The Implications of International Financial Reporting Standards (IFRS) on Investment Funds

1. The Implications of International Financial Reporting Standards (IFRS) on Investment Funds © 2006 Ernst & Young All Rights Reserved. Ernst & Young is a registered trademark. June 6, 2006

2. AgendaA. Background & Framework B. Executive Summary of IFRS Issues Affecting Investment FundsC. Specific IFRS affecting Investment FundsD. Impact of IFRS on the work of the auditorE. Relationship between the auditor and the investment fund regulator

3. Background & Framework

4. EU Regulation EU Regulation adopted by EU Parliament on 7 June 2002: Who? All European companies listed on a stockexchange What? Consolidated annual accounts When? Financial periods commencing 1 January 2005 (including at a minimum comparatives for 2004)

5. IFRS Required for Investment Funds? • IFRS is obligatory when listed & only when consolidated accounts are required, however • Member states have the option to permit/oblige application of IFRS • Requirements of supervisors of stock exchanges • Local standard setters are gradually implementing IFRS • More and more funds apply IFRS • IFRS are becoming an indication for quality of reporting • Supervisors/regulators are investigating the impact on regulations and reporting requirements

6. IFRS Framework • IFRS comprise International Accounting Standards, International Financial Reporting Standards and associated pronouncements and interpretations issued by the International Accounting Standards Board (IASB)

7. IFRS Framework (cont’d) • IFRS represent a comprehensive set of standards setting rigid disclosure requirements and accounting rules • Significant development over past 5/10 years • More widely accepted and now endorsed by the European Union • Judgment based • GAAP convergence – IASB/FASB • Limited industry specific guidance promulgated by IASB • Complex measurement and disclosure requirements for financial instruments

8. Terminology • IAS – International Accounting Standard • IFRS – International Financial Reporting Standard • ISA – International Standard on Auditing

9. B. Executive Summary of IFRS Issues Affecting Investment Funds

10. Issues affecting investment funds • No separate standards for investment funds • No illustrative financials or disclosures promulgated by IASB for investment funds • Format of financial statements established by IAS 1 – Presentation of Financial Statements • IAS 7 – Cash Flow Statement • IAS 14 – Segmental Reporting • IAS 21 – The Effects of Changes in Foreign Exchange Rates • IAS 24 – Related Party Disclosures • IAS 27 – Consolidation

11. Issues affecting investment funds (cont’d) • IAS 33 – Earnings per share (EPS) • IAS 38 – Accounting for formation expenses • IAS 32 and IAS 39 establish significant accounting and disclosure requirements affecting investment funds for financial instruments (including the classification of redeemable shares as liabilities)

12. C. Specific IFRS affecting Investment Funds

13. IAS 1 – Presentation of Financial Statements IFRS Balance sheet x Income statement x Statement of changes in shareholders equity x Statement of cash flows x Schedule of investments Accounting policies and explanatory notes x Management report * 2yrs Comparatives * Recommended but not obligatory

14. IAS 7 - Cash Flow Statement • IFRS • IAS 7: Cash flows from operating, investing and financing activities – strict classification requirements set out in IAS 7 • Currently no exemptions available

15. IAS 7 - Cash Flow Statement - Issue • Lack of exemption inconsistent with other GAAPs (US, UK and Canadian) • Does not provide additional meaningful information

16. IAS 14 – Segmental Reporting • Segmental reporting is required for entities whose equity or debt is publicly traded • Business and geographical segments • Primary and secondary reporting formats

17. IAS 14 – Segmental Reporting - Issue • Current market practice is to disclose portfolio positions in line with the investment policy as per the fund’s prospectus • May be impossible to define a common classification of business and geographical segments to be accepted in various countries since no generally accepted standards

18. IAS 21 – The Effects of Changes in Foreign Exchange Rates • Financial statements should be reported in the functional currency of the investment fund • This represents the currency of the primary economic environment in which the entity operates • Consider the currency in which financing is generated and the currency from which gains and losses from investment activities are retained/distributed

19. IAS 21 – The Effects of Changes in Foreign Exchange Rates – cont’d • For most investment funds, the functional currency will be based on the currency in which the capital of the fund is designated • Exceptions may arise where majority of assets denominated in another specific currency with no hedging • Consider the currency in which the return is being provided to investors • If functional currency differs from the local currency disclose this and the reason why

20. IAS 24 - Related Party Disclosures • A party is related to an entity if:It controls, is controlled by or is under common control with the entityIt has an interest in the entity that gives it significant influence over the entityIt has joint control over the entityThe party is an associate of the entityThe party is a joint venture in which the entity is a venturer

21. IAS 24 - Related Party Disclosures (cont’d) • The party is a member of the key management personnel of the entityThe partner is a close member of the family of any of the aboveThe party is an entity controlled, jointly controlled or significantly influenced by a key member of management personnel or their close familyThe party is a post-employment benefit plan for the benefit of the employees of the entity

22. IAS 24 - Related Party Disclosures (cont’d) • Generally an administrator or custodian would not be considered a related party • However, if an employee of the administrator or custodian was a director or key member of management of the fund, then they would become related parties • Key member of management is defined as having the authority and responsibility for planning, directing and controlling the activities of the fund • Disclosure of administration and custody arrangements, fees and balances may be considered desirable if considered key contractual arrangements

23. IAS 27 - Consolidation • If ‘Control’ exists, then consolidate • IAS 27.13A: A subsidiary is not excluded from consolidation simply because the investor is a venture capital organization, mutual fund, unit trust or similar entity • Key question for Investment Funds: • Does control exist?

24. IAS 27 - Consolidation (cont’d) • Control is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity unless, in exceptional circumstances, it can be clearly demonstrated that such ownership does not constitute control

25. IAS 27 - Consolidation (cont’d) • Control also exists even when the parent owns half or less of the voting power of an entity when there is • Power over more than half of the voting rights or power to govern the financial and operating policies by virtue of an agreement with other investors • Power to appoint or remove the majority of the members of the board of directors or equivalent governing body and control of the entity is by that board or body; or • Power to cast the majority of votes at meetings of the board of directors or equivalent governing body and control of the entity is by that board or body

26. IAS 27 - Consolidation (cont’d) • It is not possible to give a general interpretation of consolidation requirements for investment funds. The actual situation has to be taken into account. Relevant elements are - What are the rights attached to the ordinary shares (changing the articles of association, change the investment policy, replace the fund manager, determine the dividend policy, change the cost structure)

27. IAS 27 - Consolidation (cont’d) • What are the rights attached to the preference shares (and who owns these shares) • Do specific provisions exist regarding the share in the revenues and expenses of the fund, have certain minimum return guarantees been issued to the investors

28. IAS 27 - Consolidation - Umbrella Funds • No specific requirements regarding umbrella funds included in IFRS • The fact of being a ‘standard’ umbrella fund does in itself not lead to a consolidation requirement • Therefore, being an umbrella fund does not automatically lead to the application of IFRS • If a Fund has a subsidiary, for example Indian Tax subsidiary, etc, there may be a need to consolidate, therefore IFRS may apply

29. IAS 27 – Consolidation (cont’d) - Issues • No equivalent to US GAAP Master-Feeder accounting framework for investment funds • Feeder must fully consolidate a master fund in which it holds the majority of the voting shares unless it can demonstrate that it does not have control • Expected to be rare that feeder will have voting control but can demonstrate that it does not have control

30. IAS 27 – Consolidation (cont’d) - Issues • Feeder that does not have voting control is not required to consolidate unless it has the ability to control by contractual agreement • Certain stock exchanges require such contractual agreements, therefore most listed feeder funds will need to consolidate master funds under IFRS

31. IAS 33 – Earnings per share • Earnings per share should be disclosed by funds whose ordinary or potentially ordinary shares are publicly traded • Presented on face of Income Statement (even if negative) • Basic EPS – profit/loss attributable to ordinary shareholders divided by weighted average number of ordinary shares outstanding during the period • Diluted EPS – profit/loss adjusted for effects of all dilutive potential ordinary shares

32. IAS 33 – Earnings per share - Issue • Disclosure of EPS not consistent with other GAAPs (US, UK) • May completely change the manner in which performance of a fund is measured • Does not provide investors with meaningful information thus it does not enhance presentation and transparency

33. IAS 38 – Intangible Assets • Formation costs should be expensed as incurred

34. Financial Instruments – IAS 32 & IAS 39 1. SCOPE OF IAS 32 & IAS 39 2. CLASSIFICATION AND MEASUREMENT 3. DISCLOSURES

35. Application Scope

36. Key definitions • A financial instrument is a contract that gives rise to both • A financial asset in one enterprise, and • A financial liability or equity instrument in another enterprise • An equity instrument is any contract that results in a residual interest in the assets of an enterprise after deducting all of its liabilities

37. Key definitions (cont’d) A financial asset is any asset that is • Cash • A contractual right to • Receive cash or another financial asset from another entity • To exchange financial instruments with another enterprise under conditions that are potentially favourable • An equity instrument of another enterprise • A contract that will or may be settled in the entity’s own equity instruments

38. Key definitions (cont’d) A financial liability is any liability that is a contractual obligation • To deliver cash or another financial asset, or • To exchange financial instruments with another enterprise under conditions that are potentially unfavourable • A contract that will or may be settled in the entity’s own equity instruments

39. Key definitions (cont’d) • Financial instruments issued by the enterprise should be classified as liabilities or equity instruments according to their substance • This depends on whether the instrument contains any of the elements of a liability as defined in the standard • Where the instrument contains both liability and equity components, they should be classified and accounted for separately • Interest, dividends, losses and gains should be classified in the P&L consistently with the balance sheet treatment

40. Key definitions (cont’d) A derivative is a financial instrument • Whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate or similar variable (sometimes called the ‘underlying’) • That requires little or no initial net investment, and • That is settled at a future date

41. Financial Instruments 1. SCOPE OF THE NEW STANDARDS 2. CLASSIFICATION AND MEASUREMENT 3. DISCLOSURES

42. Classification

43. Classification (cont’d) • Any financial asset or liability may be designated when initially recognized as a financial asset or liability at fair value through profit and loss • Except for investments in equity instruments that do not have a quoted market price in an active market, and whose fair value cannot be reliably measured

44. Held-to-maturity • Financial assets with a fixed maturity and fixed or determinable payments • Enterprise has the positive intent and ability to hold to maturity • The intent and ability must be assessed at each year end

45. When not classified as « held-to-maturity » • They are intended to be held for an undefined period • They would be sold if it became expedient to do so, e.g. because of market conditions, liquidity needs etc. • The issuer has the right to settle at significantly below carrying value, or • The portfolio is “tainted” (i.e. if in the last three years, the enterprise sold more than an insignificant amount of held-to-maturity investments)

46. Held-to-maturity (cont’d) • Held to maturity financial instruments are carried at amortized cost, using the effective interest method • If it no longer becomes appropriate to classify an investment as held-to-maturity, re-measure to fair value

47. Available-for-sale • These are financial assets that do not fall under any other classification • They are measured at fair value, unless fair value cannot be reliably measured

48. Loans and receivables • Created by the enterprise by providing money, goods or services directly to a debtor • Excludes any originated for trading purposes • Includes any participations and syndicated loans funded on origination • Loans acquired after origination are classified as trading, held-to-maturity or available for sale • Loans and receivables are measured at amortized cost, less provision for impairment

49. Accounting for gains and losses • Financial asset or financial liability at fair value through profit and loss: (un)realized gains and losses recorded in the income statement • Available-for-sale: realized gains and losses in the income statement. Unrealized gains and losses directly in reserves • Impairment losses on available-for-sale investments always included in the income statement

50. Initial Measurement • All financial assets and liabilities are initially measured at fair value • Plus, in the case of financial assets and liabilities not at fair value through profit or loss • Transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability • IAS 18 - certain financial service fees are an integral part of the effective interest rate of a financial instrument