[10375]
October 14, 1998
TO: ACCOUNTING/TREASURERS COMMITTEE No. 43-98
TAX COMMITTEE No. 31-98
UNIT INVESTMENT TRUST COMMITTEE No. 29-98
RE: PROPOSED AUDIT GUIDE FOR INVESTMENT COMPANIES
______________________________________________________________________________
The AICPA Accounting Standards Executive Committee (AcSEC) recently issued an
exposure draft of a revised Audit and Accounting Guide, Audits of Investment Companies
(Exposure Draft or Proposed Guide). The Proposed Guide will replace the current Audit and
Accounting Guide, which was issued in 1986 and updated only for conforming changes.
Among other things, the Proposed Guide provides new guidance on: a) amortization of
premium and discount on fixed-income securities, b) organization and offering costs, c) liability
recognition in connection with excess expense reimbursement plans, d) capital infusions and
corrections of investment restriction violations, e) complex capital structures, and f) financial
statement presentation and disclosure of portfolio securities, the components of net assets, and
dividend distributions. These proposed changes are described in more detail below. The
Proposed Guide also contains specific chapters on taxation of regulated investment companies
and unit investment trusts.
You may obtain a copy of the Exposure Draft by accessing the AICPA’s web site,
www.aicpa.org. You may also request one free copy from the AICPA order department by
calling 888/777-7077 and requesting product code #800123. Comments on the Proposed Guide
must be received by the AICPA by December 22, 1998. Please provide me with any comments
on the Exposure Draft by telephone (202/326-5851), fax (202/326-5853) or e-mail (smith@ici.org)
by November 13. If you have comments on the tax section of the Proposed Guide, please
forward them to Anne Barr (202/326-5837), fax (202/326-5841) or e-mail (barr@ici.org).
Amortization of Premium and Discount on Fixed-Income Securities
The Proposed Guide requires that premiums and discounts on fixed-income securities
be amortized using the interest method. Many funds investing in taxable bonds currently do
not amortize premiums for book or tax purposes. Mandatory amortization of premium will
affect the characterization of income shown in the statement of operations and in the financial
highlights. While this proposed change results in no net increase or decrease in the net gain or
loss from investment activities reported in the statement of operations, it will cause a
reclassification between net investment income and realized or unrealized appreciation for
those fixed-income funds that do not currently amortize premium. In reported in the financial
highlights table. Further, the proposed change in accounting policy will cause a "book-tax
difference" to the extent the fund does not amortize premium for tax purposes.
Transition guidance in the Exposure Draft indicates that the cumulative effect of the
proposed change should be reflected as an adjustment to the disclosed amount of the amortized
cost of debt securities held as of the beginning of the year in which the Proposed Guide is first
applied, based on retroactive recomputation of premium or discount from the initial acquisition
date of each security. The cumulative effect of the change should also be reflected as an
adjustment of the undistributed net investment income and net unrealized gains or losses as of
the beginning of the year in which the Proposed Guide is first applied.
Organization and Offering Costs
Consistent with SOP 98-5 Reporting on the Costs of Start-up Activities, the Proposed Guide
requires that organization costs be expensed as incurred. The Exposure Draft provides
guidance on the types of costs that may be considered organization costs and those that may be
considered offering costs. Consistent with current practice, open-end funds (and closed-end
funds with a continuous offering) should treat offering costs as a deferred charge until
operations begin, at which time they would be amortized to expense over twelve months on a
straight-line basis. Closed-end fund offering costs should be charged to paid-in capital when
shares are sold.
The Exposure Draft provides new guidance for unit investment trust offering costs. The
Proposed Guide requires that UIT offering costs be charged to paid-in capital on a pro rata
basis as the units are issued or sold by the trust (i.e., when the units are purchased by the
underwriter).
Excess Expense Reimbursement Plans
Under an excess expense reimbursement plan, the adviser agrees to reimburse all fund
expenses in excess of a stated percentage of average net assets during the first several years of
the fund’s operations. The investment company agrees to repay the adviser in later years if,
and to the extent that, the investment company’s net assets increase sufficiently to permit such
payments without causing the fund’s expense ratio to exceed the stated percentage expense
limitation. The economic result of these agreements is to defer payment of the expenses until
the investment company is financially able to bear them or, upon termination or expiration of
the reimbursement agreement, to eliminate them entirely.
Some have argued that a liability is incurred at the time the adviser reimburses the fund
and that the fund should recognize that liability. However, the proposed Guide indicates that a
liability for such excess expenses should not be recorded by the fund unless all substantive
criteria for reimbursement have been met and amounts are actually due under the
reimbursement agreement. AcSEC noted that payment of any amount under an excess expense
plan depends upon the fund achieving and maintaining a sufficient asset level to support
repayment and that there is no assurance that the fund will achieve that asset level. Further,
the fixed expiration date of the excess expense agreement could result in the adviser being
unable to recover part or all its reimbursement payments to the fund.
Capital Infusions and Corrections of Investment Restriction Violations
Capital infusions are typically undertaken by an investment adviser to reimburse the
effect of a loss attributable to a decline in the value of a portfolio security. Capital infusions
may take the form of a direct cash contribution, the purchase of a security from the fund at a
price in excess of its current fair value, or provision of a credit enhancement. The Proposed
Guide indicates that capital infusions should be reported as contributions to capital, appearing
in the statement of changes in net assets immediately after the capital share transactions
section, and in the financial highlights table immediately after reported distributions per share.
This guidance is consistent with two letters issued by the Chief Accountant in the SEC’s
Division of Investment Management in 1994 and 1995 addressing money fund bailouts.
The Exposure Draft also addresses payments to the fund to compensate it for realized
losses on portfolio securities that were purchased in violation of the fund’s investment
restrictions. The Proposed Guide requires that these payments be reported as a separate line
item in the statement of operations immediately after the net realized gain or loss from investments
caption. Further, gains recognized by the fund resulting from investment restriction violations
during the period should be disclosed in the notes to the financial statements.
Complex Capital Structures
The proposed Guide includes a separate chapter on accounting, reporting, and auditing
of multiple-class funds, master-feeder funds, and funds of funds. This new chapter is primarily
derived from SEC rules, letters, and positions in exemptive orders and prevailing industry
practice.
Disclosure of Portfolio Securities
The Exposure Draft proposes to reduce the extent to which investment companies must
disclose their portfolio holdings. Under generally accepted accounting principles, registered
investment companies would be required to disclose:
Each investment (including short sales) constituting more than 1 percent of the fund’s
net assets,
a. All investments in any one issuer aggregating more than 1 percent of the fund’s net
assets, and
b. At a minimum, the fifty largest investments.
As you know, SEC regulations currently require registered investment companies to disclose
each security holding, regardless of size. Accordingly, unless the SEC were to modify its
disclosure requirements, registered investment companies will continue to be required to
disclose all portfolio securities, notwithstanding the Proposed Guide. The Institute recently
submitted recommendations to the SEC for improving shareholder reports. The Institute
1 See letter to Barry P. Barbash from Craig S. Tyle, August 11, 1998 (Accounting/Treasurers Committee
No. 28-98).
recommended that the level of detail required in the schedule of investments be reduced, and
the ICI’s recommendations are generally consistent with the Proposed Guide.1
Disclosure of the Components of Net Assets and Dividend Distributions
The Exposure Draft would require investment companies to disclose only two
components of capital on the balance sheet: shareholder capital and retained earnings. The
components of retained earnings, on a tax basis, would be required to be disclosed in a footnote
to the financial statements. This footnote information would enable investors to determine the
amount of accumulated and undistributed earnings they potentially could receive in the future
and on which they could be taxed. However, SEC regulations require that the components of
capital (i.e., shareholder capital, undistributed net investment income, undistributed net
realized capital gains, and unrealized appreciation/depreciation) be disclosed on the balance
sheet. Accordingly, unless the SEC were to modify its disclosure requirements, registered
investment companies will continue to be required to disclose the components of capital,
notwithstanding the Proposed Guide.
The Exposure Draft proposes that dividends paid be consolidated into a single line item
in both the statement of changes in net assets and the financial highlights table. Financial
statement footnotes would be required to disclose the tax basis components of dividends paid
(i.e., ordinary income and capital gain). Any distribution deemed a tax return of capital would
require separate disclosure on both the face of the financial statements and in the footnotes.
SEC regulations currently require distributions from net investment income and from realized
gains be presented separately, and accordingly, theses regulations would have to be modified
in order for consolidated distribution reporting to be implemented.
Gregory M. Smith
Director - Operations/
Compliance & Fund Accounting