NEWS ANALYSIS: IFRS conversion myths debunked

By Amy Edwards, financial services office, Ernst & Young In August 2008 the Securities and Exchange Commission (SEC) announced its proposed timetable for conversion from US Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS).

When the comment period ends on April 20, 2009, the industry will be another step closer to a single set of high-quality, globally accepted accounting standards the SEC has called "an international language of disclosure and transparency."

While there is some discussion about how the new administration will proceed, some US investment companies, including hedge funds, are continuing to analyse the likely impacts of a conversion on their organisations. But those funds are a minority of the market participants.

Since the proposed roadmap does not include entities defined under the Investment Company Act of 1940, many institutions believe their conversion to IFRS is even further off than the transition proposed for their public peers. So many hedge funds believe it is even further off for them.

This, however, may change sooner than investment managers expect. The SEC's division of investment management, which oversees registered investment companies (RICs), is still assessing the effect of IFRS adoption by RICs and has not, in fact, made a final decision whether to exclude them from the mandate.

Therefore, it is possible RICs and even hedge funds managed by SEC-registered investment advisors (RIAs) could join the list of organisations required to convert.

Additionally, the wide use of IFRS by hedge funds in other parts of the world and the resulting lack of comparability may be used as an argument for including RICs and other investment companies.

So while it is true questions remain regarding the degree of IFRS application within the industry, there are already many marketplace misconceptions regarding possible conversion. Here is a look at six of the most common myths and why believing them could have an adverse impact on your fund.

Myth one
IFRS will never be required for hedge funds in the US - at least not during the next decade. The recent activities of the SEC may have shortened the path to a US conversion, making many believe the adoption of IFRS by public companies is a matter of "when and how," not "if."

Those opposing it cite various hurdles, such as the inability to train preparers, users and auditors; the significant cost of conversion versus its perceived benefits and the possibility that the amount of judgment inherent in IFRS could open the door to litigation, especially as it relates to fair value.

However, in reality, IFRS is already being used by a growing number of institutions around the world, including hedge funds, many of which currently prepare their financial statements in compliance with IFRS in order to be competitive and reach investors globally.

While the roadmap's lack of provision for RICs may seem to imply they will always be excluded, if the SEC excludes one industry, it is likely other industries would lobby for exemption, too. Such industry carve-outs are not the SEC's intent as it works to move the US to IFRS. On further consideration, it is quite possible it may opt to include RICs and hedge funds managed by SEC RIAs.

Myth two
There is plenty of time to deal with this. Wishful thinking about how much time is actually available has historically driven companies to wait too long to prepare for conversions of this size and magnitude.

Although the application of IFRS requirements to hedge funds and the exact dates for conversion are still under discussion, the proposed timeline of 2014-16 for publicly traded companies (currently 2014 for larger entities and 2016 for smaller entities) suggests at a minimum investment managers should make an effort to understand the differences between US GAAP and IFRS.

In addition there is the potential impact on their financial statement presentation and operations. They should take particular note of how these changes may be communicated to investors in the future. Advisors who use external administrators should understand their vendors' state of readiness as conversion decisions move forward.

When considering how much there is to do, it quickly becomes apparent this is not a simple endeavour. Its impact goes beyond accounting and into all corners of a fund's operations.

For example, selected key activities relate to a conversion that underscores the need to begin thinking about IFRS.

First, the proposed roadmap requires two years of comparative financial statements. Financial statements will need to be restated at transition (for example, mandatory puttable shares will need reclassification from equity to debt, and schedules of investments will have to be revised).

Processes and technology used throughout an organisation to prepare financial statements will need to be assessed and adjusted (for example, expensing of commissions will be required as will the use of bid/ask in active markets, with a potential resulting reconciliation of shareholders' net asset value (NAV) to the fund's NAV).

The manner in which business is conducted and monitored as a whole will need to be assessed and, where appropriate, alterations will need to be made. This means things like changes to financial highlights and increased expense ratios due to commissions expense.

By understanding the impacts of conversion early, efficiencies can be gained and savings realised. For example, if a fund currently reports under US GAAP and its governing documents require a full distribution of operating income to shareholders, conversion to IFRS may result in shareholders' equity being classified as debt under IFRS.

To avoid this classification and its unintended consequences, governing documents could be revised prior to conversion to not require a full distribution of operating income to shareholders.

Myth three
Conversion to IFRS is simply an accounting exercise. So if the accounting rules change, trading and operations will run as before. Right? Wrong.

IFRS-related changes will have ripple effects across the entire organisation. It may begin with accounting but an IFRS conversion rapidly reveals the need for essential changes in business processes and systems in order to capture new data and satisfy reporting requirements.

IFRS influences how securities are valued, what investors will need to know and how results are monitored. Areas such as portfolio management, risk management, front- and back-office operations, compensation, sales and investor relations will be affected. It is difficult to find an area of the business that will not feel the impact of an IFRS conversion.

Myth four
This can be done in spare time. Most hedge funds run lean. This fact combined with the reality that necessary changes and recalibrations could be extensive, means the adoption of IFRS is not something that will happen in the ordinary course of business or through a series of episodic, ad hoc measures.

Funds need to plan systematically for the changes. Buy-in from senior management and resources specifically dedicated to the project will be critical.

Myth five
IFRS rules are 'principles-based', so it will be possible to interpret them more broadly. There is agreement that, unlike the meticulously defined US GAAP, IFRS tends to offer users general concepts, with fewer specifics and less guidance on interpretation. However, before assuming this means greater latitude, consider three points.

While some argue that being 'principles-based' means the rules are open to liberal interpretation, the reality is actually something different. With US GAAP the lines of practice often are clearly drawn.

However, the less detailed nature of IFRS means judgments need to be made and evaluations of the substance of a transaction. While some detractors categorise this aspect as open to interpretation, the truth is that fewer "bright lines" reduce the probability of structuring only for accounting purposes.

There are incidences especially related to hedge funds in which IFRS has more specificity than US GAAP. For example, IFRS requires the use of 'bid' for long positions and 'ask' for short positions in a liquid market.

It requires commissions be shown as an expense. Also, a fund must indicate potential timing, proceeds and method of disposing of illiquid securities. (Within these evaluations, a review of a fund's operating memorandum will be important.)

As IFRS continues to evolve, it is likely that additional interpretations will be provided to narrow further any diversity in its practice.

Myth six
Some people believe this is just a compliance exercise. Although there will be a significant degree of compliance involved in converting to IFRS reporting; it does provide a unique opportunity for hedge funds to review, streamline and improve processes and technology.

Improvement initiatives that have been postponed may become more of a priority as additional cost savings could be realised by making these projects part of an organisation's IFRS efforts. While there are costs associated with a conversion, some funds may view it as an opportunity to make significant improvements across the enterprise.

Global trend
Many global hedge funds have already adopted IFRS. The benefits of standardising the criteria for comparison among investment opportunities across borders, along with the ability to eliminate duplicative reporting environments, may spur the movement of the US hedge fund community toward harmonisation.

Signs continue to point to an acceptance of changing standards. Although it is increasingly unlikely the global accounting language will be US GAAP, the US cannot afford to be an outlier. Regardless of the timing for adoption, hedge funds that begin to prepare now will be best positioned to reap the benefits and ensure an efficient conversion to IFRS. That is no myth.