The agenda by U.S. and international accounting groups to develop a set of global accounting rules brings with it significant challenges for asset managers worldwide.
Investment firms are watching cautiously as U.S. regulators overhaul the nation's accounting rules to more closely align with international standards. Most of the business community supports some version of accounting convergence, but specific changes could be problematic. Investment firms would do well to study what's on the table, influence the process where possible and prepare for change, whatever form it may take.
The U.S. Financial Accounting Standards Board and its international counterpart, the International Accounting Standards Board, are working to harmonize their standards and improve financial statement transparency. To do so, they have identified areas in which U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards differ, and are weighing how to merge them into a single set of high-quality global standards. Also, the Securities and Exchange Commission will decide soon, perhaps this year, whether U.S. companies will be required or permitted to follow the IFRS — whether it is merged with U.S. GAAP or not.
The FASB and IASB have found common ground on several important issues — for example, how to handle revenue recognition, lease accounting and presentation of financial instruments. But when it comes to accounting for financial instruments, consolidation and several other initiatives, they remain apart. If they cannot agree, the SEC might abandon plans for converged standards or move the U.S. to current international standards.
While the debate over convergence and/or conversion continues, asset management firms face significant changes. Standards-setters are preparing to establish principles-based accounting concepts that will apply to all businesses and might discard the industry-specific, rules-based approach that characterize U.S. GAAP. Firms will find some of these broad principles to be an uncomfortable fit.
Asset management firms might find the new revenue-recognition model challenging because it will lead to deferral of revenue recognition when the revenue is contingent and cannot be reasonably estimated at contract inception. For example, the incentive fee for managing a portfolio of assets may be a fixed percentage of the net asset value of the fund at the end of each performance period. As this is based on market performance, the revenue may not be reasonably estimated at contract inception, making allocated revenue zero. The industry now uses an accrual model, under which managers receive and record incentive fees based on the current value of a fund at the end of each reporting period. While this will not change the value of the firm, it is likely to change how observers perceive fund performance and could confuse investors, as it does not reflect the economics of the transaction.
The consolidation proposal presents another challenge. Although the IASB and the FASB decided that an investment company should measure its investments in entities that it controls at fair value through profit or loss (which is consistent with current U.S. GAAP but a change to the approach in IFRS), the IASB believes a parent of an investment company should consolidate all entities that it controls, including those that are controlled by an investment company subsidiary, unless that parent is an investment company itself. This proposal could require an investment adviser or general partner of an investment company to consolidate with its own financial statements those of companies in which it has a controlling interest, rather than simply including the fair value of the holding, as is done today.
Another key point of contention centers on classification and measurement of financial assets. The IASB's standard provides for significantly less measurement recognition at fair value than the FASB's proposal to move to mark-to-market. The FASB's proposal has triggered opposition from banks and others concerned that mark-to-market will subject their long-term assets to market volatility.
The new proposal, if adopted as proposed, will affect investment funds in various areas such as transaction costs, which would be expensed as incurred, hurting funds' expense ratios. The requirement to measure financial liabilities at fair value also will have an impact on NAV calculations, with a greater impact on funds with longer-dated debt or mandatorily redeemable preferred shares.
The FASB probably will move toward the IASB model, but will not force a wholesale shift. Still, the U.S. approach to these investments seems destined to change, with an altered use of fair value accounting added to the mix.
There is little time to waste. The standards bodies are eager to hear the views of companies while they consider these and other proposals. Asset management firms should start educating their senior-level managers and other key staff inside their organizations now about the proposed accounting standards and elicit their feedback on how the changes are likely to affect the firm and their business. By gathering and analyzing this input, accounting policy teams and executives can hope to productively influence the standards-setting process and final outcome — and arrive at a strategy for bringing their company and funds successfully through this time of significant change.
Deha Rozanes is an executive director in the financial services office of Ernst & Young LLP, New York.