ETFs Need Their Own Accounting Rules- Part III- Emerging Markets ETFs

Posted by Investment Management Group on Sep 27, 2011 5:56:03 PM

There are several emerging markets that do not allow for in-kind transfers of securities, for example Brazil and India. Additionally, some countries, such as Brazil, impose a tax on new purchases of their currency. When units are created in ETFs that focus on these emerging markets, cash is contributed by the authorized participant (“AP”) in lieu of securities since an in-kind transfer is not possible. The ETF then uses this cash to purchase the securities requested at creation. Along with this cash in lieu, the ETF and the AP typically agree to lock in the price of the securities at the time of creation. If the price of the securities rise from the time of creation until the time the Fund is actually able to purchase the securities, the AP makes an additional cash contribution to the Fund to cover the increase in cost. If the prices decrease, the Fund returns cash to the AP. Additionally, the AP typically agrees to reimburse the Fund for costs incurred to acquire securities that were not able to be transferred in kind, such as transaction costs and taxes (i.e.Brazil currency).

How should the additional payments to and from the AP be accounted for on the books and records of the ETF? There are two options: 1) an additional contribution to paid in capital or; 2) an adjustment to the cost basis of the securities purchased with the cash received in lieu. There are valid arguments for either treatment. Many, maybe even most, will argue that an addition to paid in capital is the proper treatment. The payment is, after all, an additional contribution made by a shareholder of the ETF. Additionally, it is my understanding it would be treated as such for tax purposes, and treating the same for book would eliminate the headache of tracking book/tax differences. Administratively speaking, treating the payments as additions / reductions from paid in capital is the easiest course of action.

The argument against paid in capital treatment is that it does not reflect the economic effect of the transaction. Consider the following example: A new ETF with a net asset value of $10 requests a list of securities with a total market value of exactly $500,000 in exchange for 1 creation unit or 50,000 shares (I know, not a very realistic example, but it does emphasize the point I am trying to make.) The AP contributes $500,000 of cash to the ETF. Moments later when the ETF purchases the securities, the collective prices of the securities rise $550,000 and remain unchanged the remainder of the day (unrealistic again, I know). As a result, the AP contributes another $50,000 to the ETF. If this additional payment was treated as an addition to paid in capital, the ETF would have a cost basis in the securities of $550,000, and the market value would be the same - $0 unrealized appreciation. The statement of operations would show nothing. However, the net asset value of the ETF would have risen from $10 (initial NAV - $500,000 / 50,000 shares) to $11 ($550,000 / 50,000 shares). The ETF would have a 10% return, but nothing to show for it in terms of realized and unrealized gains on the statement of operations. However, if the additional payment were treated as an adjustment to cost, the ETF would have a cost basis in the securities of $500,000 with a market value of $550,000 - $50,000 of unrealized appreciation. The statement of operations would show change in unrealized appreciation of $50,000. The ETF’s return of 10% and the statement of operations would be aligned. Without regards to the tax treatment, this seems like a better answer to me.

Further evidence is evident in the case of an AP contribution to reimburse transaction costs and taxes. Currently, transaction costs are capitalized and included with the cost of the securities. The matching principle of accrual accounting requires revenues and their related expenses be recognized in the same accounting period. The transaction costs are recognized over time when the securities are sold and the cost is relieved. If the payments by the AP are treated as contributions to capital, they will never be recognized and the matching principle will not be met.

So what is the solution? A combination of both treatments appears to be the industry practice. ETFs are treating the payments as contributions to capital, but are adding additional disclosures regarding the payments. Additionally, the per share amount of capital contributions is being added to the financial highlights table to alleviate the disparity between the realized and unrealized gain per share on the financial highlights and the amounts reported on the statement of operations. I often see a footnote explaining the reasons for the capital contributions as well as the amount of the contributions. Ultimately, the information needed for the reader to understand the economic impact of the transaction is provided while avoiding book/tax differences that would be an administrative burden to track.

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