! 17
Investment Companies treatment of investments All investments held at fair value IPEV valuation guidelines are consistent with US GAAP Investments are always trade date accounted for FX can be separated from fair value or combined Discounts/premiums on debt securities are amortised using effective interest rate method, except for payment in kind (PIK) debt (which is fair valued) 18
Investment Companies consolidation Consolidation by an investment company of an investment is not appropriate Limited clear guidance and varying market practice around consolidation of investment holding od gspvs On the one hand, they are a part of the investment therefore should not be consolidated But could consolidate on the grounds that they provide a service to the investment company Fund SPV Operating Group Senior Lenders 19
Investment Companies other points Schedule of investments, to include: Both cost and dfvf for each hinvestment, t in totality t or condensed dform Categorised by type of instrument (common stock, loan note etc) and related industry and geographic region Disclose the % of net assets for each category (or investment) Financial highlights section, to include: Total return or internal rate of return Investment and expense ratios Committed capital, year of formation, ratio of drawdowns to commitments etc. 20
A classic problem area: fair value and 1-3 level hierarchy
A Classic problem area Fair values and the level 1-3 hierarchy FRS29/IFRS 7 applicable for periods beginning on or after 1 January 2009 Requires the fair value hierarchy (basically a photocopy of FAS157) Level 1 quoted active market Level 2 valuation using observable inputs Level 3 valuation where there are some significant non-observable observable inputs However there is no bright line between active markets and inactive markets Characteristics of an inactive market Significant decline in the volume and level of trading activity Available prices vary significantly over time or among market participants Prices are not current 22
Assessing level in the fair value hierarchy Quoted price in an active market? Yes Price is adjusted? No Level 1 No Valuation technique applied Yes Any significant unobservable inputs? No Yes Level 2 Level 3 23
Examples of observable and unobservable inputs Examples of observable bl inputs Quoted prices in active markets for similar, but not identical, instruments Transaction prices in markets that are not active for similar, but not identical, instruments Interest rates derived from quoted bond prices Quoted foreign exchange and interest rates (e.g. forward currency rates and swap rates) Implied volatilities derived from quoted option prices Credit spreads derived from quoted credit default swap prices Examples of unobservable inputs Interest rates in a currency that are not observable and cannot be corroborated by observable market data for the term of the financial instrument being valued Volatility for a share option derived from the share s historical prices, as it does not generally represent current market expectations about future volatility A credit risk adjustment based on historical data on credit losses 24
Forthcoming developments
Forthcoming developments IFRS 9 Key points IFRS9 will eventually replace IAS39 in a process that will be carried out in 3 stages: 1. Classification and measurement dealt with in the current draft of IFRS9 2. Impairment proposes recognition of impairment losses over the life of the financial asset 3. Hedge accounting Categories of financial i instruments t will be simplified as follows IAS 39 IFRS 9 FVTPL Fair value (through PL or OCI) AFS debt AFS equity Amortised cost Held to maturity Loans and receivables The business model of the entity and the characteristic of the financial asset will determine the appropriate classification and measurement of financial assets Financial liabilities largely unchanged from IAS 39 except for accounting of fair value change due to changes in the entity s own credit risk Retrospective application required from 1 January 2013 but provides exemption for prior period restatement if applied from 1 January 2012 26
Forthcoming developments IFRS 9 What it means to Funds Review investment portfolio based on guidance for new categories Business model test purpose for holding the asset (e.g. collect contractual cash flows vs holding asset for appreciation in value) Characteristic of asset test terms of the asset gives rise to cash flows which represent payment of interest or principal or both The category fair value through OCI is only available to equity instruments and the decision should be made on an instrument-by-instrument basis. The decision to classify equity investments in this category is irrevocable. For equity investments, use of cost as approximation of fair value will be very limited. No significant change on accounting for financial liabilities of funds unless there are financial liabilities accounted for at fair value 27
Forthcoming developments Leasing rules for property funds Joint project between IASB and FASB Dramatic overhaul of lease accounting rules after 30 years does away with the operating lease, representing the majority of property lease rentals - no more off-balance sheet financing Ensures all leased property assets and associated liabilities are brought onto the lessee s balance sheet as a right-of-use asset and corresponding liability The lessor (e.g. a fund) in most cases continues to recognise the underlying property asset in full PLUS recognises: A new asset representing the right to receive lease payments A corresponding liability for obligation to deliver use of the underlying property asset Currently at ED stage, with new standard scheduled for release in Q2 2011. Effective date is TBC 28
Forthcoming developments Leasing rules for property funds Good news: Funds applying the FV option under IAS40 Investment Property are excluded from the changes - they carry on as normal Only those using the cost option will need to need to apply the new standard, with the following likely effects: Will lead to a grossing up in the fund s balance sheet Will increase the complexity of fund accounts and introduce net present value discounting May also affect fund performance ratios and loan covenants as more debt is coming on to the balance sheet 29
Forthcoming developments the demise of UK GAAP? In July 2010 the UK s ASB proposed a 3 tier reporting structure: Tier 1 publically accountable entities, full IFRS Tier 2 non-publically accountable entities, IFRS for Private Entities Tier 3 very small entities (less than 2.8m total assets and 5.6m revenue) - ASB s FRSSE A six month consultation process began last year ending 30 April 2011 Timetable seems to have moved back 18 months, so accounting periods commencing 1 July 2013 (with comparatives restated) Retail type funds will be considered publically accountable, with full IFRS In Jersey this means recognised funds, but possibly others? For PE type structures, IFRS for Private Entities will apply 30
Forthcoming developments Investment Company rules for IFRS Joint project between IASB and FASB A new exposure draft expected Q2 2011, but implementation of actual standard is some way off (3+ years?) Will result in radical changes to IFRS, especially for funds: Defines an Investment Company for the first time, based on US GAAP definition Will no longer be appropriate to consolidate investments that are controlled (PE funds) if the fund meets the definition of an investment company Controlled investments will be shown at FV on BS, with FV changes through profit or loss No longer the need for a technical audit qualification for PE funds or use of LP GAAP to carve out consolidation requirement Other US GAAP Investment Company features expected, such as Financial Highlights disclosures 31
Forthcoming developments Qualifying Limited Partnerships The UK government has proposed statutory changes for English limited partnerships An English limited partnership will become a Qualifying Limited Partnership if its general partner is a company (regardless of GP s jurisdiction). Many Jersey administered funds are structured as English LPs with a Jersey company as the GP QLPs will need to prepare accounts under full statutory UK GAAP Burdensome, with additional disclosures and formatting No LP GAAP permitted Ultimately a switch over to IFRS (consolidation!) 32
Forthcoming developments Qualifying Limited Partnerships The partnership financial statements will also become publically available Either via a filing with UK Companies House Or by being made available at the fund manager s head office The proposed changes are expected to come into force for accounting periods commencing 1 Jan 2012 The BVCA are lobbying against the changes as it may encourage fund partnerships to move offshore 33
Forthcoming developments SEC registration (Dodd-Frank) The Dodd-Frank Banking Reform Act broadens the definition of a Registered Investment Advisor to include certain foreign fund managers Unless exempt, these non-us fund managers will need to register with the SEC by 1 July 2011 AND apply the SEC s Custody Rule The Custody Rule is widely expected to be satisfied by the following: US GAAP fund accounts to be submitted to investors within 120 days (180 days for FOF); and Audit to be conducted on a US GAAS basis Effective for 31 December 2011 year ends - this may mean preparation of additional special purpose US GAAP accounts to satisfy the Custody Rule 34
Audit of funds: what we look for
Audits what we look for Objectives Key risks are addressed Financial statements are compliant with relevant GAAP Audit opinion i is appropriate Key concerns for fund audits Assets: valuation and existence Liabilities: completeness Profit and loss accounts: completeness and accuracy of key income and expenses. Investors capital accounts: accuracy Going concern: covenants, cashflow, liquidity etc Compliance with the LPA or PPM 36
5 Golden rules for preparing fund accounts Investors need to know: 1) How much they have put in 2) How much income has been earned on investments 3) How much they have been charged for management 4) How much has been distributed back 5) And most importantly what their investment is worth 37
Thank you ANY QUESTIONS?
Nick Stevens Tel: (01534) 608441 nstevens@kpmg.jersey.je Andrew Quinn Tel: (01534) 608439 andrewquinn@kpmg.jersey.je 2011 KPMG Channel Islands Limited, a Jersey company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International Cooperative ( KPMG International ). The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that t such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. KPMG Channel Islands Limited 5 St. Andrew s Place, St Helier, Jersey JE4 8WQ Tel: (01534) 888891 www.kpmg.com/channelislands