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Some hedge funds have trouble revaluing certain kinds of assets at the end of each period
The first written descriptions of accounting methods appeared 500 years ago.1 Double-entry accounting methods have evolved to accommodate the specialization that has developed in the economy, the new technologies that have been created, and the tremendous increase in size of businesses. The accounting principles and methods used for manufacturing and service firms are used with little change to account for leveraged investments in stocks, bonds, and commodities denominated in a variety of currencies.
ACCOUNTING PRINCIPLES APPLIED TO HEDGE FUND ACCOUNTING
Double-entry bookkeeping is used to account for hedge fund transactions and ownership interests of the investors. Hedge funds adopted methods from other types of portfolio investors and from broker-dealers to meet their special needs.
Most of the principles of accounting found in standard accounting textbooks apply with little or no reinterpretation. Take, for example, the principle of consistency. An accounting system should use consistent methods to calculate results from different periods. For an industrial corporation, the need for consistency rests on assuring that comparisons between periods result from the operation of the company and are not an artifice of changing methods. Results from several periods over time allow an investor to monitor the success and forecast results. The hedge fund investor must also track fund performance and cannot do so without a consistent accounting. More important, the investor contributes capital, receives allocations of performance, and redeems capital. It is even more important that the hedge fund accounting is consistent because the investors return is based on changes in the accounts during the investment period.
Similarly, the principle of disclosure also applies to hedge funds. In general, the financial statements should disclose adequate information so that readers of the statements can make informed decisions about the company. Managers of manufacturing or service companies may prefer to make incomplete disclosures to make the results look favorable, but auditors, regulators, and readers of the financial statements pressure the companies to make adequate disclosures. Likewise, hedge fund managers often resist making adequate disclosure, especially about the nature of investment positions. These managers argue that the information cannot be disclosed without putting the investors at risk that others will use this information to the detriment of the hedge fund investors. Hedge funds sometimes received qualified opinions from auditors because they fail to disclose enough information in their financial statements. For all but the largest hedge funds, auditors, regulators, and investors prevail on the fund managers to make adequate disclosures.
The materiality principle also applies to hedge fund accounting. A hedge fund may violate most generally accepted accounting methods if doing so creates no impact on financial statements large enough to affect any user of the statements. This is not an invitation to falsify records, ignore data, or mislead investors. Nevertheless, financial statements are acceptable despite errors and shortcuts that create tiny discrepancies.
When a difference in method might result in more than one result, financial statements should reflect the least favorable result. The principle of conservatism presents no clear standard for hedge fund accounting. In general, conservatism calls for accounting policies that lead to lower revenues, higher expenses, lower asset values, higher liability values, and lower equity. The principle of conservatism cannot be used to justify undervaluing assets in an early period to create gains in later periods when less conservative methods are used. New investors should not be able to buy into the fund at bargain prices, just as existing investors should not be redeemed at a low net asset value to assure that the financial statements are conservative.
The revenue principle determines when revenues are recognized. Some companies have trouble defining when revenue is recognized because it is difficult to point to a specific date when the service has been performed or the good has been delivered. This ambiguity doesnt generally exist for hedge funds. The positions are repriced each statement period, and the income, expenses, gains, and losses are tallied. Since the service provided by the hedge fund is the production of investment returns, revenues (and all components of investment performance) are recognized at the end of each period.
Some hedge funds have trouble revaluing certain kinds of assets at the end of each period. For example, a fund that invests in venture capital and other private equity may find it difficult to identify prices that are objective enough to use to calculate investment returns and assess performance fees. These funds may hold such assets at historical cost until resold and assess no incentive fees on unrealized gains.
These funds use a method called side-pocket allocations. The hedge fund that acquires assets that are difficult to value will segregate those assets and establish the ownership percentages based on the capital positions of the investors. These percentages remain fixed until the assets are liquidated, unaffected by capital contributions and withdrawals. In other words, a new investor does not participate in returns on existing assets, and old investors are not permitted to withdraw capital committed to assets in side-pocket allocations. As a result, revenues are timed to either the liquidation of assets or a time when the price of the assets becomes easier to determine (for example, after an initial public offering).
The matching principle is the main basis for accrual accounting (see later). Corporations accumulate the costs of production as inventory or in other accounts that postpone recognizing a cash outflow as an expense. Hedge fund income statements recognize revenue each accounting period, so they likewise recognize most expenses in the current period. As will be noted, the revenues and expenses are accrued, not necessarily the timing of the cash flows.
Lower of Cost or Market Rule
Accounting values are generally based on historical cost. Both as a reality check and as a reasonable effort to control fraud, most accounting entries (including assets, liabilities, equity, revenues, and expenses) are based on the actual cash value at the time of the entry. In order to keep financial statements conservative, a corporation will sometimes be required to recognize a loss if an asset permanently falls below historical cost. In general, assets are not written up when fair value exceeds historical cost.
The lower of cost or market rule does not apply to portfolios. The rule may apply to office equipment or supplies, but these assets would generally be carried on the books of the fund manager, not the fund. In any case, the fund investments will comprise most of the assets (and liabilities) on the balance sheet.
Many of the rules about valuation are controlled by the tax code. These rules are covered in Chapter 10. For financial reporting purposes, stocks, bonds, commodities, and derivatives are valued at the current market value of the assets. The portfolio accounting measures the changes in value of the fund caused by realized and unrealized changes in prices of the individual positions.
Finally, the definition of market value can influence the performance of the fund. A fund may be able to choose to price positions based on the last price, a closing price, offer, bid, or some combination. Within a range of reasonable alternatives, managers are not required to choose the most conservative pricing. Rules and regulations do, however, require a hedge fund manager to apply a pricing strategy consistently.
Accrual versus Cash Accounting
Like nearly all corporations, hedge funds use accrual accounting to time the recognition of accounting entries. It is difficult to imagine how cash accounting would treat limited partners fairly. In fact, tax reporting requires the hedge fund to accrue unrecognized gains and losses (see Chapter 10).
The managers of hedge funds are organized into business units separate from the business unit that contains the assets. The manager may compile these accounting records using either accrual or cash accounting. If a fund is organized as a flow-through tax entity such as a partnership, a limited liability corporation, or an S corporation, the accounting records probably must be compiled using the same basis as the owners. As a result, many hedge fund managers use cash accounting because their owners are individuals who use cash accounting.
Using Double -Entry Bookkeeping
Portfolio accounting is a specialized form of double-entry bookkeeping. A hedge fund could produce an income statement and balance sheet using mass market general ledger software. Funds would not use many types of accounts commonly used in manufacturing and service companies, however. In practice, most funds use software designed to keep track of extra data that isnt preserved in the general ledger records. The software may port information to portfolio management software, risk management software, tax reporting software, and other specialized applications.
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