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Accounting for investments in a fund's financial statements has historically been relatively straightforward - almost always at fair value. While difficulties arise when attempting to arrive at a reliable and supportable fair value on a consistent basis, the concept of fair value for non-listed securities has been largely accepted by the industry and its investors. However, the implementation of "IFRS equivalent" standards, and hence the adoption of IAS 32 and 39 into several of the region's accounting frameworks (such as those in Hong Kong, Singapore and Australia), has brought to the surface other accounting issues with very different and problematic operational implications for the industry.
One of these issues - the accounting for certain convertible bonds - is not restricted to the funds industry, but is prevalent in many sectors including in entities operating in China that are seeking private equity finance in the run-up to an IPO. Private equity funds frequently attempt to structure financing transactions so as to limit the downside risk associated with an equity stake in an IPO candidate. This has often been achieved through the use of convertible instruments that provide both a guaranteed return of capital and the opportunity to benefit from upside potential in the value of the investee.
From an accounting perspective, convertible instruments typically combine the characteristics of an equity component, to be able to gain from an increase in value of a portfolio company post-listing, and a host debt instrument, that requires the portfolio company to redeem the instrument for cash under certain circumstances. Under previous accounting standards, the conversion option embedded in a convertible instrument was ignored in the financial statements of the issuer, often leading to a reduced interest expense and no requirement to remeasure the instrument.
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Read more about how the new standards can lead to volatility, the details and examples of applications in practice by downloading our Impact of HKFRS on investment structuring (pdf file, 253KB) for your reference.
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