Hedge Fund
Accounting
Student Manual
Copyright © 2011 BNY Mellon Alternative Investment Servicing
All material contained herein is confidential and proprietary. Do not reproduce or distribute to any third party without
written consent from BNY Mellon.
Data as of 07/01/2010
Short Sales
A Short Sale is when a Fund sells a security which it does not actually own.
How does that work?
The Fund borrows the security, which it perceives to be over-priced, from a broker
and sells it immediately on the market.
Eg.
Fyffes shares are currently trading at €18.50. Based on his experience, the Fund Manager
knows that this price can’t be maintained.
He approaches a broker and borrows 1,000 shares and immediately sells them out on the
market. The proceeds of this sale are €18,500.
As anticipated the price falls to €14.25. At this stage the Fund Manager buys 1,000 shares
which will cost him €14,250. he immediately pays back the broker
Therefore
cost
Sales proceeds
Gain
14,250
18,500
4,250
Short sales can occur on numerous instruments, including stocks, bonds, debentures,
warrants and commodity futures. The focus of this chapter will be in relation to equity short
sales. With equities, the Fund will not only be required to return the security to the broker; it
will also have to repay any dividend income that was earned on the security during the short
sale. This will be dealt with at a later point.
Jargon
Uptick
Exchange rules permit short sales only after an “uptick” which means
they an only be executed when the last recorded change in the stock
price is positive.
Long
buying
Short
Selling
Cover
when you buy back the underlying security, you are said to have
covered your position. When the Fund purchases the security, it must
immediately return it to the broker from whom the security was
originally borrowed
Against the box
A situation where the Fund holds a security of identical property, but
does not intend to deliver such property to cover the short sale - the
Fund is permitted to deliver a security of identical property that it holds
to cover the short sale.
Rebate Fee
Interest earned on the cash (short sale proceeds) held in the
segregated accounts The rebate fee may be equivalent to all or some
portion of this interest. Repaid to the fund by the broker/custodian
Sale proceeds
The proceeds of the short sale must be held by the broker, so that the
Fund cannot invest the proceeds to generate income for the Fund.
Obligations to the Broker Lending the Security for the Short Sale

Any income earned by the investment sold short must be returned to the broker.

If the broker requires that the shares of the security be returned, the Fund must do so,
by purchasing the shares on the open market at whatever the prevailing price is, which
may even result in a realised loss for the Fund.
Strategy
The Fund intends to sell high and repurchase low.
Short sale
Traditional
The diagram below compares the strategy of short selling to the traditional long strategy.
Margin Requirements
Initial Margin
Generally 50% (as per SEC requirement) of the total trade value has to be deposited with
the custodian.
The initial margin has to be at least to the value of $2,000 – so if 50% of your trade is less
than this then you must deposit $2k. (exchange rulings)
Once the short sale is covered, i.e once you buy the underlying stock and return it to the
broker you lent it off,all margin moneys are returned to the Fund.
The margin is simply a “good-faith” deposit, provided as protection to the broker, in the
event that the Fund defaults on its obligation to return the security.
Maintaining the margin
Each contract entered into will also incorporate a maintenance requirement. As the market
value of the security increases, the Fund may be required to deposit additional funds. This
is so that the margin money does not fall below the maintenance requirement – and the
fund will receive a “margin call”.
Example of the Margin Requirement
A Fund has executed a short sale on 1,000 MSFT shares at a price of $102 per share,
giving sales proceeds of $102,000.
It has deposited 50% of the market value in a segregated account with its custodian $51,000. The Maintenance Requirement on this account has been set at 30%
To calculate the MSFT price at which the Fund receives a “Margin Call”, follow the working:The total equity in the segreagated account is currently $153,000, from which the cost of
purchasing the 1,000 shares must be deducted (refer to as 1,000 X).
Therefore,
$153,000 – 1,000 X / 1,000 X = 0.30
$153,000 – 1,000 X = 300 X
$153,000 = 1,300 X
$117.69 = X
Therefore, if the price of MSFT were to rise above $117.69, the Fund would receive a margin call and would
be required to deposit additional funds to re-establish the 30% margin requirement.
The following diagram summarises the cash flows involved in a short sale transaction:
The diagram shows all of the cash-flows from the Fund to the broker and the custodian
(represented by
). When the short sale is covered, and all obligations have been
fulfilled by the Fund, the diagram shows the cash flows that the Fund receives back
(represented by
).
It is the responsibility of the Fund Advisor to instruct the custodian to close the short
position, return the margin deposit and deliver the security.
Dividends
The Fund must pass on any dividends that have gone ex during the period that the short
sale is open.
These dividends will be recorded as an expense payable on the books of the Fund, and not
as an income receivable. As we do not own the equities, we cannot claim any income
earned on them.
For example, the Fund has executed a short sale on 200 IBM shares. Notification is
received that an IBM dividend is going ex today, with a dividend rate of 2.5 per share.
The accounting entry required will be as follows, and will be recorded on ex-date:
DR
CR
Dividend Expense
Dividend Expense Payable
(C)
(L)
500
500
The dividend income will be paid to the broker who leant the Fund the 200 shares of IBM,
on the date when the contract is covered.
Accounting Treatments for Short Sales
Example
The “Global Equity Fund” enters a short sale of AOL shares, with the following details:
Security:
Sedol:
Shares:
Price:
Principal:
AOL
00184A105
1,000
$58.00
$58,000.00
SEC Fee:
Commission:
Total Receivable:
$32.00
$100.00
$57,868.00
Broker:
JP Morgan
Opening entries
DR
Investment sold unsettled
CR Investment at Cost
(A)
(A)
57,868
57,868
(A)
(A)
28,934
28,934
Initial margin entries (50% of value)
DR
Margin Receivable
CR Cash
Appreciation/ Depreciation
The security sold short will then be valued daily and unrealised appreciation or depreciation
is recorded.
If the price of AOL rises to $63.00, the following entry will be made:
Cost to cover contract
Sale proceeds
Therefore loss
DR
1,000 * $63 =
=
=
$63,000
$57.868
$ 5,132
Unrealised Price Gain/Loss Shorts
(C)
CR Unrealised Price Gain/ Loss Shorts (A)
5,132
5,132
If the price of AOL falls to $50.00, the following entry will be made:
Cost to cover contract
Sale proceeds
Therefore gain
DR
1,000 * $50 =
=
=
7,868+5,132
To show right
position
$50,000
$57.868
$ 7,868
Unrealised Price Gain/Loss Shorts
(A)
CR Unrealised Price Gain/ Loss Shorts (C)
13,000
13,000
If a dividend goes ex on AOL with a rate of 4.50, the following entry will be made on exdate:
DR
Dividend Expense
CR Dividend Expense Payable
(C)
(L)
4,500
4,500
Closing out the position
If the Fund were then to close out the position, by purchasing 1,000 shares of AOL at a
price of $56.00 pre share, the following entries would be needed:
Cost to cover contract
Sale proceeds
Therefore gain
DR
1,000 * $56 =
=
=
Investment at Cost
CR Investments Purchased Unsettled
CR Realised Capital Gain Shorts
$56,000
$57.868
$ 1,868
(A)
(L)
(C)
57,868
56,000
1,868
The unrealised entries must also be backed out, as the gain is realised. Let us assume that
the prior price was $50.00
DR
Unrealised Price Gain/Loss Shorts
(C)
CR Unrealised Price Gain/ Loss Shorts (A)
7,868
7,868
Settlement date entries
When the moneys are moved, the following entries will be needed to clear the transaction
from the books of the Fund, leaving only the realised capital gain:
DR
DR
DR
CR
CR
Cash
Dividend Expense Payable
Investment Purchased Unsettled
Investment Sold Unsettled
Margin Receivable
(A)
(L)
(L)
(A)
(A)
26,302
4,500
56,000
57,868
28,934
Explanation of entries
a.
the balance of all the cashflows explained below. We would only see this
amount coming in from the broker/ custodian.
b.
Dividend that went ex during the period is now being paid out to the true
owner of the equities
c.
Today we are paying for the securities that we purchased to cover our position
d.
Today we are receiving in the proceeds of the short sale
e.
Today, as we have not defaulted on our contract, we receive back into the
fund the initial margin that we paid out at the beginning of the contract.