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In Comment Letters, Auditors Seek More Details on Fund Liquidity Proposal

The SEC proposed rules to strengthen the way mutual funds and exchange-traded funds manage their cash holdings so that shareholders can redeem their shares without causing a loss in value for other investors. The proposal includes a swing option that lets funds adjust their share prices to pass on trading costs to shareholders buying or selling shares, but three of the Big Four firms said the proposed swing pricing poses some financial reporting challenges. They want the SEC to clarify its accounting guidance for the pricing option.

Three of the Big Four accounting firms submitted comment letters to the SEC that said a proposal intended to improve fund managers’ liquidity presents a number of financial reporting challenges and asked the agency to provide more direction.

In September 2015, the SEC issued Release No. 33-9922, Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, to propose that mutual funds and exchange-traded funds (ETFs) better manage access to cash so that shareholders can redeem their shares in an orderly fashion, particularly during market declines. The comment period ended on January 13, 2016. The proposal does not apply to money market funds, for which the SEC had issued separate rules.

Among other things, the proposal would give funds the option to use swing pricing, which the SEC defines as an adjustment to a fund’s share price, or net asset value (NAV), to pass on the costs of a purchase or redemption to the shareholder making the trade. But PricewaterhouseCoopers LLP wrote in a January 13 comment letter that the SEC should clarify how swing pricing should be accounted for on the financial statements. This would include the appropriate accounting for the historical impact of swing pricing and the effect of the use of swing pricing at the reporting date.

PwC said such accounting could also affect reporting entities who invest in funds and value their positions using the net asset value reported in a fund’s audited financial statements.

Table of Contents linkFASB ASC 946, Financial Services—Investment Companies, defines NAV as “the amount of net assets attributable to each share of capital stock, other than senior equity securities, that is, preferred stock, outstanding at the close of the period.” As a result, KPMG LLP said in a January 26 comment letter that if the NAV were adjusted on the financial reporting date for swing pricing, there would be a difference between the NAV disclosed under U.S. GAAP and the SEC’s proposed requirements.

“It is unclear whether disclosure of the swung NAV or the U.S. GAAP NAV on the statement of assets and liabilities will be more beneficial and useful to all investors because the swung NAV reflects the NAV paid or received by investors that transacted on the financial reporting date, while the US GAAP NAV is more representative of the proportionate share of net assets attributable to the shares held by investors that did not transact on the financial reporting date and is not necessarily equal to the unadjusted NAV,” KPMG wrote.

For example, if a fund had an unadjusted NAV of $10 on the last day of a financial reporting period and an adjusted or a swing NAV of $9.90 because of higher than normal redemptions, shareholders would redeem at $9.90. Assuming the effect of processing redemptions at $9.90 results in the fund’s NAV increasing to $10.01, the fund’s U.S. GAAP NAV is $10.01, which is not equal to the fund’s unadjusted NAV.

“For shareholders not transacting on the last day of the period, the U.S. GAAP NAV is the ‘starting point’ for the future NAV. It is that NAV adjusted for income, expense, gain, and loss that forms the subsequent day’s unadjusted NAV,” the accounting firm explained. “We also note that if swing pricing was employed on the last day of the financial reporting period and the swung NAV was the only NAV disclosed, a user of the financial statements would not be able to divide the net assets of the fund, or class, by the shares outstanding to arrive at the swung NAV disclosed and the proposal does not require a reconciliation of these amounts.”

KPMG was also worried about auditing swing prices because auditors generally do not have the expertise to assess whether the “swing threshold” or the estimated market impact costs and trading costs used for the “swing factor” is reasonable.

Release No. 33-9922 proposes that a fund that uses swing pricing would reflect in its NAV a specified amount, the swing factor, once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund’s NAV, known as the swing threshold. Funds would be required to consider various factors to determine the swing threshold and swing factor, and to test the threshold each year.

Because U.S. GAAP does not provide objective criteria that would enable auditors to assess the reasonableness of such judgments, Ernst & Young LLP in a January 14 comment letter said the procedures performed by auditors should be limited to gaining an understanding of a fund’s swing pricing policies and procedures and verifying that the policies and procedures have been approved by the fund’s board and consistently applied.

The proposal is part of a series of rules the SEC plans to use to increase its supervision of the asset management industry’s 16,600 funds and 11,500 investment advisers. At the end of 2014, fund companies managed assets of more than $18.8 trillion, almost four times the $4.7 trillion managed in 1997.

Among the major rules planned in Release No. 33-9922, funds would be required to categorize and monitor the liquidity of a portfolio’s position. The liquidity would be classified into one of six categories based on the number of days it would take to convert the securities to cash at a price without taking a significant loss.

Instead of classifying a position as simply liquid or illiquid, the proposal would have funds reflect a security’s liquidity range from very liquid to substantially illiquid.

A fund’s board would be required to approve the three-day liquid asset minimum. The proposal would also codify the current SEC guideline that says that funds should not invest more than 15 percent of a portfolio in illiquid assets, which are those that can not be sold in seven days.

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Meet Paul Raymond

Meet Paul Raymond

Mr. Raymond is a sought after speaker in tax controversy law by many attorney, accountant, and business groups and at the request of the Internal Revenue Service, has presented programs at the IRS Nationwide Tax Forum, attended by tax professionals throughout the United States.

Additionally, he continues to be an active member in the Section of Taxation, American Bar Association, where he was the Past Chair of the Employment Taxes Committee.

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