Cayman Islands: New 2013 Financial Instrument Disclosures Impacting Hedge Funds

Back in December 2011, the US and International accounting standard setters (the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), respectively) issued new financial statement disclosures regarding the offsetting of financial assets and financial liabilities. Specifically, these new disclosures are meant to address financial-statement users' concerns about differences between International Financial Reporting Standards (IFRS) and United States Generally Accepted Accounting Principles (US GAAP) with respect to when an entity can offset a financial asset against a financial liability on the balance sheet. Offsetting is also referred to as netting.

Historically, owing to differences in accounting standards, many financial institutions have offset more assets with liabilities under US GAAP than under IFRS. Unfortunately, the accounting- standard setters were not able to converge these differences into a new accounting standard. As a result, the standards setters decided to continue to permit more offsetting under US GAAP than can be achieved under IFRS. However, in order to address these offsetting differences, and to assist financial- statement users in understanding these differences, new disclosures were mandated which will require entities reporting under both IFRS and US GAAP to present various financial assets and liabilities on a gross basis (before any offsetting or netting) and also on a net basis. It is hoped that these new disclosures will help financial-statement users reconcile an IFRS balance sheet to a similar entity which prepares their balance sheet under US GAAP.

It is important to note that these changes will not impact the accounting under IFRS and US GAAP, but rather only mandates new financial-statement disclosures. The IASB mandated such new disclosures by making an amendment to IFRS 7 referred to as Disclosures— Offsetting Financial Assets and Financial Liabilities. At the same time, the FASB updated US GAAP by issuing Accounting Standard Update (ASU) 2011-11 under the same title, which amended the accounting disclosures in US GAAP's Accounting Standard Codification 210. Hedge funds reporting under IFRS or US GAAP will need to comply with these new disclosures in their financial statements for any financial accounting period which begins on or after January 1, 2013, which effectively captures all 2013 calendar year ends.

The IFRS 7 amendment covers all financial instruments, which includes many assets and liabilities used by hedge funds such as cash, receivables, financial investments, derivatives, repurchase agreements, securities lending/borrowing arrangements and payables. The US GAAP amendment initially had the same broad scope; however, the FASB decided to subsequently clarify the scope by issuing ASU 2013-01. This ASU narrowed the scope of the disclosures under US GAAP to only include derivatives, repurchase/reverse repurchase agreements, and security lending/ borrowing arrangements. In addition, these new IFRS and US GAAP disclosures are only required when the entity has: (1) offset one or more of these assets with a liability within the balance sheet or (2) if the assets or liabilities are subject to a master-netting or similar agreement (irrespective of whether they in fact have been offset in the balance sheet).

It is very important that hedge funds carefully assess the scope of these standards. Many hedge funds do not offset financial assets with financial liabilities on the balance sheet as the criteria to do so are quite restrictive, especially under IFRS. Therefore, many hedge funds will not be caught by the first part of the scope of the disclosure amendment. However, many hedge funds do have master- netting arrangements in place with their derivative counterparties. Therefore, such hedge funds will be caught by the second part of the scope of the standard and required to provide the new disclosures.

Although a careful analysis will need to be made of all agreements to determine whether affected financial assets and liabilities are caught by any master-netting (and equally important similar) agreements, it is expected that most hedge funds will likely only need to make such disclosures for their OTC derivatives and repos.

The disclosure amendments will require hedge funds to prepare in tabular format the following columns for each type of financial asset and liability affected by the amendment:

a) The gross amount of the asset/liability (gross amount for a derivative would be the unrealised gain/loss at the balance-sheet date)

b) The amount of the asset/ liability which has been offset in accordance with the current offsetting accounting principles

c) The net amount of the asset/ liability following any such offset in (b) (this amount should then reconcile to the balance sheet)

d) Less the amounts subject to master-netting or similar arrangements which have not been offset in (b) above, including the effects of any collateral

e) The remaining net exposure for each type of financial asset and liability covered by the amendment

As indicated above, because hedge funds commonly do not offset items on their balance sheet, the amounts disclosed in (a) would often match (c) with (b) being nil, and (c) would equal the balance sheet. For example, let's assume the hedge fund has an unrealised gain of $100 with counterparty ABC on a forward contract, and the hedge fund also has an unrealised loss of $120 on another forward contract with the same counterparty, and the hedge fund has not done any offsetting. Therefore, such hedge fund would present $100 in columns (a) and (c) for its forward assets and $120 separately in columns (a) and (c) for its forward liabilities. However, because most hedge funds manage their derivatives through master-netting arrangements, in this example, the hedge fund would need to offset the unrealised gain with the unrealised loss in column (d), and separately for its liabilities, the hedge fund would offset the unrealised loss with the unrealised gain in column (d) leaving a net $20 unrealised loss, and to the extent any collateral has been posted for the unrealised loss, such collateral would further reduce the unrealised loss, possibly to nil. These disclosures will need to be made for each type of derivative, and any other financial assets/liabilities caught by the amendment. It should be noted that given the complexity of collateral arrangements and the need to assess the offsetting by counterparty, the new standards do allow entities to present the disclosures in (c) through (e) by counterparty instead of by type of financial asset/liability.

In summary, hedge funds will need to carefully assess their entire master-netting (and similar) agreements and collateral arrangements in order to ensure that their disclosures are compliant with the new IFRS/US GAAP rules.

About the author

Colin Hanson is an assurance partner with PwC Cayman islands. Colin specialises in the asset-management and banking business and also leads his firm's US GAAP and IFRS technical groups..

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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