Mutual fund valuation and accounting notes @ bec doms


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Mutual fund valuation and accounting notes @ bec doms

  1. 1. Executive SummaryMutual fund is a trust that pools the savings, which are then invested incapital market instruments such as shares, debentures and other securities.It works in a different manner as compared to other savings organizationssuch as banks, national savings, post office, non-banking financialcompanies etc. as most, if not all capital market instruments, have anelement of risk, it is very essential that the investors have a clearunderstanding of how mutual fund operates and what are the advantages aswell as limitations, how the net asset value (NAV) are calculated and what isthe impact of dividend on NAV etc. this understanding has to be createdamong the investors by the distributors engaged in the marketing of mutualfund products. The distributors should also be knowledgeable enough toanswer fundamental and basic questions raised by the investors. Thedistributors need to understand accounting for the fund’s transactions withthe investors and how the fund accounts for its assets and liabilities which isessential for them to perform basic role in explaining the mutual fundperformance to the investors. For example, unless the distributor knows howthe NAV is computed, he cannot use even simple measures such as NAVchange to assess the fund performance. He should also understand theimpact of dividends paid out by the fund or entry/exit loads paid by theinvestor on the calculation of the NAV and therefore the fund performance. 1
  2. 2. INTRODUCTION:Meaning:The mutual fund industry in India started in1963 with the formation of UnitTrust of India, at the initiative of the Reserve Bank and the Government ofIndia. The objective then was to attract the small investors and introducethem to market investments.In a mutual fund, many investors contribute to form a common pool ofmoney. This pool of money is invested in accordance with a stated objective.The ownership of the fund is thus joint or mutual; the fund belongs to allinvestors. A single investor’s ownership of the fund is in the same proportionas the amount of the contribution made by him bears to the total amount offund.A mutual fund uses the money collected from investors to buy those assetswhich are specifically permitted by its stated objective. Thus, a growth fundwould by mainly equity assets- ordinary shares, preference shares, warrants,etc. An income fund would mainly buy debt instruments such as debenturesand bonds. The fund’s assets are owned by the investors in the sameproportion as their contribution bears to total contributions of all investorsput together. 2
  3. 3. When an investor subscribes to mutual fund, he becomes part owner of fund’s assets. In USA, mutual fund is considered as an investment company andan investor “buys into the fund”, meaning he buys the shares of the fund. InIndia, a mutual fund is constituted as a Trust and the investors subscribes tothe “units” of a scheme launched by the fund, which is where the term unitTrust comes from. The term “unit-holder” is used to denote the mutual fundinvestor which includes in both the open-end and close-end schemes.In an open-end scheme, investors can buy and sell units from the fundcontinuously. The stock exchange is not in picture. To ensure that there isfairness, sale and purchase has to take place at fair value of the unit. Sincethe units held by an investor evidence the ownership of the fund’s assets,the value of the total assets of the fund when divided by the total number ofunits issued by the mutual fund gives us the value of one unit. This isgenerally called as Net Asset Value (NAV) of one unit or one share. The totalvalue of an investor’s part ownership is thus determined by multiplying theNAV with the number of units held. As the fund’s investments are revaluedat their market prices, the net value of investments will change dependingupon the way prices of the investments move in the market. Therefore, theNAV of the fund also fluctuates. 3
  4. 4. Definitions: Source Definition Mutual Fund$ for “A mutual fund is a large pool of investment Dummie$ 1997 money from lots and lots of people.” FSOS Performance “A mutual fund is a collection of stocks, Support New bonds, or other securities purchased by a Employee Orientation group of investors and managed by a 2/1/97 professional investment company.” 4
  5. 5. Quarterly Market “An investment company that pools theGuide to Merrill Lynch money of many individuals and invests in aMutual Funds portfolio of stocks, bonds and/or cash equivalents, actively managed by a portfolio manager who buys and sells securities in an attempt to take advantage of current or expected market conditions.”Business Week’s “A mutual fund is an investment companyAnnual Guide to that pools the money of many individualMutual Funds 1991 investors. When the fund takes in money from investors, it issues shares.”Words of Wall Street “Popular name for the shares of open-end1983 management investment companies. Such shares represent ownership of a diversified portfolio of securities, which are professionally managed and which are redeemable at their net asset value.” 5
  6. 6. “A mutual fund is a company that bringser/inwsmf.htm together money from many people and invests it in stocks, bonds, or other securities. (The combined holdings of stocks, bonds, or other securities and assets the fund owns are known as its portfolio.) Each investor owns shares, which represent a part of these holdings.”Sage Online 1997 “A mutual fund is a savings/investment account managed by money managers employed by an investment company. Money managers are professionals who select the investments of the fund.Introduction to Mutual “A mutual fund is a corporation with a stateFunds and MLAM charter to conduct business as an investment1997 company. It invests in publicly traded stocks and bonds, and issues its own shares to investors, who become Mutual Fund Shareholders.” 6
  7. 7. Need for the project:The selection of an existing mutual fund depends on its performance - pastas well as expected. How should an investor judge the performance of amutual fund? What criteria should be used to evaluate and rank a mutualfund?There are a number of mutual funds in the market. New schemes are hittingthe market almost daily, with new names and targets. So, it becomes difficultfor the small investor to judge the performance of the fund accurately.The performance of a mutual fund scheme is reflected in its net asset value(NAV) which is disclosed on a daily basis in case of open-ended schemes andon weekly basis in case of close-ended schemes.The Importance of Accounting Knowledge:The balance sheet of mutual fund is different from the usual balance sheet ofother corporate entities such as Banks, Companies or Partnership firms. Allof the fund’s assets belong to investors and are held in fiduciary capacity forthem. Mutual fund employees need to be aware of the special requirementsconcerning accounting for the fund’s assets, liabilities and transactions with 7
  8. 8. investors and others like banks, custodians and registrar. This knowledgewill help them understand their place in the organization, by getting anoverview of the functioning of the firm.Even the mutual fund distributors need to understand accounting for thefund’s transactions with the investors and how the fund accounts for itsassets and liabilities, as the knowledge is essential for them to perform theirbasic role in explaining the mutual fund performance to their investors. Ifthey don’t know how the NAV is computed, then they cannot use evensimple measures such as NAV change to assess the fund performance.Scope of Project:The project enables us to know that performance of mutual fund is reflectedin its net asset value (NAV). Hence, it is not that investor’s should invest inthose units which have highest NAV, but they should also consider what arethe risk and returns associated with the NAV. Also, the investor mustconsider impact of dividend payout on the NAV. As far as accounting ofmutual fund is consider, SEBI lays down various guidelines and provisions inwhich manner the AMC’s are required to maintain their accounts, whatshould be the accounting effects and so on.Methodology:Data collection Primary data- Interviewed Fund manager Mr. Amankumar .Rajoria of Standard Chartered Bank, Mutual Fund Dept., Fort. 8
  9. 9. Secondary data- Internet Business magazines WorkbookCharacteristics of a mutual fund: Mutual funds are not guaranteed by any bank or government agency. Mutual funds provide a rate of return, in the form of dividends, capital gains, and changes in share value. There is always some investment risk. Higher rates of return usually involve higher risk. All mutual funds have costs which lower the shareholder’s rate of return. Past performance is not a guarantee of future performance. 9
  10. 10. Mutual funds can be purchased through brokers or directly from the fund through its Transfer AgentAdvantages of Mutual Funds: 1) Portfolio diversification: Mutual funds normally invest in a well-diversified portfolio of securities. Each investor is a part owner of all the fund’s assets. This enables him to hold a diversified investment portfolio even with a small amount of investment. 2) Professional management: The investment management skills along with the needed research into available investment options ensure a much better return than what an investor can manage on his own. 3) Reduction/Diversification of Risk: Diversification reduces the risk of loss. When an investor invests directly, all the risk potential loss is his own. While investing in a pool of funds with other investors, any loss on one or two securities is also shared with other investor. 4) Reduction of transaction costs: A direct investor bears all the cost of investing such as brokerage or custody of securities. When going through a fund, he has the benefit 10
  11. 11. of economies of scale; the funds pay lesser costs because of larger volumes, a benefit passed on to its investors. 5) Convenience and flexibility: Investors can easily transfer their holdings from one scheme to another. They can also invest or withdraw their money at regular intervals. The mutual fund process is further made convenient with the facility offered by funds for investors to buy or sell their units through the internet or e-mail or using other communication means.Disadvantages of Mutual funds: 1) No control over costs: Investor pays investment management fees as long as he remains with the fund, albeit in return for the professional management and research. Fees are usually payable as a percentage of the value of his investments, whether the fund value is rising or declining. He also pays distribution costs, which he would not incur in direct investing. 2) No Tailor made portfolios: Investors who invest on their own can build their own portfolios of shares, bonds and other securities. Investing through funds means he delegates this decision to the fund managers. High net-worth individuals or large corporate investors may find this to be a constraint in achieving their objectives. 11
  12. 12. 3) Managing a portfolio of funds: Availability of a large number of options from mutual funds may again need advice on how to select a fund to achieve its objectives, quiet similar to the situation when he has to select individual shares or bonds to invest in.MUTUAL FUND SCHEMES:OPERATIONAL CLASSIFICATION: 1. OPEN-ENDED SCHEME: When a fund is accepted and liquidated on a continuous basis by a mutual fund manager, it is called ’open-ended scheme.’ The fund 12
  13. 13. manager buys & sells units constantly on demand by the investors. Under this scheme, the capitalization of the fund will constantly change, since it is always open for the investors to sell or buy their share units. The scheme provides an excellent liquidity facility to investors. No intermediaries are required in this scheme. MERITS: 1. It provides liquidity facility. 2. No intermediaries required. 3. Provide long term capital appreciation. 4. No maturity period. DEMERITS: 1. Not traded on stock exchange. 2. Capitalization of fund is constantly changing.2. CLOSE-ENDED SCHEME: When units of a scheme are liquidated (repurchase) only after the expiry of a specified period, it is known as a close-ended scheme. Accordingly such funds have fixed capitalization & remain as a corpus with the mutual fund manager. Units of close-ended are to be traded on the floors of stock exchange in the secondary market. The price is 13
  14. 14. determined on the basis of demand & supply. Therefore there will be, two prices, one that is market determined & the other which is Net Asset Value based. The market price may be either above or below NAV. Managing a close-ended scheme is comparatively easy as it gives fund managers ample opportunity to evolve & adopt long term investment strategies depending on the life of the scheme. Need for liquidity arises after a comparatively longer period i.e. normally at the time of redemption. MERITS: 1. The prices are determined on the basis of market price & NAV. 2. Gives fund manager ample opportunity to evolve & adopt long term investment strategies. 3. Invests in listed stock exchange & traded securities. DEMERITS: 1. Open for subscription only for a limited period. 2. Exit is possible only at the end of specified period.RETURN BASED CLASSIFICATION:1. INCOME FUND SCHEME: 14
  15. 15. The scheme that is tailored to suit the needs of investors who are particularabout regular returns is known as ‘income fund scheme.’ The scheme offersthe maximum current income, whereby the income earned by units isdistributed periodically. Such funds are offered in two forms, the firstscheme earns a target constant income at relatively low risk, while thesecond scheme offers the maximum possible income.2. GROWTH FUND SCHEME:It is a mutual fund scheme that offers the advantage of capital appreciationof the underlying investment. For such funds, investment is made in growthoriented securities that are capable of appreciating in the long run. Growthfunds are also known as nest eggs or long haul investment. In proportion tosuch capital appreciation, the amount of risk to be assumed would be muchgreater.INVESTMENT BASED CLASSIFICATION: 1. EQUITY FUND SCHEME: A kind of mutual fund whose strength is derived from equity based investments is called ‘equity fund scheme.’ They carry a high degree of risk. Such funds do well in periods of favorable capital market trends. A variation of the equity fund schemes is the ‘index fund’ or ‘never beat market fund’ which are involved in transacting only those scripts 15
  16. 16. which are included in any specific index e.g. the scripts which constituted the BSE-30 Sensex or 100 shares National index. These funds involve low transaction cost.2. BOND FUND SCHEME: It is a type of mutual fund whose strength is derived from bond based investments. The portfolio of such funds comprises bonds, debenture etc. this type of fund carries the advantage of secured & steady income. However, such funds have little or no chance of capital appreciation, & carry low risk. A variant of this type of fund is called ‘Liquid Funds.’ This specializes in investing in short term money market instruments. This focus on liquidity delivers the twin features of lower risks & low returns. 3. BALANCED FUND SCHEME: A scheme of mutual fund that has a mix of debt & equity in the portfolio of investment may be referred to as a ‘Balanced Fund Scheme.’ The portfolio of such funds will be often shifted between debt & equity, depending upon the prevailing market trends. 4. SECTORAL FUND SCHEMES: When the managers of mutual fund invest the collected from a wide variety of small investors directly in various specific sectors may include gold & silver, real estate, specific industry such as oil & gas 16
  17. 17. companies, offshore investments, etc.5. FUND-OF-FUND SCHEME:There can also be funds of funds, where funds of one mutual fund areinvested in the units of other mutual funds. There are a number offunds that direct investment into a specified sector of the economy.This makes diversified & yet intensive investment of funds possible. 17
  18. 18. History of Mutual Funds in India and role of SEBI inmutual funds industry:Unit Trust of India was the first mutual fund set up in India in the year 1963.In early 1990s, Government allowed public sector banks and institutions toset up mutual funds. In the year 1992, Securities and exchange Board ofIndia (SEBI) Act was passed. The objectives of SEBI are – to protect theinterest of investors in securities and to promote the development to and toregulate these securities market. As far as mutual funds are concerned, SEBIformulates policies and regulates the mutual funds to protect the interest ofthe investors. SEBI notified regulations for the mutual funds in 1993.Thereafter, mutual funds sponsored by private sector entities were allowedto enter the capital market. The regulations were fully revised in 1996 andhave been amended thereafter from time to time. SEBI has also issuedguidelines to the mutual funds from time to time to protect the interests ofinvestors. All mutual funds whether promoted by public sector or privatesector entities including those promoted by foreign entities are governed bythe same set of Regulations. There is no distinction in regulatoryrequirements for these mutual funds and all are subject to monitoring andinspections by SEBI. The risks associated with the schemes launched by themutual funds sponsored by these entities are of similar type. It may bementioned here that Unit Trust of India (UTI) is not registered with SEBI as amutual fund (as on January 15, 2002). 18
  19. 19. Sponsor, Trustee, AMC and Other Constituents: Mutual funds in India have a 3-tier structure of Sponsor-Trustee-AMC. Sponsor is the promoter of the fund. Sponsor creates the AMC and the trustee company and appoints the boards of both these companies, with SEBI approval. The mutual fund is formed as trust in India, and not as a company. In the US mutual funds are formed as investment companies. The AMC’s capital is contributed by the sponsor. Investors’ money is held in the Trust (the mutual fund). The AMC gets a fee for managing the funds, according to the mandate of the investors. 19
  20. 20. The trustees make sure that the funds are managed according to theinvestors’ mandate. Sponsor should have at least a 5-year track record in the financialservices business and should have made profit in at least 3 out of the5 years.Sponsor should contribute at least 40% of the capital of the AMC.Trustees are appointed by the sponsor with SEBI approval.At least 2/3 of trustees should be independent.At least ½ of the AMC’s Board should be of independent members.An AMC cannot engage in any business other than portfolio advisoryand management.An AMC of one fund cannot be Trustee of another fund.AMC should have a net worth of at least Rs. 10 crores at all times.AMC should be registered with SEBI.AMC signs an investment management agreement with the trustees. 20
  21. 21. Trustee company and AMC are usually private limited companies.Trustees are required to meet at least 4 times a year to review the AMC.The investors’ funds and the investments are held by the custodian,who is the guardian of the funds and assets of investors.Sponsor and the custodian cannot be the same entity.If the schemes of one fund are taken over by another fund, it is calledas scheme takeover. This requires SEBI and trustee approval.If two AMCs merge, the stakes of sponsors changes and the schemesof both funds come together. High court, SEBI and Trustee approvalneeded.If one AMC or sponsor buys out the entire stake of another sponsor inan AMC, there is a takeover of AMC. The sponsor, who has sold out,exits the AMC. This needs high court approval as well as SEBI andTrustee approval. Investors can choose to exit at NAV if they do not approve of thetransfer. They have a right to be informed. No approval is required, inthe case of open-ended funds.For closed-end funds, investor approval is required for all cases ofmerger and takeover (as per the curriculum). 21
  22. 22. Closed end fund investors also do not have exit option.Legal and Regulatory Framework: Mutual funds are regulated by the SEBI (Mutual Fund) Regulations, 1996. SEBI is the regulator of all funds, except offshore funds. Bank-sponsored mutual funds are jointly regulated by SEBI and RBI. If there is a bank-sponsored fund, it cannot provide a guarantee without RBI permission. 22
  23. 23. RBI regulates money and government securities markets, in whichmutual funds invest.Listed mutual funds are subject to the listing regulations of stockexchanges.Since the AMC and Trustee Company are companies, any complaintsagainst their board can be made to the CLB.Investors cannot sue the trust, as they are the same as the trust andcannot sue themselves.UTI does not have a separate sponsor and AMC.UTI is governed by the UTI Act, 1963 and is voluntarily under SEBIRegulations.SROs are the second tier in the regulatory structure.SROs get their powers from the apex regulating agency, act on theirinstructions and regulate their own members in a limited manner.SROs cannot do any legislation on their own.All stock exchanges are SROs. 23
  24. 24. AMFI is an industry association of mutual funds. AMFI is not yet a SEBI registered SRO. AMFI is regulated by its own board made up of its members.VALUATION OF SCHEME PORTFOLIOS:The Need to Know Valuation Methods:The value of investors’ holdings of units in a mutual fund is calculated onthe basis of Net Asset Value of investments by the fund. Distributors andinvestors need to understand how mutual funds value the securities held by 24
  25. 25. them in their portfolios, so they can understand how value of the investor’sholdings in fund schemes is arrived at.This knowledge will help them anticipate the fluctuations in the portfoliovalues under different market scenarios and recommend or take theirdecisions accordingly. This will also help them in comparing theperformance of different fund schemes by reviewing the valuation methodsfollowed by them.The Regulation of Valuation Practices:As the industry regulator, SEBI aims at protecting the investors by ensuringthat the valuation practices adopted by the AMC’s (Asset ManagementCompany) are a. Based on the principles of “fair valuation” of portfolios securities. b. Are uniform across the fund types and AMC’s to the extent possible.The fair valuation ensures that realistic prices are used to compute the valueof portfolio securities and that there is no manipulation of the values ofportfolios. Uniform valuation practices ensure that everyone can compare theperformance of different schemes and AMC’s without worrying aboutwhether the fund valuation practices may be different from one scheme toanother.AMC’s therefore adopt uniform portfolio valuation practices to the extentpossible. 25
  26. 26. SEBI in turn regulates and a. Prescribes detailed valuation methodologies in its Fund regulations b. Mandates disclosure of valuation methods used for information of investors.Basic Valuation Principles:Fair value-It means value of security that is realistic and not based on any arbitrarymethodology. Fair value may be determined based either on purchase cost,market price or on some accepted principles.Fair value of Traded Securities-Mutual funds invest essentially in marketable securities traded either on thestock exchange or on to the money markets. The preference for tradedsecurities is given to ensure liquidity of the investments- ease with which thesecurities can be sold. The second reason for the preference for ‘tradedsecurities” is to ensure that these securities receive ‘fair valuation at marketprices’ that are publicly available. This valuation process is known as “markto market”- bringing the value of the securities in the portfolio to reflecttheir market value. 26
  27. 27. Fair value of Illiquid Securities-While fund managers always strive to include only traded or liquid securitiesin their portfolios market conditions often result in some securities not beingtraded in the market. Valuation of such non-traded securities poses aproblem of how to determine their ‘fair value’. Regulators prescribe methodswherever possible or require the Trustees to determine the rightmethodology and disclose to the extent possible.Valuation date-The date on which the fund calculates the value of its portfolio and the NAVis known as the valuation date. Where funds value their investments on a‘mark to market’ basis, the valuation date is the date on which the tradedprice of a security is available. For non-traded security it means the date thatis selected and used for the valuation in accordance with some principlesand regulations. 27
  28. 28. Valuation of Equity Securities:The valuation principle to be used depends also upon whether a security istraded in the market or not.Traded Securities- For traded securities the basis of valuation is ‘mark to market’. For thispurpose, on the valuation date, once the market price is obtained the fundwill multiply its current holdings in number of shares by the applicablemarket price to get the “mark to market” value. The market price to be usedfor valuation is determined as follows: a. An equity security is valued at the last quoted closing price on the stock exchange where it is “principally traded”. b. If no trade is reported on principal stock exchange, the last quoted price on any other recognized stock exchange may be used c. If an equity security is not traded on ant stock exchange on a particular valuation day, the value at which it was traded on the selected/other stock exchange on the earliest previous day, may be used, provided such date is not more than 30 days prior to the valuation date. 28
  29. 29. Thinly Traded Security-For some securities market prices is not available easily. It becomes difficultin such cases to apply the principle of ‘mark to market’. The reason fornon-availability of market price is the infrequency or small volume of tradingin a security. Such securities are then considered ‘thinly traded’ and SEBI givesome freedom to AMC’s to use their own methods of valuation in such cases.SEBI defines thinly traded security as:“An equity/convertible debenture/warrant is considered as a thinly tradedsecurity if trading value in a month is less than Rs.5 lakhs and the totalvolume is less than 50000 shares.”Then market price or free valuation principle is used as follows: a. In case trading I the security is suspended up to 30 days, then the last traded price is used. b. If trading in the scrip is suspended for more than 30 days, then the AMC can decide the valuation norms to be followed and such norms would be documented and recorded.Non-Traded Securities:When a security is not traded on any stock exchange for 30 days prior to thevaluation date, it becomes a ‘non-traded security’.Valuation of Non-traded/Thinly traded securities: 29
  30. 30. Both non-traded and thinly traded securities are to be valued “in good faith”by the AMC on the basis of the valuation principles laid down below:- a. Based on the latest available Balance sheet, Net worth per share is calculated. [Net worth per share= (Share capital+ Reserves- Miscellaneous expenditure and Debit balance of P&L A/c)/ No. of paid up shares.] b. Then value per share is calculated using the Capitalized Earnings Method. The formula used is (Earnings per share *applicable P/E multiple). For this purpose, average P/E ratio for the industry is to be based upon BSE or NSE data. PER should be followed consistently. The identified PER has to be discounted by 75% and only 25% of the industry average P/E shall be taken as the applicable P/E multiple. Earnings per share of the latest audited annual accounts are considered for this purpose. c. The value per share based on the net worth method and capitalized earnings method, calculated as above, is averaged and further discounted by 10% for illiquidity, to arrive at the value per share. d. In case the EPS is negative, EPS value for that year is taken a zero for arriving at capitalized earnings. e. Where the latest balance sheet of the company is not available within nine months from the close of the year, unless the accounting year is changed, the shares of such companies shall be valued at zero. 30
  31. 31. f. In case an individual security accounts for more than 5% of the total assets of the scheme, an independent valuer has to be appointed for the valuation.Example: 1. Assume that we hold an engineering company’s share that is not quoted on the market, but we know that the company makes Rs.2 EPS and has a net worth of Rs.8 per paid up share. 2. We can use other traded engineering companies industry average for basing the applicable P/E multiple say Rs.12. 3. With a 75% discount, the P/E multiple applicable to our untraded share is 3 (12*25%). 4. We can use the multiple of 3 to obtain our untraded share’s price by multiplying our company’s Rs.2 EPS with the applicable PER and get the valuation price of Rs.6. 5. This is further averaged with the company’s net worth of 8 to give a value of Rs. 7 per share [(6+8)/2]. 31
  32. 32. 6. Since our share is not liquid we must discount 7 by 10% to give a valuation of Rs. 6.30 per share.Equity dividends impact on NAV:Income to be distributed as a dividend remains part of the fund’s NAV untilex date. On ex date, the NAV is reduced by the amount of the dividend. Thetable below illustrates the impact of an equity dividend payout on NAV. Who When What XYZ Biotech Initially began with $100,000 in fund (January 1) assets issued 10,000 shares had an initial NAV of $10.00 per share 32
  33. 33. XYZ Biotech At the end of has had no expensesfund the first quarter did not issue or redeem of operation any shares (April 5) earned $5,000 in interest and dividends from the assets in it’s portfolio has an NAV of $10.50 per share ($105,000/10,000=$10. 50)XYZ Biotech’s April 10 decides to distribute allboard of of the income earned bydirectors the fund declares a dividend with record date set as April 15, ex date set as April 16, and payable date set as April 25XYZ Biotech April 15 still has an NAV offund (record date) $10.50 33
  34. 34. XYZ Biotech’s April 16 (ex Removes the $5,000 board of date) from the fund’s assets directors and puts it in a pending dividend distribution account (this will decrease NAV by $0.50 per share) XYZ Biotech April 16 (ex now has an NAV of fund date) $10.00 XYZ Biotech April 25 pays a dividend of $0.50 fund (payable date) per share to all shareholders of record as of April 15 Note: The NAV is not impacted by this payment event.Dividend entitlement relative to NAV paid/received: 34
  35. 35. The table below illustrates which investors (buyers or sellers)are entitled to the dividend in the previous example, and relatestheir entitlement to the NAV they either paid for purchases orreceived for liquidations. An investor who is and who places the will... a... trade... buyer prior to ex date pay $10.50 per share, (April 16) which includes the $5,000 in income, and will be entitled to the dividend when it pays. buyer on or after ex date pay $10.00 per share, (April 16 ) which does not include the $5,000 in income, and will not be entitled to the dividend. 35
  36. 36. seller prior to ex date receive $10.50 per share (April 16) for the liquidation, which includes the $5,000 in income, and will not be entitled to the dividend, as the income was already reflected in the $10.50 NAV.seller on or after ex date receive $10.00 per share (April 16 ) for the liquidation, which does not include the $5,000 income, and will Be entitled to the dividend when it pays. 36
  37. 37. Valuation of Debt Securities:Traded Securities-A debt security may be traded on a stock exchange (corporate securities) orin the interbank market (government security). If a security is traded on thestock exchange then again publicly available and quoted market prices areused for its valuation. If a debt security (other than govt. security) is nottraded on any stock exchange on a particular valuation day, the value atwhich it was traded on the principal stock exchange on the earliest previousday, may be used, provided such date is not more than 15 days prior to thevaluation date. If a debt security (other than govt. security) is purchased byway of private placement, the price at which it was bought may be used for aperiod of 15 days beginning from the date of purchase.Thinly Traded Securities-These needs to be identified and then valued especially. A debt security(other than govt. security) is considered as a thinly traded security if on the 37
  38. 38. valuation date there is no individual trade on that security in marketable lotson the principal stock exchange or any other stock exchange.Valuation of Non-traded/Thinly traded security:Valuation norms of such securities depend upon their maturity. Thus, 1. Money Market Securities and Debt Securities up to 182 days to maturity- Non-traded debt securities with residual maturity of up to 182 days should be valued on the same basis as money market securities. These securities are valued on the basis of amortization of purchase cost plus accrued interest till the beginning of the purchase plus the difference between the redemption value and the purchase cost that is spread uniformly over the remaining maturity period of the investments. 2. Non- traded, Non-Government, debt instruments over 182 days to maturity- All non-traded debt securities including asset backed paper with maturity of over 182 days are valued ‘in good faith’ by the AMC I accordance with the detailed valuation principles laid by SEBI. a. All Non-traded Debt Securities are classified into “Investment grade” and “Non-Investment grade” securities based on their credit rating. The non-investment grade securities are further classified as “Performing” and “Non Performing” assets. 38
  39. 39. b. All Non-Government, investment grade debt securities, classified as non-traded, are valued on yield to maturity (YTM) basis as described later. c. All Non-Government, non-investment grade, performing debt securities are valued at a discount of 25% to the face value. d. All Non-Government, non-investment grade, non- performing debt securities would be valued based on the provisioning norms.Computation Methodology for Yields used forvaluations of Debt Securities:The approach to valuation of non-traded debt security is based on theconcept of “spreads” over the ‘benchmark rate’ to arrive at the yields forpricing of non-traded security. The process is as follows-Step A:A Risk Free Benchmark Yield is calculated, using the government securitiesas the base as they are traded regularly, free from credit risk and traded 39
  40. 40. across different maturity spectrums every week. All securities with minimumtraded value of Rs. 1 crore are grouped by maturities called “durationbuckets” – 0.5 to 1 year, 1 to2 year, 2/3 years, 3/4,4/5,5/4,5/6 and over 6years. Then, volume weighted yields are calculated for each bucket. This isdone weekly or whenever the interest rates change.Step B:Expected yield on non-govt. securities is generally higher than thecorresponding maturity govt. security to reflect the higher credit risk onnon-govt. securities. The differences between the two yields are the “spread”over the benchmark yield. “Spreads” are determined using the market pricesof non-govt. securities and comparing them with the yields on govt.securities. The spreads are built only for investment grade corporate paperwhich is grouped credit rating within each of the 7 duration buckets.Step C:Yields to be used for valuation are further adjusted to reflect the illiquidityrisk of a security. The yields have to be marked up/marked down to accountfor the illiquidity risk, promoter background, finance company risk and theissuer class risk. As illiquidity risk would be higher for non-rated securities,higher expected yield would be used to value non-rated securities ascompared to rated securities. For securities rated by external agencies, SEBIpermits a discretionary discount up to 2 years and 0.75% for those of higher 40
  41. 41. duration. The AMC has to assign an internal credit rating to non ratedsecurities but with mandatory lower discounts or premiums.Step D:The yields so arrived for all categories of securities are used to price theportfolio. If yields for any category of securities cannot be obtained usingany or all of the above steps, then a fund may use the credit spreads fromtrades on appropriate stock exchange for the relevant rating category overthe AAA securities trades.Valuation of securities with Call/Put Option: a. Securities with Call option- An issuer may call a debt security and repay before maturity. Such securities with call option have to be valued at the lower of two 41
  42. 42. values- value obtained by valuing the security to final maturity and that obtained valuing the security to call option date. b. Securities with Put option- Where investors have the option to redeem earlier than maturity. Such securities with put option shall be valued at the higher of the values obtained the security to final maturity and valuing the security to the put option date.Valuation and Disclosure of Illiquid Securities :SEBI stipulates that- a. Aggregate value of “illiquid securities” of a scheme, defined as non-traded, thinly traded and unlisted equity shares shall not exceed 15% of the total assets of an open-end scheme and 20% of a closed-end fund. Illiquid assets held in excess of the limits have to be assigned zero value. b. All mutual funds have to disclose s on March 31 and September 30 the scheme-wise total illiquid securities in value and percentage of the net assets while making disclosures of half yearly portfolios to the unit holders. c. Mutual funds are no allowed to transfer illiquid securities internally among their schemes from October 1, 2000. 42
  43. 43. Risk, Return and Performance: 43
  44. 44. Rate of return is computed as: (Income earned/Amountinvested)*100.This number can be annualized by multiplying the result by the factor 12/n,where n is the number of months in the holding period. If the holding periodis in days, the above factor will be 365/n, where n is the number of days inthe holding period. Change in NAV method of calculating return is applicable to growth funds and funds with no income distribution. Change in NAV method computes return as follows: (NAV at the end of the holding period – NAV at the beginning of theholding period)/NAV at the beginning of the period. Return is thenmultiplied by 100 and annualized) E.g.) Annualizing the Rate of Return If NAV on Jan 1, 2001 was Rs. 12.75 & June 30, 2001 was Rs. 14.35 % age change in NAV = (14.35 – 12.75)/12.75 x 100 = 12.55% Annualized return = 12.55 x 12/6 = 25.10% Percentage Change in NAV: Assume that change in NAV is the only source of return. Example: NAV of a fund was Rs. 23.45 at the beginning of a year 44
  45. 45. Rs. 27.65 at the end of the year.%age change in NAV = (27.65 – 23.45)/23.45 *100 = 17.91%The total return with re-investment method or the ROI method issuperior to all these methods. It considers dividend and assumes thatdividend is re-invested at the ex-dividend NAV.Total Return or ROI Method computes return as follows:[(Value of holdings at the end of the period - value of holdings at thebeginning of the period)/ value of holdings at the beginning of theperiod] x 100.Value of holdings at the beginning of the period = number of units atthe beginning x begin NAV.Value of holdings end of the period = (number of units held at thebeginning +number of units re-invested) x end NAV.Number of units re-invested = dividends/ex dividend NAV.Expense ratio is an indicator of efficiency and very crucial in a bondfund.Income ratio is the ratio of net investment income by net assets. Thisratio is important for fund earning regular income, such as bond funds, 45
  46. 46. and not for funds with growth objective, investing for capitalappreciation.Portfolio turnover rate refers to the ratio of amount of sales orpurchases (whichever is less) to the net assets of the fund.Higher the turnover ratio, greater is the amount of churning of assetsdone by the fund manager.High turnover ratio can also mean higher transaction cost. This ratio isrelevant for actively managed equity portfolios.If the turnover of a fund is 200%, on average every investment is heldfor a period of 6 months.Risk arises when actual returns are different from expected returns.Standard deviation is an important measure of total risk.Beta co-efficient is a measure of market risk. The quality of betadepends on ex-marks.If ex-marks are high beta is more reliable.Ex-marks are an indication of extent of correlation with market index.Index funds have ex-marks of 100%.Comparable passive portfolio is used as benchmark. 46
  47. 47. Usually a market index is used as a benchmark. Compare both risk and return, over the same period for the fund and the benchmark. Risk-adjusted return is the return per unit of risk. Comparisons are usually done With a market index With funds from the same peer group With other similar products in which investors invest their funds When comparing fund performance with peer group funds, size and composition of the portfolios should be comparable. Treynor and Sharpe ratios are used for evaluating performance of funds. The quality of beta depends on ex-marks.While fund managers are under pressure to increase their asset base, theyare confident of giving reasonable returns in the long term.While that is a comforting thought for retail investors, fund managers agreethat it may be difficult to achieve the same levels of outperformance as inthe past. Prashant Jain, chief investment officer of HDFC Mutual Fund, notesthat in India, equities will continue to outperform all other asset classesgoing forward. But there is a caveat. "The gap between performance ofequities and other asset classes will narrow," says Jain. 47
  48. 48. While fund managers are under pressure to increase their asset base, theyare confident of giving reasonable returns in the long term. However, theywarn against high expectations. "Investors should not expect equity funds togive 90-100 per cent returns every year. Broad markets should give a CAGRreturn in the range of 12-15 per cent over the next two-three years".With opportunities in the broad market tapering out, funds are dependent onthe stock-picking abilities of fund managers. "I think it is becoming a stockpickers market. If we identify good companies which have the opportunityand potential to grow, fund managers will continue to outperform themarkets”.But fund managers are guarding against taking sectoral bets. Nilesh Shah,chief investment officer of Prudential ICICI Mutual Fund, believes that thedays of sector-specific rallies are over. While they are bullish on sectors likebanking, infrastructure-related and consumer-dependent sectors, caution isadvised in taking big sectoral bets.So what will drive equity returns this year? "I expect a re-rating of Indianequities to happen soon. In many cases it has already started". Fundmanagers also expect the mid-cap segment to do well, though they agreethat returns may not match that of last year. Jain is of the opinion thatmid-caps will continue to see good growth going forward. "Though there aresome stocks which have become overheated, the universe of mid-caps is stillpretty large, and it is possible to find 30-35 good stocks in the segment foryour portfolio," says he. "I would back them to do better than large-capstocks in the longer term". 48
  49. 49. Overall, fund managers continue to be bullish on equities, though they warnagainst big return expectations. But rest, assured, if fund managers are to bebelieved, they will continue to give better returns than other asset classes. "Ithink at least for the next five-10 years, diversified funds will continue tooutperform the markets.” ACCOUNTING: Net Asset Valuation (NAV): A mutual fund is a common investment vehicle where the assets of the fund belong directly to the investors. Investor’s subscriptions are accounted for by the fund not as liabilities or deposits but as “Unit Capital”. The investments made on behalf of the investors are reflected on the assets side and are main constitutes of fund’s scheme. Liabilities of a mainly short term nature may be part of the balance sheet. The fund’s total net assets are therefore defined as the assets minus the 49
  50. 50. liabilities. The following are the regulatory requirements and accountingdefinitions laid down by SEBI. NAV = Net Asset of the scheme/ Number of Units Outstanding i.e.; (Market value of investments+ receivables+ other accrued Income+ other assets- Accrued expenses- other payables –other liabilities.)/ No. of units outstanding on the valuation date. For the purpose of the NAV calculation, the day on which NAV is calculated by the fund is known as the valuation date. NAV for all schemes must be calculated and published at least every Wednesday for closed end schemes and daily for the open end schemes. The day’s NAV must be posted on AMFI’S website by 8.00 p.m. that day. Those close end schemes which are not listed on the stock exchanges mat be publish NAV at monthly or quarterly intervals as permitted by SEBI. For valid applications received up to the cut off time, NAV computed later that day would form the basis. For valid applications after the cut off time, NAV computed the following day would form the basis. For all schemes except liquid schemes, the cut off time is 3 p.m. in respect of liquid schemes, a different method is followed. Applications for fresh sales received till 1 p.m.’ NAV computed the previous day would form the basis for 50
  51. 51. that day and for applications received after 1 p.m., the same dayNAV shall be used. For repurchases, the corresponding cut off timeis 10 am.A fund’s NAV is affected by 4 sets of factors i.e.; Purchase and saleof investment securities, valuation of all investments securities,other assets and liabilities and Units sold or redeemed.“Other Assets” include any income due to the fund not received ason the valuation date. “Other Liabilities” include expenses payableby the fund. These income and expenses have to be accrued and tobe included in the computation of the NAV.Additions and sales from the portfolio of securities, and changes inthe number of units outstanding will both affect the per unit assetvalue. Such changes in securities and number of units must berecorded by the next valuation date. If frequency of NAV declarationdoes not permit this, recording may be done within 7 days of thetransaction, provided that the non-recording does not affect NAVcalculations by more than 1%. For example, if a fund declares NAVevery week, with the next declaration date being January 15, thenall sales/purchases/redemptions up to January 14 have to bereflected in the NAV as of January 15, except for transactionswhose value does not affect the NAV by more than casenon-recording of transactions leads to difference of more than 1%between the declared NAV and final NAV, the AMC must pay the 51
  52. 52. investors at a price higher than NAV or repurchased from them at aprice lower than NAV. Similarly, the AMC/scheme must be recoverthe difference from the investors where units are allotted to them ata price lower than NAV or repurchased from them at a price higherthan NAV.NAV are required to be rounded off up to four decimals places incase of liquid/money market schemes and up to two decimalsplaces in case of all other schemes. 52
  53. 53. Pricing of Units:Although NAV per unit defines the fair value of the investor’s holding in thefund, the fund may not repurchase the investor’s units at the same price asNAV. There can be entry and exit loads. The sale price is NAV plus entry load:the repurchase price is NAV minus exit load. SEBI requires that the fund mustensure that repurchase price is not lower than 93% of NAV (95% in case ofclose end schemes) and that sale price is not more than 107% of NAV. Thedifference between the repurchase and sale price should not exceed 7% ofthe sale price.SALE PRICE= Applicable NAV*(1+Entry load, if any)REPURCHASE PRICE= Applicable NAV* (1-Exit load, if any)For example, if the applicable NAV is Rs.10, the entry and exit load is 2%,then sale price will be Rs. 10.20 and repurchase price will be Rs. 9.80. Thisevident from the fact that difference between sale price and repurchase priceis Rs. 0.40, which is lower than 7% of sale price. 53
  54. 54. Fees and Expenses:The AMC may charge the scheme with investment management and advisoryfees that are fully disclosed in the offer document subject to following limits: @1.25% of the first Rs. 100 crores of weekly average net assets outstanding in the accounting year, and @ 1% of weekly average net assets in excess of Rs. 100 crores. For no load schemes, the AMC may charge an additional management fee up to 1% of weekly average net assets outstanding in the accounting year.In addition to fees mentioned above, the AMC may charge the scheme withthe following expenses: A. Initial expenses of launching schemes ( not to exceed 6% of initial resources raised under the scheme); and B. Recurring expenses including: Marketing and selling expenses including distributors commission 54
  55. 55. Brokerage and transaction cost Registrar service for transfer of units sold or redeemed Fees and expenses of trustees Audit fees Custodian fees Cost related to investor communication Costs of fund transfer from location to location Costs of providing account statements and dividend/ redemption cheques and warrants Insurance premium paid by the fund or a scheme Costs of statutory advertisements Winding up costs for terminating a fund or a scheme.The following expenses cannot be charged to the schemes: Penalties and fines for infraction of laws 55
  56. 56. Interest on delayed payment to the unit holder Legal, marketing, publication and other general expenses not attributable to any schemes Expenses on investment management/general management Expenses on general administration, corporate advertising and infrastructure costs Depreciation on fixed assets and software development expenses.The total expenses charged by the AMC to a scheme, excluding issue orredemption expenses but including investment management and advisoryfees are subject to the following limits: On the first Rs. 100 crores of daily or average weekly net assets- 2.5% On the next Rs. 300 crores of daily or average weekly net assets- 2.25% On the next Rs. 300 crores of daily average weekly net assets- 2.0% On the balance of daily or average weekly net assets- 1.75% 56
  57. 57. For bond funds, the above percentages are required to be lower by 0.25%.Initial Issue Expenses:SEBI has rationalized the Initial Issue Expenses as follows effective from April4, 2006: Initial Issue expenses will be permitted for closed ended schemes only and such scheme will not charge entry load. In closed ended schemes, the initial issue expenses shall be amortized on weekly basis over the period of scheme. For example, a 5 year (260 weeks) closed ended scheme with initial expenses of Rs. 5 lakhs shall charge Rs. 1923 (500000/260) every week. In closed ended schemes where initial issues are amortized for an investor exiting the scheme before amortization is completed, AMC 57
  58. 58. shall redeem the units only after recovering the balance proportionateunamortized issue expenses.Conversion of a closed ended scheme or interval scheme to open endscheme/ or issuance of new units shall be done only after the balanceunamortized amount has been fully recovered from the scheme.Open ended scheme should meet the sales, marketing and other suchexpenses connected with sales and distribution of scheme from theentry load and through initial issue expenses.Unamortized portion of initial expenses shall be included for NAVcalculation, considered as “other asset”. The investment advisory feecannot be claimed on this asset. Hence, they have to be excluded whiledetermining the chargeable investment management/ advisory fees.While calculating the maximum amount of chargeable expenses, theunamortized portion of the initial issue expenses will not be includedas part of the average daily/weekly net assets figure. 58
  59. 59. Disclosures and Reporting Requirements: MF/AMC shall prepare for each financial year, annual report and annual statement of accounts for all the schemes. MF shall have the annual statement of accounts audited by an auditor who is independent of the auditor of the AMC. Within 6 months of the closure of the relevant accounting year the fund shall display the scheme wise annual report on their websites 59
  60. 60. which should be linked with AMFI website, mail the annual report/ arbitraged annual report to all unit holders.Specific Disclosures in the Accounts: Each item of expenditure accounting for more than 10% of total expenditure should be disclosed in the accounts or the notes thereto of the schemes. The mutual fund shall make scrip wise disclosures of NPAs on the yearly basis along with the half yearly portfolio disclosure. The total amount of provisions against the NPAs shall be disclosed in addition to the total quantum of NPAs and proportion of the assets of the mutual fund scheme. Large unit holdings (over 25% of net assets of a scheme) shall be disclosed in annual and half yearly results by giving the number of such investors and their total holdings in percentage terms. It should be mentioned in the annual report of the Mutual fund that unit holders may, if they so desire, request for the annual report of the AMC.Dissemination of Information: 60
  61. 61. The fund shall furnish to SEBI once in a year, copies of audited annual statements of accounts for each scheme and copy of six-monthly unaudited accounts. Within 30 days of the close of each of half year (March 31 and September 30), the fund shall publish its unaudited financial results in one national English newspaper and one newspaper in the language of the region where the head office of the fund is situated. These results are also required to be put on the websites of mutual fund with a link provided to the AMFI website. The trustees shall make such disclosures to the unit holders as are essential to keep them informed about any information which may have an adverse bearing on their investments The annual report containing accounts of the asset management companies should be displayed on the website of the mutual funds.Accounting Policies: 61
  62. 62. Investments are required to be marked to market using market prices.Any unrealized appreciation cannot be distributed and provision mustbe made for the same.Dividend received by the fund on a share should be recognized, not onthe date of declaration, but on the date the share is quoted onex-dividend basis. For example, if a fund owns shares on whichdividend is declared on April 5, and the shares are quoted onex-dividend basis on April 20, the dividend income will be included bythe fund for distribution/NAV computation only on April 20.In determining the holding cost of investments and the gain or loss onsale of investments, the average cost method must be followed.Example, a fund acquires 100 shares in company A for Rs. 5000 onApril 1. It buys another 150 shares in the same company for Rs. 7000on April 15. It sells shares of company A for Rs. 3500 on April 30. Thegain on sale is Rs. Rs. 1100 calculated as- Average cost of holding pershare in company A= (5000+7000)/ (100+150) = 48. Total holdingcost of shares sold= 48*50=2400. Gain on sale= 3500-2400=1100.Purchase/sale of investments should be recognized on the trade dateand not settlement date.Bonus/rights shares should be recognized only when the originalshares are traded on the stock exchange on an ex-bonus/ex-rightsbasis. 62
  63. 63. Nonperforming assets and income thereon shall be treated inaccordance with SEBI’s guideline issued on this subject.Investments owned by mutual funds are marked to market. Therefore,the value of investments appreciates or depreciates based on marketfluctuations, which is reflected in the balance sheet. However, thischange in value constitutes unrealized gain/loss. When anyinvestments are actually sold, the proportion of the unrealizedgain/loss that pertains to such investments becomes realizedgain/loss, therefore, at any time, the NAV includes realized andunrealized gain/loss on investments. While SEBI prohibits thedistribution of unrealized appreciation on investments, realized gain isavailable for distribution.Equalization: An open end scheme sells and repurchases units on thebasis of NAV. SEBI therefore prescribes the use of an equalizationaccount, to ensure that creation/redemption of units does not changethe percentage of income distributed. This involves following steps: Computation of distributable reserves: Income + Realized gain on investments – Expenses – Unrealized Losses (Unrealized gains are excluded). Practically, many funds make the adjustment for unrealized losses in computation of equalization only at the time of dividend distribution. This is to avoid variation in per unit equalization balance on a day to day basis. 63
  64. 64. The following percentage is then computed: Distributable Reserves/Units outstanding The above percentage is multiplied with the number of new units sold, and the equalization account is credited by this amount, if units are sold above par: if the units are sold below par, the equalization account is debited by this amount. The same percentage is multiplied with the number of units repurchased, and the equalization account is debited by this amount if the units are repurchased above par: if the units are repurchased below par, the equalization account is credited.The net balance in the equalization account is transferred to the profitand loss account. It is only adjusted to the distributable surplus anddoes not affect the net income for the period.Illustration of accounting of important mutual fundtransactions:Day 1:An open end fund issues 1000 units at its face value of Rs. 10 per unit. Unit capital will appear in the balance sheet at Rs. 10,000 (1000*10) 64
  65. 65. (If units were issued at a price above par i.e. at a price higher than Rs.10 per unit, the difference will appear as premium in the balance sheet)Rs. 10,000 received is invested in various securities. Investments will also appear at Rs. 10,000 in the balance sheet.Effect of accounting entries Investments: Debit of Rs.10,000 Unit capital: Credit of Rs. 10,000NAV per unit= Rs.10(Net assets are the total assets at market value less current liabilitiesand provisions. In this example, we have assumed current liabilities,other income and expenses to be zero. Hence, investments= netassets. Units outstanding are 1000. Thus, NAV= 10000/1000=Rs.10)Day 2:Market value of investments rises to Rs. 11,000 Unrealized appreciation= Rs. 1000 (market value of investments 11,000 less cost 10,000). Investments will be marked to market i.e. they will appear in the balance sheet at Rs. 11,000 65
  66. 66. Effect of accounting entries: Investments: Further Debit of Rs.1000 Profit and Loss Account: Credit of Rs.1000.NAV per unit= 11,000/1000= Rs. 11.Day 3:Market value of investments rises to Rs. 12,000.10% of the original portfolio is sold i.e. investments with an originalcost of Rs. 1000 are sold for 1200. Investments will now appear in the balance sheet at Rs. 10,800 Realized gain on sale of investments= Rs.200 (Sale price-cost i.e. 1200-1000) Unrealized appreciation now stands at Rs. 1800 (market value of investments in hand 10800 less cost 9000)Effect of accounting entries: Investments: Credit of Rs.1200 Cash/Bank: Debit of Rs.1200NAV per unit= Rs.12 Face value of unit: Rs.10 Realized gain: Rs.0.20 (200/1000) 66
  67. 67. Unrealized gain: Rs.1.80 (1800/1000)Day 4:Investments continue at a market value of Rs. 10,800 (original costRs.9000)The fund sells 100 additional units and repurchases 75 units, bothtransactions taking place at Rs.12 per unit.Effect of transaction involving sale of units: Units outstanding will increase to Rs.1100 Sale consideration will be Rs.1200, accounted as: Increase in unit capital (Credit)= Rs.1000 (Thus, unit capital will appear in the balance sheet at Rs.11,000) Credit to equalization account=Rs. 20 (realized gain in NAV: Rs. 0.20per unit * units sold:100) Credit to unit premium reserve= Rs.180 (unrealized appreciation in the NAV:Rs.1.80 per unit * units sold:100)Effect of transaction involving repurchase of units: Units outstanding will decrease by 75 to 1027 Cash outlay on repurchase will be Rs. 900 (75*12) accounted as: 67
  68. 68. Decrease in unit capital= Rs. 750 (75*10). (Thus, unit capital will appear in the balance sheet at Rs.10,250) Debit to equalization account= Rs.15 (unrealized gain in NAV:Rs. 0.20per unit * units repurchased:75) Debit to unit premium reserve: Rs.135 (unrealized appreciation in NAV:Rs.1.80 per unit* units repurchased:75) Transfer to revenue account= Net balance in the equalization account.Guidelines for Identification and Provisioning forNon-Performing Assets (Debt Securities) for Mutualfunds:Non- performing assets in a fund’s portfolio have a significant bearing onfund’s NAV. Hence, SEBI has become out with guidelines for theidentification and treatment of non-performing assets by mutual funds. A. Definition of Non-Performing Assets (NPA): 68
  69. 69. An asset shall be classified as non-performing, if the interest and/or principal amount have not been received or remained outstanding for one quarter from the day such income/installment has fallen due.B. Effective date for classification and provisioning of NPA’s: The definition of NPA may be applied after the lapse of a quarter after the due date of the interest. For example, if the due date for interest is 30.06.2000, it will be classified as NPA from 01.10.2000, if the interest was still unpaid as of 1.10.2000.C. Treatment of income accrued on the NPA and further accruals: After the expiry of the 1st quarter from the date income has fallen due, there will be no further interest accrual on the asset, i.e. if the due date for interest falls on 30.06.2000 and if the interest is not received, accrual will continue till 30.09.2000 after which there will be no further accrual of income. In short, taking the above example, from the beginning of the 2nd quarter there will be no further accrual of income. On classification of the asset as NPA from a quarter past due date of interest, all interest accrued and recognized in the books of accounts of the fund till the due date should be provided for. For example, if interest income falls due on 30.06.2000, accrued will continue till 30.09.2000 even if the income as on 30.06.2000 has not been received. Further, no accrual will be done from 01.10.2000 onwards. 69
  70. 70. Full provision will also be made for interest accrued and outstanding as on 30.09.2000.D. Provision for NPAs- Debt Securities: Both secured and unsecured investments, once they are recognized as NPAs, call for provisioning in the same manner. Where these investments are part of a close end scheme, the phasing would be such as to ensure full provisioning prior to the closure of the scheme, unless the schedule phasing is earlier. The value of the asset must be provided as per the following timeframes or earlier, at the discretion of the fund. A Mutual fund will not have any discretion to extend the period of provisioning. The provisioning against the principal amount or installments should be made at the following rates, irrespective of whether the principal is due for repayment or not. a) 10% of the book value of the asset should be provided for after 6 months past due sate of interest i.e. 3 months from the date of classification of the asset as NPA. b) 20% of the book value of the asset should be provided for after 9 months past due sate of interest i.e. 6 months from the date of classification of the asset as NPA. 70
  71. 71. c) Another 20% of the book value of the asset should be provided for after 12 months past due sate of interest i.e. 9 months from the date of classification of the asset as NPA. d) Another 25% of the book value of the asset should be provided for after 15 months past due sate of interest i.e. 12 months from the date of classification of the asset as NPA. e) The balance 25% of the book value of the asset should be provided for after 18 months past due sate of interest i.e. 15 months from the date of classification of the asset as NPA.In other words, a mutual fund is allowed to phase out the provisioningover a one-half-year period from the date interest becomes overdue.Book value for the purpose of provisioning for NPAs has to be taken asvalue determined a sper the prescribed valuation method.Illustration:10% provision of book value as determined above01.01.20016 months past due date of interest i.e. 3 months from the date ofclassification of asset as NPA(01.10.2000) 71
  72. 72. 20% provision 01.04.2001 20% provision 01.07.2001 25% provision 01.10.2001 25% provision 01.01.2002Thus, 1 ½ years past due date of income or 1 ¼ year from the date ofclassification of the asset as an NPA, the asset will be fully provided for.If any installment is fallen due, during the period of interest default, theamount of provision should be installment amount or above provisionamount, whichever is higher. E. Reclassification of assets: An asset earlier classified as non-performing can become performing again if the borrower starts paying the interest or principal amount that were overdue. Upon reclassification of assets as performing assets: 1. In case a company has fully cleared all the arrears of interest, the interest arrears provisions can be written back in full. 72
  73. 73. 2. The asset will be reclassified as performing on clearance of all interest arrears and if the debt is regularly serviced over the next two quarters. 3. In case the company has fully cleared all the arrears of interest, the interest not credited on accrual basis would be credited at the time of receipt. 4. The provision made for the principal amount can be written back in the following manner: 100% of the asset provided for in the books will be written back at the 2nd quarter where the provision of principal was made due to the interest defaults only. 50% of the asset provided for in the books will be written back at the 2nd quarter and 25% after every subsequent quarter where both installments and interest were in default earlier. 5. An asset is reclassified as a standard asset only when both overdue interest and overdue installments are paid in full and there is satisfactory performance for a subsequent period of 6 months.F. Receipt of past dues: 73
  74. 74. When fund has received income/principal amount after their classifications as NPAs: 1. For the next 2 quarters, income should be recognized on cash basis and thereafter on accrual basis. 2. The asset will be continued to be classified as NPA for these two quarters. 3. During this period, of two quarters, although the asset is classified as NPA, no provision needs to be made for the principal if the same is not due and outstanding. 4. If part payment is received towards principal, the asset continues to be classified a NPA and provisions are continued as per the norms set at (D) above. Any excess provision will be written back.G. Classification of Deep Discount Bonds as NPAs: Investments in Deep Discount Bonds can be classified as NPAs, if any two of the following conditions are satisfied: 1. If the rating of the bond comes down to grade “BB” or below. 2. If the company is defaulting in their commitments in respect of other assets, if available. 74
  75. 75. 3. In case of full Net worth erosion. Provision should be made as per norms of set at (D) above as soon as the asset is classified a NPA. Full provision will be made if the rating comes down to grade ‘D’.H. Reschedulement of an overdue asset: In case any company defaults on either interest or principal amount and the fund has accepted a reschedulement of the schedule of payments then the following practice may be adhered to: i. In case it is a first reschedulement and only interest is in default, the status of the asset, namely NPA may be continued and existing provisions should not be written back. This practice should be continued for two quarters of regular servicing of the debt. Thereafter, this may be classified as performing assets and the interest provided nay be written back. ii. If reschedulement is done due to default in interest and principal amount, the asset should be continued as non-performing for a period of 4 quarters, even though the asset is continued to be serviced during these 4 quarters regularly. Thereafter, this can 75
  76. 76. be classified as performing asset an d all the interest provided till such date should be written back. iii. If the reschedulement is done for a second/third time or thereafter, the classification of NPA should be continued for eight quarters of regular servicing of the debt. The provision should be written back only after it is reclassified as performing asset.Treatment of derivatives:In India, SEBI has permitted mutual funds to use derivative trading subject tocertain conditions. From the perspective of accounting, such instrumentsneed to be marked to market, with consequent impact on NAV. That meansthe open positions are valued at the last quoted price at the exchange wherethe instrument is traded, while non traded contracts are valued at fair priceas per procedures determined by the AMC and approved by the Trustees.The unrealized value appreciation/depreciation on all open positions isconsidered for determining net asset value. 76
  77. 77. Case Study:Funds and Liability Reconciliation.The Client:State Bank of India Mutual Fund (SBIMF) is one of the leading Mutual Fundhaving 29 Investor Service Centres (ISCs) across the country. It has a corpusof about Rs 50 billion ($125 million) from approximately 50 differentschemes having more than a million investors. 77
  78. 78. The inflow of funds is from their ISCs. The funds collected are subsequentlytransferred to their main account at SBIMF corporate office. Similarly, theyissue cheques for dividend, interest, brokerage and redemption on regularintervals.The Challenge:SBIMF wanted their investor applications to be processed, and the statementof account to be dispatched on the same day. This was possible only ongetting credit confirmation from the bank i.e. the investors cheques gettingcleared and deposited.Fund Reconciliation:The funds were collected under various schemes through ISCs and the samewas deposited in various banks across the country. Depending on depositedamount the investor was allotted units calculated on the prevailing NAV (NetAsset Value) of that day. To reach the final corpus for the days transaction,for a particular scheme one had to reconcile all the cleared and unclearedcheques.Liability Reconciliation:Similar to fund reconciliation, all cheques issued to investors and brokershad to be reconciled. Before issuing the cheques one had to make sure that 78
  79. 79. the required funds were available in the scheme account.The Solution:Computronics followed up with SBIMF ISCs to get clearance of wrong creditsand pending applications. Close vigilance of bank accounts of all schemesled to faster reconciliation. During peak periods we managed more than a1000 cheques a day.The Benefits:Due to Computronics close monitoring of the reconciliation process SBIMFwas able to mobilize and invest their fund in different securities dependingon the scheme features. This also led to High Net Investors being able toinvest and redeem faster. 79
  80. 80. Conclusion:The value of investors’ holdings of units in a mutual fund is calculated onthe basis of Net Asset Value of investments by the fund. Distributors andinvestors need to understand how mutual funds value the securities held bythem in their portfolios, so they can understand how value of the investor’sholdings in fund schemes is arrived at.This knowledge will help them anticipate the fluctuations in the portfoliovalues under different market scenarios and recommend or take theirdecisions accordingly. This will also help them in comparing theperformance of different fund schemes by reviewing the valuation methodsfollowed by them.Mutual fund employees need to be aware of the special requirementsconcerning accounting for the fund’s assets, liabilities and transactions withinvestors and others like banks, custodians and registrar. This knowledgewill help them understand their place in the organization, by getting anoverview of the functioning of the firm.Even the mutual fund distributors need to understand accounting for thefund’s transactions with the investors and how the fund accounts for itsassets and liabilities, as the knowledge is essential for them to perform theirbasic role in explaining the mutual fund performance to their investors. Ifthey don’t know how the NAV is computed, then they cannot use evensimple measures such as NAV change to assess the fund performance. 80
  81. 81. 81