FUND ACCOUNTING UPDATE

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FUND ACCOUNTING UPDATE Focus on Private Equity
Funds 19 October 2006
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Outline

• Discuss
• Overview of US GAAP for PE Funds
• Similarities and differences IFRS/UK GAAP/US GAAP
• Valuation Issues
• SPVs Disclosure Issues
• Questions

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• Overview of US GAAP

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Part 1 Overview of US GAAP

• Accounting Principles Generally Accepted in the
  United States of America
• One of the two most widely used sets of global
  accounting standards
• Characteristics are
• Industry Focused (eg Accounting and Audit Guide
  Investment Companies)
• Very Detailed (you never become an expert in US
  GAAP you need to focus)
• A vast number of different organisations
  participate in the setting of accounting rules.
• Those organisations include
• FASB (Financial Accounting Standards Board)
• AICPA (American Institute of Certified Public
  Accountants)
• SEC (Securities Exchange Commission)
• Other Regulatory Bodies (eg NASD, SBA, FDIC)
• Government (GASB)

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Part 1 Overview of US GAAP

• Question Which of these organisations have set
  rules which are applicable to me?
• From the FASB website
• Since 1973, the Financial Accounting Standards
  Board (FASB) has been the designated organization
  in the private sector for establishing standards
  of financial accounting and reporting. Those
  standards govern the preparation of financial
  reports. They are officially recognized as
  authoritative by the Securities and Exchange
  Commission.
• The Securities and Exchange Commission (SEC) has
  statutory authority to establish financial
  accounting and reporting standards for publicly
  held companies under the Securities Exchange Act
  of 1934. Throughout its history, however, the
  Commissions policy has been to rely on the
  private sector for this function to the extent
  that the private sector demonstrates ability to
  fulfil the responsibility in the public
  interest.
• Answer Start with the standards set/endorsed by
  the FASB.

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Part 1 - Overview of US GAAP

• Question Okaybut what are those standards?
• The FASB Standards
• The FASB is a board of seven full time members
  from the accounting, finance and other
  professions. They are supported by a staff of 68
• The final product of most technical projects
  undertaken by the FASB is a Statement of
  Financial Accounting Standards (SFAS).
• The last SFAS to be issued was SFAS 155
  Accounting for Certain Hybrid Financial
  Instruments an amendment of FASB Statements No.
  133 and 140
• Certain technical projects may result in other
  standards. For Example
• FASB Interpretations (FIN) These are
  interpretations of existing GAAP (eg FIN 46
  Consolidation of Variable Interest Entities an
  interpretation of ARB 51)
• Accounting Research Bulletins (ARB) These are
  accounting standards established by the AICPA
  Accounting Standards Executive Committee prior to
  the creation of the FASB which have not yet been
  superseded by a FASB pronouncement (eg ARB 51)

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Part 1 Overview of US GAAP

• Question Okaybut what are those standards?
• Other standard setters
• AICPA
• The AICPAs Accounting Standards Executive
  Committee (AcSEC) establishes task forces which
  develop industry specific guidance such as
• Accounting and Audit Guides are designed by task
  forces of the AcSEC to assist preparers of
  financial statements in specific industries in
  the preparation of GAAP compliant statements and
• Statements of Position (SOPs) which provide
  guidance on and amendments to the application of
  principles contained in the Accounting and Audit
  Guides (eg SOP 03-4)
• The AICPAs Auditing Standards Board established
  auditing standards (SASs) that auditors are
  required to comply with when auditing financial
  statements of private entities in accordance with
  US GAAS.

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Part 1 Overview of US GAAP

• Question Okaybut what are those standards?
• Other standard setters
• Public Company Accounting Oversight Board (PCAOB)
• Established in 2002, the PCAOB regulates the
  auditing profession and sets standards for those
  auditors to follow when auditing financial
  statements of public companies. When it was
  established, it adopted all the SASs and has
  been working to develop its own standards to
  address particular public company audit issues.
• Emerging Issues Task Force
• Established in 1984, the task force was
  established by the FASB and aims to identify at
  an early stage implementation and emerging
  issues. An EITF consensus establishes accounting
  practice for specific issues. For example EITF
  04-5 establishes accounting practice for
  Determining Whether a General Partner, or the
  General Partners as a Group, Controls a Limited
  Partnership or Similar Entity When the Limited
  Partners Have Certain Rights

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Part 1 Overview of US GAAP

• Question What happens if all these standards
  conflicts with each other?
• The GAAP Hierarchy
• The GAAP hierarchy is currently presented in the
  AICPAs SAS 69, The Meaning of Present Fairly in
  Conformity With Generally Accepted Accounting
  Principles. It sets out the hierarchy of
  accounting standards that must be followed when
  deciding on which standards are applicable in
  which circumstances. The hierarchy is complex and
  there are plans to improve on it. The hierarchy
  is broadly set out as follows
• - Category A Includes ARBs, Accounting
  Principles Board Opinions (APBs),
• SFASs, and FINs
• - Category B Includes AICPA Accounting and
  Audit Guides and SOPs
• - Category C Includes EITF consensuses
• - Category D Includes accepted industry best
  practice

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Similarities and differencesIFRS/UK GAAP/US GAAP
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Part 2 Similarities and Differences
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Part 2 Similarities and Differences
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Part 2 Similarities and Differences
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Part 2 Similarities and Differences
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Fair Value - IFRS
Part 3 Valuation Issues

• the amount for which an asset could be exchanged
  between knowledgeable, willing parties in an
  arms length transaction.
• How should we calculate Fair Value?
• IAS 39 is not prescriptive but recommends the
  following estimation techniques
• When a quoted market price is available
• Current bid price
• When a quoted market price is not available
• Reference to the current market value of another
  instrument that is substantially the same
• Discounted cash flow analysis
• Option pricing models

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Fair Value - UK
Part 3 Valuation Issues

• Not applying FRS 26
• Currently private equity firms are permitted to
  hold investments at cost less impairment.
• Applying FRS 26
• FRS 26 IAS 39 - Broadly requires listed
  companies to apply the provisions of IAS 39 ie
  fair value from 1/1/05 and from 1/1/06 for
  unlisted companies prepared in accordance with
  the fair value accounting rules set out in the
  Companies Act 1985.

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Fair Value - US
Part 3 Valuation Issues

• FAS 157 has the same general concept of fair
  value as IAS 39.
• FAS 157s objective is to use the valuation
  technique or combination of valuation techniques
  that provide the best estimate of fair value in
  the circumstances.
• Fair value hierarchy
• The standard establishes a fair value hierarchy
  to prioritise the inputs used in the valuation
  techniques
• Level 1 Observable inputs (which are based on
  market data obtained from independent sources)
  that reflect quoted prices (unadjusted) for
  identical assets in active markets
• Level 2 Inputs other than quoted prices included
  in Level 1that are observable for the asset
  through corroboration with observable market
  data
• Level 3 Unobservable inputs (e.g. a companys
  own data).
• The above hierarchy is designed to indicate the
  relative reliability of the fair value measures.

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International Private Equity Venture Capital
Valuation Guidelines
Part 3 Valuation Issues

• FRS 26/IAS 39/FAS 157..
• Require fair value accounting
• Very little guidance on how to reach fair
  value.
• The International Private Equity and Venture
  Capital Valuation Guidelines were developed by
  the BVCA, the EVCA and the AFIC (the British,
  European and French Venture Capital Associations)
  and were issued in their final form in March
  2005. They have been adopted internationally by
  over 20 Venture Capital Associations. The
  guidelines are intended to provide a framework
  for arriving at a Fair Value for private equity
  and venture capital investments. The guidelines
  define fair value as
• the amount for which an asset could be exchanged
  between knowledgeable, willing parties in an
  arms length transaction.
• This is consistent with the definition contained
  within IAS 39.

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Valuation methodologies Unquoted cos
Part 3 Valuation Issues

• The Valuer should exercise his or her judgement
  to select the methodology that is the most
  appropriate for a particular investment.
• Price of recent within one year investment -
  consider the background to the
• transaction
• Earnings multiple - an established investment
  with maintainable earnings
• Net Assets value derived from assets rather
  than earnings eg property holding or
• investment business
• Discounted Cash Flow flexible but subjective
  since many assumptions are used.
• Useful as a cross-check.
• Industry Valuation Benchmarks - limited
  situations. Useful as a cross-check.

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Comparison to GAAP
Part 3 Valuation Issues
The Valuation Guidelines state that valuers who
are required to follow GAAP should do so.
However - It gives advice on the application of
marketability discounts (which generally are
not permitted under GAAP). - IAS 39 suggests the
use of Discounted Cash Flow models as a
valuation technique. However, the Valuation
Guidelines state that DCF should only be used
as a cross-check given the number of variables
involved. Generally the IPEVC Guidelines are
GAAP compliant But be wary of advice highlight by
the guidelines as non-GAAP compliant
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SPVs Disclosure Issues
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Part 4 SPVs Disclosure Issues

• Increasing use of Special Purpose Vehicles to
  structure Private Equity investments in a manner
  which is tax efficient for its investors.
• These investment structures are becoming more and
  more complex
• Generally, we find that the monitoring over these
  structures needs improvement
• Preparers of financial statements should take the
  following into account
• Contingent liabilities at the SPV level may need
  disclosure at the fund level
• In particular, loan arrangements put in place at
  the SPV level may need disclosure at the fund
  level
• Transactions undertaken by the SPV may dilute the
  value of the funds investment.

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Questions