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A hedge fund, in contrast, carries a portfolio of investment securities

UNIQUE ASPECTS OF HEDGE FUND ACCOUNTING

Although hedge funds follow the general procedures used by any user of double-entry accounting, the unique needs of hedge funds present a series of challenges. Accountants have developed methods to satisfy these unique accounting requirements.

Distinguishing the Fund from the Manager

It is typical for a corporation to conduct business in several distinct business units. Usually these businesses are organized hierarchically. The results of subsidiaries are consolidated into parents results. A hedge fund may have subsidiaries. A fund may carry some or all of its assets as investments in other hedge funds. See Chapter 5 to learn more about motives for these kinds of structures.

It is important to contrast this parent/subsidiary structure with the two business units universally associated with hedge funds. A hedge fund is a business unit that exists to hold the financial assets. It generally has no physical operations. A hedge fund manager contains the employees who make investment decisions, market the fund, and account for performance. In principle, these can be completely independent legal entities. In practice, the management company may have a considerable investment in the hedge fund and may act as the general partner of a hedge fund. It would be wrong, however, to consolidate the positions and income of the hedge fund with the positions and income of the manager, because the two businesses do not fit the model of a parent/subsidiary relationship.

Flow -Through Entity Hedge funds within the United States are generally organized as limited partnerships or limited liability corporations. There are substantial tax advantages to these structures and tax regulations strictly control tax reporting of the fund results. Chapter 10 presents some of those tax requirements. In general, the fund is not considered an economic entity. Instead, the financial results of the fund are allocated to the funds investors and taxed only at that level.

Surprisingly, this flow-through tax status has little effect on financial reporting. The financial statements present the income statement and balance sheet accounts without regard to the tax treatment of the fund.

Inventory Accounting Hedge funds dont carry inventory in the same sense that a manufacturing firm carries inventory. The manufacturer uses inventory accounting to postpone expenses so that the timing of the expenses matches the timing of the revenues. A retailer uses inventory accounting to reflect the investment the company carries in merchandise.

A hedge fund, in contrast, carries a portfolio of investment securities. It is tempting to treat these positions as inventory. Indeed, the positions fit well into the methods used to account for inventory. However, the tax code, not generally accepted accounting principles (GAAP), defines the ways a hedge fund can determine the cost of positions that are sold.

Mark to Market In general, accountants rely on historical cost. There are exceptions where a corporation must mark down the carrying value of assets if they fall below historical cost. The tax reporting of hedge fund results resembles this type of accounting. In contrast, the financial records of a hedge fund rely on current market prices of the securities. The differences between financial or performance accounting and tax accounting create major accounting burdens for the hedge fund accounting system.

Futures and Other Derivatives Hedge funds dont treat futures and derivatives differently than do manufacturing companies or financial corporations (banks, broker-dealers, and insurance companies). However, like many financial companies, hedge funds may carry substantial positions in these derivatives. These positions dont appear on the balance sheet, although the fund must disclose the positions in footnotes. These footnotes disclose the notional amount of the derivatives positions. The fund does not detail these positions or the economic significance of the positions.

The Financial Accounting Standards Board (FASB) prescribed the GAAP treatment of derivatives transactions in its Financial Accounting Standard 133 (FAS 133).

The derivatives positions are consistently carried at current market value, like the securities positions. As a result, hedge funds are not significantly affected by FAS 133, which controls which derivatives are marked to market with other types of businesses.

Hedge funds can deliver securities to satisfy initial margin in a futures account. No accounting entry is required because the securities are still owned by the hedge fund. The accounting system does not record the change in the location of the securities or the encumbrance granted to the futures broker (unless, of course, the broker seizes the positions to satisfy a margin deficit).

However, the hedge fund may also deposit initial margin in cash. This transfer would generally enter the accounting system because the accounting records contain an account for cash held at the broker:

When Cash Is Transferred to the Broker

Cash held at broker$10,000Cash held in demand deposit account #123$10,000

After the deposit of initial margin, the purchase or sale of contracts is not recorded in the general ledger system. The fund will no doubt keep track of this information outside the accounting ledger and must report information about the position in footnotes.

After the trade, the broker adjusts the margin balance daily. These adjustments enter the general ledger:

Daily Margin Maintenance on Futures Position

The debit holding the loss is a particular category for losses that is reported separately from securities gains. See Chapter 10 to learn more about Section 1256 gains and losses. As is clear from the credit record, the broker removes cash equal to the daily loss. The loss may require the hedge fund to restore margin to the minimum maintenance amount. If the loss is large enough, the hedge fund must transfer additional cash (not securities) and the entries are handled the same as a cash deposit.

Identified Straddles and Mixed Straddle Election Hedge funds, brokerdealers, and other trading businesses may be required to mark some or all of their positions to market for tax purposes. A hedge fund may identify a combination of trades as a straddle if gains on part of the position occur at the same time as losses on another part of the position (usually because the position contains both long and short trades). Hedge funds are not allowed to recognize a loss on one part and postpone realizing gains on another part of a straddle.

Some funds declare in advance that all trades should be treated as if they were part of a straddle (mixed straddle election). In both cases, the fund must calculate unrecognized gains and losses on all positions and include them in taxable income. These tax calculations more or less match the calculation of NAV, but it means that financial statements must reflect current market prices rather than historical cost.

Nonledger Accounting Information The hedge fund must keep track of a large amount of data that doesnt fit into the debits and credits of a general ledger. For example, the fund needs to know how many shares it is long or short. It probably needs to know the cost basis of individual lots and the dates the lots were acquired. This data is maintained by a portfolio accounting system and can be passed to position-management routines or risk management routines, or used for tax reporting.

Maintaining Capital Accounts The hedge fund must keep track of many details concerning the ownership interests of the partners investing in the fund. It is possible to use the general ledger to record some of this information. For example, the funds accountants could establish a unique capital account for each investor (or even distinguishing multiple lots for investors). A hedge fund may have hundreds of different investors, so this could require many separate accounts. In contrast, a corporation may have only a few capital accounts: common stock, additional paid-in capital, retained earnings. Frequently a hedge fund will establish a capital account for general partners and a capital account for limited partners. Details, including ownership percentages, cost, and tax information, can be preserved in subledgers or subsidiary ledgers. A portfolio accounting system should handle this information automatically, but a hedge fund may also track this portfolio data in many spreadsheets maintained by hand outside the general ledger system.

ACCOUNTING AND CONTROL

Perhaps the most important job of any accountant is control. Chapter 11 describes risk management as it pertains to hedge funds, but the accounting records, the accountants, and the auditors have a role in corporate control that differs somewhat from risk management, which focuses on position risks, financing risks, and counterparty risks.

Accountants are the first line of defense against loss of control. The accounting process must assure that all tickets have been written. The accountants should monitor trading to ensure that all trades are authorized and consistent with trading limits.

The accountants are responsible for making sure that positions are fairly valued. These valuations are important to investors entering and exiting the fund. They also affect the return of the fund. Traders, risk managers, and investors are all interested in getting accurate return information, and inaccurate pricing can lead to bad decisions.

Accountants should make fair allocations. Traders have no concern over costs that are not allocated. For example, if commission expenses or financing costs are not allocated, traders are tempted to enter into uneconomic trades that nevertheless show up as profitable to individual traders. Similarly, if traders are not held accountable for their individual contributions to the risk in the portfolio, traders may be tempted to take excessive risks. Finally, the firm should associate the cost of trading capital with the positions of individual traders, so that traders are motivated to treat capital as a scarce resource.

Accountants are responsible for maintaining deposits for the hedge fund. These deposits include cash balances for liquidity needs, investment balances held for medium-term investing, and margin balances. The accountants must be sure that balances in these accounts are adequate for the possible needs the hedge fund positions might create. The accountants, too, should work with the risk managers to monitor the hedge funds exposure to counterparties.

The accountant is responsible for monitoring the money flows. The accountants must have procedures in place to prevent and detect fraud. The procedures should include cross-checks to prevent collusion.

CONCLUSIONS

Despite their unique nature, hedge funds record accounting information in general ledgers and use most of the same conventions and principles that are adopted as generally accepted accounting principles (GAAP). Like a manufacturer or retailer, the hedge fund must also keep track of additional data. This data must be accurate and available on a timely basis to be useful to the managers of the hedge fund.

QUESTIONS AND PROBLEMS

9.1A hedge fund has a debt-to-equity ratio of 3:1. What is the leverageon this hedge fund?

9.2 A hedge fund buys $25 million in common stock and finances 50 percent of the position in the stock loan market. How much does this stock position and financing contribute to the total assets of the hedge fund?

9.3 A hedge fund sells $10 million in common stock and posts $12 mil

lion to borrow the shares. How much does this stock position and financing contribute to the total assets of the hedge fund?

9.4 A hedge fund buys 10,000 shares of XYZ common at $10 per share

(net of commissions). The fund later buys 15,000 additional shares of XYZ common at $12.50. The fund sells 5,000 shares of XYZ at $15. What value appears on the balance sheet for the value of 20,000 shares of XYZ?

9.5 What factors would influence the hedge fund to use the cost of the

$10 shares or the cost of $12.50 lot to determine the gain for financial reporting?

9.6What problems would a hedge fund have creating its accountingrecords on a cash basis?

9.7 A hedge fund manager disagrees with his auditor on the issue of disclosure. The auditor believes some information must be disclosed to comply with generally accepted accounting practices. The manager argues that disclosing the information to investors could cause damage to the investors because the information is sensitive. Does this mean that the principle of disclosure doesnt apply to hedge funds?

9.8 A hedge fund mispriced some assets at year-end. Some assets were priced too high and other assets were priced too low. No investor had redeemed capital and the fund accepted no new capital at that time. Based on the argument of materiality, the fund argued to its auditor that it didnt need to restate the funds results. Should the auditor require the fund to restate the year-end results?

9.9 An auditor told a hedge fund to use the bid-side prices to value long positions and to use offer-side prices to value short positions. The fund manager said this violated the principle of consistency. Is the fund manager right?

9.10 A particular hedge fund carries a position of long and short assets.

The positions roughly hedge the major movement of the market. The fund auditor announces that all of the long positions must be carried at the lower of cost or market. The hedge fund manager objects, saying that this would lead to misleading and spurious gains and losses. Should the auditor prevail in requiring the fund to adhere to the lower of cost or market accounting principle?

.11 A particular hedge fund is designed to profit from lower prices. The fund has no long positions and a portfolio of short positions. Would the leverage of this fund be zero because the firm has no assets?

9.12 A corporation declared a dividend of $1 per share of common stock on April 22 for holders of record April 29 to be paid May 5. A hedge fund holds 50,000 shares of the stock on April 30. How should it treat the dividend payment?

9.13 A particular hedge fund has $100 million is assets and $50 million in liabilities. The fund is a limited partnership that has sold 28,000 partnership units at $1,000 each. What is the current NAV of a partnership unit?

9.14 A hedge fund has long and short Treasury positions. During the year, it receives $25 million in Treasury interest. The fund also makes $20 million in substitute interest payments on the funds short Treasury positions. The Treasury interest on long positions is exempt from state income taxes when allocated to taxable investors. How is the interest expense treated for financial reporting?

9.15 A hedge fund has $100 million under management on April 30. The hedge fund manager charges a management fee of 1 percent of the assets under management. To calculate NAV on May 5, how much should the manager deduct for the fraction of the month that has passed?

9.16 A hedge fund is able to create long and short positions exclusively with futures contracts. It is carrying long positions equivalent to 100 percent of partners capital. It carries short positions approximately equal to its long positions. What is the leverage of the hedge fund?



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Previous Issues

200605-15Hedge funds may be organized as corporations, especially outside the United States

200605-14Some hedge funds have trouble revaluing certain kinds of assets at the end of each period

200605-13Hedge funds are affected by many laws and regulations

200605-12The most common measure of portfolio risk used by practitioners and academics

200605-11Investors commit funds to a particular investment for a variety of reasons

200605-10Hedge funds face many limits on leverage they can employ

200605-09Investors may measure hedge fund's leverage in a variety of ways

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