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ASC 480, Distinguishing Liabilities from Equity, establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). ASC 480-10-65-1 indefinitely deferred the provisions of ASC 480 for mandatorily redeemable financial instruments for nonpublic entities that are non-SEC registrantsunless the instrument is mandatorily redeemable on a fixed date for amounts that either are fixed or are determined by reference to an interest rate index, currency index, or another external index.
Many hedge funds may meet the definition of being "nonpublic entities that are not SEC registrants" as defined by ASC 480-10-65-1, but careful consideration must be given to this issue. ASC 480-10-65-1 defines SEC registrants as "entities, or entities that are controlled by entities, (a) that have issued or will issue debt or equity securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets), (b) that are required to file financial statements with the SEC, or (c) that provide financial statements for the purpose of issuing any class of securities in a public market." Therefore, consideration needs to be given to, not only whether the entity itself (e.g., the hedge fund) meets the criteria of (a), (b) or (c), but whether any entity that controls the hedge fund (e.g., possibly the general partner) meets any one of the criteria. Therefore, even if a hedge fund does not meet any of the criteria outlined in ASC 480-10-65-1, it may nevertheless be considered an SEC registrant for the purposes of applying ASC 480 if it is controlled by an SEC registrant. Typically, this may occur when the hedge fund is consolidated by an SEC registrant general partner. In those situations, the engagement team will need to consider the full effects of ASC 480.
Assuming that a hedge fund is a "nonpublic, nonSEC registrant" as defined by ASC 480-10-65-1, the primary consideration then becomes whether the redemption request itself is for a fixed or variable amount. If the amount of capital subject to the redemption is fixed (or is indexed to a stated interest rate or interest rate index), recognition as a liability is appropriate for financial reporting purposes at the date an irrevocable redemption request is made, even though that capital may continue to participate in the earnings of the fund until it is actually paid to the withdrawing investor. If the amount of capital subject to the redemption is variable based on the hedge fund’s earnings, it would generally not be recorded as a liability until such time as the amount of capital to be redeemed became fixed.
As stated above, once the redemption amount becomes fixed, recognition as a liability is appropriate. This would be the case for redemptions paid after year-end, but based upon year-end net assets. Therefore, redemptions paid after year-end (such as on January 1st for a calendar year-end fund) which are based upon the NAV at year-end (such as December 31st), should be considered a liability at December 31st. Said differently, a redemption notice received on November 15th, 45 days prior to the redemption date, may not be a liability of the hedge fund during those 45 days if the ultimate amount to be redeemed is not fixed but based upon the hedge fund’s earnings. However, when the amount becomes fixed on December 31st, recognition of redemptions payable (as well as related redemption fees, if applicable) on a December 31st balance sheet is appropriate. See FG, PwC's accounting and financial reporting guide, Financing transactions for further discussion on ASC 480. Additionally, see Asset Management Technical Advisory 2006-02 for discussion regarding the applicability of ASC 480 and specifically ASC 480-10-65-1 to hedge fund redemptions. Additionally, see Asset Management Technical Advisory 2009-25 for further discussion on emerging issues related to hedge fund redemptions under ASC 480-10-5 and ASC 480-10-65.
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