Course Code and Title : FINE-4 –Mutual Fund

Chapter : 12
Topic : Accounting and Valuation of Mutual Funds

Professor : Prof. Romualdo Del Agua/Prof. Geric Baliao

INTRODUCTION:

Mutual funds accounting involves portfolio valuation, net asset value (NAV) calculation, and

client record keeping. It is a complex and vital process.

LEARNING OBJECTIVES:

1. Identify the Mutual funds accounting  portfolio valuation

2. Illustrate the difference between amortized cost, fair value and the equity method for
reporting debt securities
3. Evaluate (NAV) Net Asset Value, and client record keeping.

LESSON PRESENTATION:

Mutual funds accounting is a critical matter for the financial system, given the increasing preference
for mutual funds over direct holdings of securities such as stocks and bonds by the investing public.
In particular, many, if not most, individual investors and retail clients have the majority of their savings
in employer-sponsored 401(k) plans, which typically offer a selection of mutual funds as the
investment choices. The end product of mutual funds accounting is the accurate pricing of these
investment vehicles and the correct assignment of investment income to holders thereof. These are
thus, the major concerns for the chief financial officers (CFOs), controllers, and operations managers
of mutual fund companies. 

Aspects of Mutual Funds Accounting 

Mutual fund accounting encompasses a variety of basic tasks, which may be performed by in-house
staff or outsourced to other providers, such as custodian banks. These processes include:
  Calculating the value of its investment portfolio on a daily basis—known as the net asset value
(NAV).
 Anticipating and recording all income, such as dividends and interest.
 Recording accruing interest on bonds and other similar fixed income securities held in the
investment portfolio.
 Properly amortizing the discount or premium on bond purchases. See the detailed explanation
below.
 Recording all securities transactions, such as buys and sells of portfolio investments.
 Recording all realized capital gains, both short-term, and long-term, that result from securities
transactions in the fund.
 Recording all inflows and outflows of funds due to purchases and redemptions of shares by
investors.
 Maintaining records of the shares owned, and transactions made, by each shareholder in the
fund.
 Tracking distributions of income and capital gains made to shareholders in the fund.

In the best mutual funds accounting departments, these activities will be highly automated. However,
some manual input, reviews, and adjustments may still be necessary.

Net Asset Value

Often abbreviated NAV, it is the aggregate value of a mutual fund's investment portfolio divided by the
number of its shares outstanding. The standard convention is to calculate NAV at the end of each
trading day, based on the closing prices of all securities held therein. NAV also takes account of other
activities listed above.

Orders to purchase or sell shares of a mutual fund are executed at the closing NAV for the day if they
are received before the market close. If not, they are executed at the closing NAV for the next trading
day.

Bond Amortization

When bonds are purchased at a discount or premium to their par value (that is, at a price lower or
higher than the principal value that will be returned to the investor holding it when the bond matures),
the difference between the purchase price and par value is recorded over time as an adjustment to
the interest income generated by the bond.

The interest income recognized on a bond bought at a discount will be higher than the actual interest
payments received. On a bond bought at a premium, it will be lower. The net effect is that any
discount or premium on the purchase of a bond held to maturity will not be recognized as a capital
gain or loss, but rather as an adjustment to interest income. Bond amortization is calculated on a daily
basis by mutual funds.

Case Study

It is also a prime example of the sorts of engagements that are encountered in the field of operations
consulting. A leading custodian bank offered mutual funds accounting services to mutual fund
companies that already utilized it for the safekeeping of securities. Mutual funds accounting, in this
context, primarily was involved with the daily computation of net asset value (NAV). The bank and
its mutual fund clients were dissatisfied with the timeliness and accuracy of the NAV calculations
being done.
The bank engaged a team of consultants from a Big Four public accounting firm to study the
processes within the mutual funds accounting department and to recommend changes to improve it.
The consulting team from the Big Four firm spent several days observing how the mutual funds
accounting department worked, by shadowing its employees as they performed their daily tasks. The
consultants also interviewed employees and their managers, to get a better understanding of how
they viewed their responsibilities, as well as to assess how knowledgeable they were about the
mutual funds accounting field.

Information Gathering

The consulting team developed detailed flowcharts of processes in the department and discussed
these with management, pointing out where work processes could be improved. The consultants also
suggested improved automation. After getting approval from bank management, the consultants
searched for software vendors that had packages appropriate to the bank's situation. They then
identified one that was willing to customize its existing system to meet the specifications needed for
the bank's unique situation and its mix of clients.

Process Planning

Next, the consultants drew up these specifications in detail, and conducted extensive testing of the
software as each module was completed, to be sure that calculations were done properly, and the
system was durable and reliable. The user acceptance testing phase took a number of months and
required extreme attention to detail.

When the system was finally completed to specifications, the consulting team oversaw its installation
and implementation, and led the training of employees, remaining on-site until the bank was
comfortable that the new procedures were working well. In all, the project lasted almost precisely one
year, with a team of three consultants on-site at the bank daily.

Mutual funds accounting involves portfolio valuation, net asset value (NAV) calculation, and

client record keeping. It is a complex and vital process fund accountant is kept on staff to
calculate the fund's NAV, the daily value of the portfolio that determines if share prices go up
or down.
Mutual funds accounting is a critical matter for the financial system, given the increasing
preference for mutual funds over direct holdings of securities such as stocks and bonds by the
investing public. In particular, many, if not most, individual investors and retail clients have the
majority of their savings in employer-sponsored 401(k) plans, which typically offer a selection
of mutual funds as the investment choices. The end product of mutual funds accounting is the
accurate pricing of these investment vehicles and the correct assignment of investment income
to holders thereof. 
Aspects of Mutual Funds Accounting 

Mutual fund accounting encompasses a variety of basic tasks, which may be performed by in-house
staff or outsourced to other providers, such as custodian banks. These processes include:

 Calculating the value of its investment portfolio daily—known as the net asset value (NAV).
 Anticipating and recording all income, such as dividends and interest.
 Recording accruing interest on bonds and other similar fixed income securities held in the
investment portfolio.
 Properly amortizing the discount or premium on bond purchases. See the detailed explanation
below.
 Recording all securities transactions, such as buys and sales of portfolio investments.
 Recording all realized capital gains, both short-term, and long-term, that result from securities
transactions in the fund.
 Recording all inflows and outflows of funds due to purchases and redemptions of shares by
investors.
 Maintaining records of the shares owned, and transactions made, by each shareholder in the
fund.
 Tracking distributions of income and capital gains made to shareholders in the fund.

In the best mutual funds accounting departments, these activities will be highly automated. However,
some manual input, reviews, and adjustments may still be necessary.
Net Asset Value

Often abbreviated NAV, it is the aggregate value of a mutual fund's investment portfolio divided by the
number of its shares outstanding. The standard convention is to calculate NAV at the end of each
trading day, based on the closing prices of all securities held therein. NAV also takes account of other
activities listed above.
Bond Amortization
When bonds are purchased at a discount or premium to their par value (that is, at a price lower or
higher than the principal value that will be returned to the investor holding it when the bond matures),
the difference between the purchase price and par value is recorded over time as an adjustment to
the interest income generated by the bond.
The interest income recognized on a bond bought at a discount will be higher than the actual interest
payments received.
ACCOUNTING FOR INVESTMENTS IN DEBT AND EQUITY SECURITIES

The accounting and financial reporting requirements for investments in debt and equity securities
under US GAAP continues to be an area of focus and complexity for preparers and users of financial
statements. This accounting topic applies to substantially all entities and investments often comprise
a significant asset on the financial statements. The purpose of this article is to provide an overview of
the current accounting and reporting requirements under US GAAP for investments in debt and equity
securities.

Investments in Equity Securities

An equity security is any security representing an ownership interest in an entity, examples of which
include common stock, preferred stock, other classes of stock, rights to acquire equity (e.g., warrants,
call options, rights) or rights to sell equity (e.g., put options, forward sale contracts) at fixed or
determinable prices.

The introduction of ASU 2016-01 introduced significant changes to the model of accounting for
investments in equity securities whereby substantially all investments in equity securities are now
required to be carried at fair value, with changes in fair value included as a component of earnings.
Several exceptions to this measurement model exist, consisting primarily of investments required to
be classified and accounted for under the equity method of accounting, investments requiring
consolidation, investments that qualify for the net asset value (NAV) carrying value practical
expedient, and equity investments that do not have a readily determinable fair value and thereby
qualify for the measurement alternative. Under the measurement alternative, an entity may elect to
carry the investments at cost, less any impairment. In addition, under the measurement alternative,
the carrying value must be adjusted to reflect any orderly market transactions observed in the same
or similar securities of the issuer, and such adjustments would result in a carrying value that is now
measured at fair value in accordance with ASC 820.

Investments in equity securities with readily determinable fair values are generally classified as
current in a classified balance sheet, even if an entity does not necessarily intend to dispose of the
securities within a year, as such investments are available to be used in current operations. Equity
investments are required to be presented as a separate line item on the balance sheet (or disclosed
in the notes to the financial statements as to which line item includes equity investments). The fair
value disclosure requirements included in ASC 820 apply to investments in equity securities carried at
fair value. In addition, for all equity investments, entities are required to disclose the portion of
unrealized gains and losses recognized during the period that relates to equity investments held at
the reporting date for each period for which results of operations are presented.

Investments in Debt Securities

A debt security is defined as any security representing a creditor relationship with an entity, examples
of which include corporate bonds, convertible debt, municipal bonds, U.S. Treasury securities, U.S.
government agency securities, commercial paper, securitized debt instruments (including mortgage-
backed securities), and certain preferred stock that by its terms must either be redeemed by the
issuing entity or is redeemable at the option of the investor.

At acquisition, and at each reporting date thereafter, an entity must classify each acquired debt
security into one of three categories as summarized below. The classification decision should
consider the entity’s intent and all facts and circumstances of the entity when making the election.
 o Trading – debt securities bought and held primarily to be sold in the near term
o Held-to-Maturity – debt securities for which management has both the positive
intent and ability to hold until the maturity of the security
o Available-for-Sale – the residual category for debt securities not classified as held-
to-maturity or trading

A summary of the three accounting models available for investments in debt securities is as follows:

A couple of items to highlight regarding the different classifications are as follows:

Trading securities are defined as those that are sold in the near term and held only for a short period
of time. An entity is not precluded from classifying an investment as trading that it does not intend to
sell in the near term; however, the entity should be prepared to maintain the trading classification until
the security is sold, and transfers into or out of the trading category should be rare.

Held-to-maturity securities are carried at amortized cost, whereby amortized cost represents the cost
to purchase the security, adjusted for the accretion or amortization of discounts or premiums paid
below or above par value, and accrued interest.

While available-for-sale securities are carried at fair value on the balance sheet, unrealized gains and
losses are included in accumulated other comprehensive income, net of tax effect, until realized
whereby the realized gain or loss is then reclassified out of accumulated other comprehensive income
and into earnings.

Debt securities classified as held-to-maturity and available-for-sale are evaluated for impairment at
each reporting period whereby it is required to determine if a decline in fair value below the security’s
cost basis is other than temporary. Determining whether an impairment is other than temporary
requires significant judgment and all facts and circumstances must be considered. If an entity
determines an other than temporary impairment (OTTI) has occurred, the accounting for the OTTI
depends on whether the entity intends to sell (or not sell) the security prior to recovery of its
amortized cost basis. When an entity intends to sell an impaired debt security or it is more likely than
not that the entity will be required to sell the impaired debt security prior to recovery of its amortized
cost basis, the entity recognized an OTTI loss in earnings equal to the difference between the debt
security’s amortized cost basis and its fair value at the balance sheet date. When an entity does not
intend to sell an impaired debt security and it is not more likely than not that it will be required to sell
the impaired debt security prior to recover of the amortized cost basis, the entity recognized the OTTI
amount representing the credit loss in net income and the amount related to all other factors in OCI,
net of applicable taxes. This accounting treatment for impairments is the same for both available-for-
sale and held-to-maturity classified securities.

There are many disclosure requirements related to investments in debt securities, a subset of which
includes the following:

o Entities are required to present the individual amounts for the three categories of
debt investments either on the face of the balance sheet or in the notes to the
financial statements.
o Cash flow activities are required to be presented separately for the three categories
of debt investments. Cash flow activity from the purchase, sale, and maturity of
held-to-maturity and available-for-sale securities are required to be presented on a
gross basis. Cash flow activities related to trading securities are generally classified
on a net basis.
o For securities classified as available-for-sale an entity must disclose the following
summarized by major security type as of each balance sheet date presented:

a. Amortized cost basis

b. Aggregate fair value
c. Total OTTI recognized in accumulated other comprehensive income
d. Total gains for securities with net gains in accumulated other comprehensive
income
e. Total losses for securities with net losses in other comprehensive income
f. Information about the contractual maturities of those securities as of the
most recent balance sheet date presented
o For securities classified as held-to-maturity an entity must disclose the following
summarized by major security type as of each balance sheet date presented:

a. Amortized cost basis

b. Aggregate fair value
c. Gross unrealized holding gains
d. Gross unrealized holding losses
e. Net carrying amount
f. Total OTTI recognized in accumulated other comprehensive income
g. Gross gains and losses in accumulated other comprehensive income for any
derivatives that hedged the forecasted acquisition of the held-to-maturity
securities
h. Information about the contractual maturities of those securities as of the date
of the most recent statement of financial position presented.

An example disclosure for a commercial entity that hold held-to-maturity and available-for-sale
securities is as follows:

Entities are also required to disclose information related to investments in an unrealized loss position.
As of each balance sheet date, an entity is required to disclose in tabular form, the following
information aggregated by each major security type:
 o The aggregate related fair value of investments with unrealized losses
o The aggregate amount of unrealized losses (that is, the amount by which amortized
cost basis exceeds fair value)
o These disclosures shall be segregated by those investments that have been in a
continuous unrealized loss position for less than 12 months and those that have
been in a continuous unrealized loss position for 12 months or longer.

GENERALIZATION:

The students should be able to learn Mutual funds accounting involves portfolio valuation, net
asset value (NAV) calculation, and client record keeping. It is a complex and vital process. Like
any business, mutual funds incur routine costs that encompass administrative, investment
management, legal, accounting, and marketing aspects of the operations.

REFERENCES:(Chapter 12)

https://www.thebalancecareers.com/mutual-funds-accounting-12872839acctg.

https://www.studocu.com/en-us/document/st-johns-university/public-finance/lecture-notes/mutual-
funds-lecture-notes-6/6028010/viewaCCTG.