Mutual fund disclosure
update
January 21, 2014
Today’s presenters
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Bob Mulhall, Partner
Adeel Jivraj, Partner
Matt Forstenhausler, Partner
Rob Meiner, Partner
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Mutual fund disclosure update
Agenda
Mutual Fund Disclosures:
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PCAOB proposal on auditor reporting model
Tax disclosures
Balance sheet offset – disclosures about offsetting assets and
liabilities
Fair value measurements and disclosures
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Mutual fund disclosure update
PCAOB proposal on auditor reporting model
Current “pass/fail” model would stay the same
What information would be new?
Auditor independence and tenure
Responsibilities for footnotes and risk of material misstatement due to fraud
Responsibilities for, and results of, auditor’s evaluation of information
outside of the financial statements
Critical audit matters
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Mutual fund disclosure update
PCAOB proposal on auditor reporting model
(cont.)
Critical audit matters (CAMs):
► Matters involving most difficult, subjective or complex judgements
► Posed most difficulty in obtaining sufficient appropriate evidence
► Posed most difficulty in forming an opinion on the financial statements
Audit report would identify CAMs and:
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Considerations that led to that determination
Relevant financial statement accounts or disclosures
Mutual fund disclosure update
PCAOB proposal on auditor reporting model
(cont.)
Considerations
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Disclosure of auditor tenure
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Evaluation of information outside of the financial statements
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Determined at the individual fund level, registrant level or overall
complex level?
Management’s discussion of fund performance
Expense example
Form N-CSR disclosures
CAMs
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Subjectivity in determination of CAMs
Lack of consistency in reported CAMs could create investor
misunderstanding
Increase in audit effort and cost
Comments were due December 11, 2013
Mutual fund disclosure update
Return of Capital
Statement of Position 93-2
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Intended to provide guidance on financial reporting by
investment companies for distributions to shareholders,
including returns of capital
Presentation of the retained earnings of the fund on a tax
basis
► undistributed net investment income
► accumulated undistributed realized gain/loss
“What would the shareholders receive as a distribution if
the fund were to liquidate?”
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Mutual fund disclosure update
ROC-SOP adjustments – key concepts
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ROC-SOP adjustments are reclass entries between the
following components of capital:
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Paid in capital
Undistributed net investment income
Undistributed net realized
ROC-SOP adjustments do not affect net assets
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Mutual fund disclosure update
ROC SOP (cont’d)
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Under SOP 93-2 and the Audit Guide, a reclassification is
made between the composition of net asset accounts for
the permanent differences, not for the temporary
differences
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Mutual fund disclosure update
ROC SOP (cont’d)
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SOP 93-2 requires an understanding of permanent vs. temporary book-to-tax
differences
Sample permanent differences:
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Reclassification between income and gains
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Foreign currency gains/losses
Paydown gains/losses
Distribution redesignations
NOL offset with STCG
Basis adjustments on PFIC sales
CLCO expired
Nondeductible expenses
NOL’s
Tax return of capital distributions
Mutual fund disclosure update
ROC SOP (cont’d)
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Sample temporary differences
► Wash sales
► Straddle loss deferrals
► PFIC mark-to-market
► IRC § 1256 mark-to-market
► Post-October/ late year ordinary losses
► Dividends Payable
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Mutual fund disclosure update
Financial statement disclosures
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Status of the fund as a regulated investment company
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Example disclosure:
The Fund intends to qualify as a regulated investment company, to
distribute substantially all of its income and to comply with the
other requirements of the Internal Revenue Code applicable to
regulated investment companies. Accordingly, no provision for
federal income taxes is required. In addition, by distributing during
each calendar year substantially all of its net investment income,
net realized capital gains and certain other amounts, if any, the
Fund intends not to be subject to a federal excise tax.
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Mutual fund disclosure update
Financial statement disclosures (cont.)
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Cost of investments for federal income tax purposes
Gross appreciation, gross depreciation and net appreciation on
a tax basis
Significant book-tax differences:
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Disclose effect on components of net assets
Example disclosure:
To reflect reclassifications arising from permanent “book/tax” differences
for the year ended October 31, 20XX, undistributed net investment income
was decreased by $41,000, undistributed net realized gain was increased
by $30,000 and additional paid in capital was increased by $11,000.
These differences are primarily due to return of capital adjustments from
real estate investment trusts and net operating losses. These
reclassifications had no effect on net assets.
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Mutual fund disclosure update
Financial statement disclosures (cont.)
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Tax character of distributions
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Disclose the tax basis components of dividends paid:
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Ordinary income
Tax-exempt income
Long-term capital gain
Tax return of capital
Short-term capital gain distributions will be reflected as
distributions from ordinary income
The total tax basis distributions should generally agree to
the total book basis distributions as shown on the statement
of changes
Both P/Y as well as C/Y information should be presented
Mutual fund disclosure update
Financial statement disclosures (cont.)
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Tax basis components of distributable earnings /(deficit)
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Undistributed ordinary income
Undistributed tax-exempt income
Undistributed long-term gain
Unrealized appreciation/depreciation
Accumulated Realized Capital and other Losses
Example disclosure
At October 31, 20XX, the components of accumulated
earnings/(deficit) on a tax basis were as follows:
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Undistributed ordinary income
Undistributed long-term capital gains
Accumulated realized capital and other losses
Net unrealized appreciation of investment
Total accumulated earnings
Mutual fund disclosure update
$1,020,599
441,226
<12,062,595>
31,430,615
$20,829,845
Financial statement disclosures (cont.)
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Capital loss carry forward (CLCF)
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Prior to RIC Modernization Act of 2010
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Post RIC Modernization Act (new provisions apply to net capital
losses for taxable years beginning after December 22, 2010)
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Capital losses — RIC’s were allowed to carryover accumulated capital
losses for a period up to 8 years
Ordinary losses — No carryover provisions were allowed. Ordinary
losses may be offset against short term gains, but otherwise may need
to be written off against capital
Capital losses — may be carried forward indefinitely (no limit on # of
years)
► Capital losses retain their character (ST/LT) and are deemed to
arise on the first day of the next tax year
► Losses without expiration must be utilized before old carryovers
can be used
Mutual fund disclosure update
Financial statement disclosures (cont.)
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Late year loss deferrals
Example disclosure:
In accordance with US Treasury regulations, the Fund has incurred and
elected to defer the following post-October capital losses incurred after
October 31, 20XX. Such losses are treated for tax purposes as arising on
November 1, 20XX; furthermore, the fund has incurred and elected to defer
the following qualified late year ordinary losses incurred after December 31,
20XX. Such losses are treated as arising on January 1, 20XX.
Qualified
Ordinary losses
ST Capital
Losses
LT Capital
Losses___
$86,000
$2,000
$1,000
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Mutual fund disclosure update
Financial statement disclosures (cont.)
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Accounting for uncertainty in income taxes (ASC 740)
Example disclosure:
As of and during the period ended October 31, 20XX, the Fund
did not have any liabilities for any unrecognized tax benefits.
The Fund recognizes interest and penalties, if any, related to
unrecognized tax benefits as income tax expense in the
Statement of Operations. During the period, the Fund did not
incur any interest or penalties.
Each of the tax years in the four year period ended October 31,
20XX, remains subject to examination by the Internal Revenue
Service and state taxing authorities.
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Mutual fund disclosure update
Disclosures about offsetting assets
and liabilities
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New reporting requirements aimed to bridge the gap between
US Generally Accepted Accounting Principles (GAAP) and
International Financial Reporting Standards (IFRS)
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IASB and FASB initially issued a joint exposure draft, but
decided to pursue different approaches
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IFRS: Requires entities to present separately recognized
financial assets and recognized liabilities at gross amounts in
balance sheet and therefore treat offsetting as exception
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Entity must offset its financial assets and financial liabilities in its
balance sheet when it intends to offset and has legally enforceable
right to do so in the normal course of business, default and
bankruptcy
Mutual fund disclosure update
Disclosures about offsetting assets
and liabilities (cont.)
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US GAAP: Provides a further exception for offsetting
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In December 2011, FASB issued ASU 2011-11: Balance Sheet
(Topic 210): Disclosures about Offsetting Assets and Liabilities,
which was clarified by ASU 2013-01.
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Permits an entity to offset its derivative assets and liabilities in
balance sheet if there is an agreement to offset, even if that right of
offset is only available in the case of bankruptcy or default
Effective for periods beginning on or after January 1, 2013
Applied retrospectively (i.e., for all periods presented on the
balance sheet)
Does not require a change to balance sheet presentation;
impact is to the notes to the financial statements
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Mutual fund disclosure update
Disclosures about offsetting assets
and liabilities (cont.)
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New disclosures required for:
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Derivatives accounted for in accordance with Topic 815 (including
bifurcated embedded derivatives)
Sale and repurchase agreements and reverse sale and repurchase
agreements
Securities borrowing and lending arrangements
Applies to above transactions that are:
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Offset on the balance sheet in accordance with offsetting guidance
Subject to enforceable master netting arrangements or similar
agreements regardless of whether or not they are presented in
accordance with offsetting guidance
Mutual fund disclosure update
Disclosures about offsetting assets
and liabilities (cont.)
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Information to enable users to evaluate the effect or potential
effect of netting arrangements of an entity:
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Gross amounts of assets and liabilities
Amounts offset in the balance sheet
Net amounts
Amounts subject to a netting arrangement not included in #2 (i.e.,
collateral or positions not offset)
Remaining net amount
Assets and liabilities separately presented in tabular format
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Mutual fund disclosure update
Disclosures about offsetting assets
and liabilities (cont.)
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Example disclosure – direct from 210-20-55-20
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Mutual fund disclosure update
Disclosures about offsetting assets
and liabilities (cont.)
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Column iii–v may be presented by counterparty
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Disclosure of counterparty legal name not required
Insignificant counterparties grouped in “other”
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Mutual fund disclosure update
Disclosures about offsetting assets
and liabilities (cont.)
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Disaggregation for sophisticated entities with significant
derivative activity
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Mutual fund disclosure update
Fair value measurements and disclosures
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ASC Topic 820 Fair value measurement (formerly FAS 157)
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Effective for fiscal years beginning after November 15, 2007
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Defines fair value and provides a framework for measuring fair
value
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Requires disclosures about fair value measurements
► Fair value hierarchy
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Level 1 – Quoted prices in active markets for identical assets/liabilities
Level 2 – Significant unobservable inputs
Level 3 – Significant unobservable inputs
For Level 3 measurements, the effect on earnings (or
changes in net assets) for the period
Mutual fund disclosure update
Fair value measurements and disclosures
(cont.)
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ASU 2011-04 – Amendments to Achieve Common Fair Value
Measurement and Disclosure Requirements in U.S. GAAP and
IFRSs
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Effective for fiscal years beginning after December 15, 2011
Significant amendments:
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For Level 3 fair value measurements, disclosure requirements:
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Quantitative information about the significant unobservable
inputs used in the valuation of Level 3 measurements (tabular
format)
Description of valuation processes surrounding Level 3
measurements
Mutual fund disclosure update
Fair value measurements and disclosures
(cont.)
Quantitative information about Level 3 fair value measurements
($ in millions)
Fair value at
12/31/X9
Residential mortgage-backed securities
Valuation technique(s)
Discounted cash flow
125
Commercial mortgage-backed securities
Discounted cash flow
50
Collateralised debt obligations
Consensus pricing
35
Venture capital investments: healthcare
Discounted cash flow
53
Market comparable companies
Venture capital investments: energy
Discounted cash flow
32
Market comparable companies
Credit contracts
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Option model
Unobservable input
Range (weighted average)
constant prepayment rate
3.5% - 5.5% (4.5%)
probability of default
5% - 50% (10%)
loss severity
40% - 100% (60%)
constant prepayment rate
3.0% - 5.0% (4.1%)
probability of default
2% - 25% (5%)
loss severity
10% - 50% (20%)
offered quotes
20 - 45
comparability adjustments (%)
-10% - +15% (+5%)
weighted average cost of capital
7% - 16% (12.1%)
long-term revenue growth rate
2% - 5% (4.2%)
long-term pre-tax operating margin
3% - 20% (10.3%)
discount for lack of marketability (a)
5% - 20% (17%)
control premium(a)
10% - 30% (20%)
EBITDA multiple(b)
revenue multiple(b)
1.5 - 2.0 (1.7)
10 - 13 (11.3)
discount for lack of marketability (a)
5% - 20% (17%)
control premium(a)
weighted average cost of capital
10% - 30% (20%)
8% - 12% (11.1%)
long-term revenue growth rate
3% - 5.5% (4.2%)
long-term pre-tax operating margin
7.5% - 13% (9.2%)
discount for lack of marketability (a)
5% - 20% (10%)
control premium(a)
10% - 20% (12%)
EBITDA multiple(b)
revenue multiple(b)
1.0 - 3.0 (2.0)
6.5 - 12 (9.5)
discount for lack of marketability (a)
5% - 20% (10%)
control premium(a)
10% - 20% (12%)
annualised volatility of credit (c)
10% - 20%
counterparty credit risk (d)
0.5% - 3.5%
own credit risk (d)
0.3% - 2.0%
(a) Represents amounts used when the reporting entity has determined that market participants would take these premiums and discounts into account in a fair value measurement.
(b) Represents amounts used when the reporting entity has determined that market participants would use such multiples when measuring the fair value of these investments.
(c) Represents the range of the volatility curves used in the valuation analysis that the reporting entity has determined market participants would use when measuring the fair value of these contracts.
(d) Represents the range of the credit default swap spread curves used in the valuation analysis that the reporting entity has determined market participants would use when measuring the fair value of these contracts.
(Note: For liabilities, a similar table should be presented.)
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Mutual fund disclosure update
Fair value measurements and disclosures
(cont.)
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Description of valuation processes surrounding Level 3 measurements
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Description of the group responsible for valuation policies and procedures, to whom that group
reports, and the internal reporting procedures in place (e.g., how pricing, risk management, or
audit committees discuss and assess the fair value measurements)
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Frequency and methods for calibration, back testing and other testing procedures of pricing
models
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Process for analyzing changes in fair value measurements from period to period
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Methods used to develop and substantiate the unobservable inputs used in a fair value
measurement
Narrative description of the sensitivity of recurring Level 3 measurements to changes in
the unobservable inputs disclosed, including the inter-relationship between these inputs
(only public companies)
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“The significant unobservable inputs used in the fair value measurement of the reporting entity’s
residential mortgage-backed securities are prepayment rates, probability of default, and loss
severity in the event of default. Significant increases in any of those inputs in isolation would
result in a significantly lower fair value measurement. Generally, a change in the assumption
used for the probability of default should be accompanied by a directionally-similar change in
the assumption used for the loss severity and a directionally-opposite change in the assumption
for prepayment rates.”
Mutual fund disclosure update
Fair value measurements and disclosures
(cont.)
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ASU 2011-04 significant amendments (continued):
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Public entities shall also disclose all transfers between Levels 1 and 2 (not
only significant transfers). Private companies are exempt from disclosing
any information about transfers.
Mutual fund disclosure update