From the Chief Accountant
of the Division of Investment Mangement:
Annual Industry Comment Letter
December 30, 1999
Dear Chief Financial Officer:
The accounting staff of the Division of Investment Management has prepared this letter to assist investment company registrants and their independent public accountants in addressing certain accounting-related matters. These comments represent the views of the staff of the Division and are not necessarily those of the Securities and Exchange Commission. The comments addressed in this letter apply to filings, including reports to shareholders, made by registered investment companies.
Management's Statement Regarding Compliance
Rules under the Investment Company Act of 1940 and the Investment Advisers Act of 1940 require that an independent accountant conduct an examination of the securities held by a regulated entity. Specifically, Rules 17f-1 and 17f-2 under the Investment Company Act require an independent accountant to conduct an examination when the securities are maintained in the custody of a member of a national securities exchange, or when the investment company itself maintains custody, respectively. Similarly, Rule 206(4)-2 under the Investment Advisers Act requires an examination when the adviser has custody or possession of client funds or securities. In all three instances, an independent accountant issues a report attesting to management's compliance with these rules, and the independent accountant's report is based upon a statement from management of the adviser or the fund that they have complied with the rules.
Our review of filings on Forms N-17f-1, N-17f-2 and ADV-E has revealed that many registrants have not included Management's Statement Regarding Compliance in their filings.1 To be a complete filing, registrants must attach Management's Statement Regarding Compliance to the Report of Independent Accountants in filings on Forms N-17f-1, N-17f-2, and ADV-E.
Accounting for Reimbursement of Expense Waivers
During examinations of registrants, we have noted receivables from fund advisers, under expense reimbursement plans, which have been outstanding for periods extending beyond one year. These receivables did not have corresponding valuation reserves reducing the outstanding receivable balance for potentially uncollectible amounts. Consistent with generally accepted accounting principles, fund management should consider the collectibility of any receivable from an adviser, particularly in circumstances where the receivable is not fully paid as frequently as the adviser receives payment for services provided under the advisory agreement.2 In addition, auditors of a fund's financial statements are reminded of the requirement under generally accepted auditing standards to satisfy themselves that receivables from an adviser or third party are properly valued to reflect collectibility concerns.3
Financial Highlights and Fee Table Disclosures
We have reviewed a number of financial highlights tables where registrants have incorrectly calculated the ratio of expenses to average net assets ("the expense ratio"). The expense ratio is calculated by dividing total expenses by average net assets.4 We have noted that a number of registrants are incorrectly reducing total expenses by brokerage offsets, custodial credits and/or other expense reductions.5 Certain registrants also are excluding interest and dividend expenses, attributable to securities sold short, from total expenses.6 Registrants are reminded that total expenses may be reduced only by fee waivers or reimbursements.
In our review of prospectuses, we have noted that some registrants are reducing the fee table expense percentages with custodial credits and/or other third-party offset arrangements. We remind registrants that the use of these credits and offsets to reduce fund expense ratios is inconsistent with the requirements of the form.7 Only contractual waivers or reimbursements may be used to reduce expense percentages in the fee table.8
Holding Period for Seed Capital Shares
Recently, we have received a number of questions regarding the holding period for shares purchased pursuant to Section 14(a) of the Investment Company Act as part of a fund's initial registration with the Commission. Some registrants and their sponsors appear to believe that the holding period for seed capital shares is related to the period over which a fund amortizes the organization costs. This view appears to have been the result of the staff's position that if any original shares are redeemed during the five-year amortization period, then the redemption proceeds must be reduced by any unamortized organization costs. Registrants and their sponsors apparently interpret this requirement to suggest that there is a five-year holding period for seed capital shares. With the imple-mentation of AICPA SOP 98-5,9 the ability to capitalize and amortize organization costs over a five-year period was eliminated. Consequently, many registrants and sponsors have asked us whether they may redeem seed capital shares shortly after a fund becomes effective.
We remind registrants and their sponsors that the redemption of seed capital shares is subject to the requirements of Section 14(a) of the Investment Company Act. The legality of a sponsor redeeming seed capital shares depends on the facts and circumstances of the redemption and is not based on the accounting for organization costs.10
Adviser Accounting for Offering Costs
In September of 1998, the Financial Accounting Standards Board (FASB) staff addressed the proper accounting treatment for the initial offering costs of closed-end funds in Emerging Issues Task Force (EITF) Topic No. D-76.11 The FASB staff concluded that an adviser could not capitalize the offering costs of closed-end funds because the adviser was not receiving both a continuing distribution fee and a contingent deferred sales charge (CDSC) or early withdrawal charge (characteristics of certain open-end funds previously addressed by the EITF). Under EITF Issue No. 85-24, advisers of open-end funds are permitted to capitalize offering costs if the adviser is compensated for the offering costs through both Rule 12b-1 fees (a continuing distribution fee) and CDSCs.12
Certain closed-end funds, such as hybrid or interval funds ("hybrid funds"), objected to the FASB staff's position on the basis that hybrid funds have many of the same features as open-end funds. Hybrid funds continuously offer shares to the public and honor redemption requests at preset dates, usually quarterly or monthly. Each hybrid fund also receives an exemptive order from the Commission that allows it to charge distribution fees and early withdrawal charges, charges that are similar to Rule 12b-1 fees and CDSCs of open-end funds.13 In an update to Topic No. D-76, the FASB staff concluded that an adviser to a hybrid fund may capitalize initial offering costs if the adviser receives both a distribution fee and early withdrawal charges. We would not object to the capitalization of initial offering costs in these situations provided that the investment company registrant has received an exemptive order permitting both distribution fees and early withdrawal charges.
Independence Standards Board Recordkeeping Requirements
In January 1999, the Independence Standards Board issued its first standard, Independence Discussions with Audit Committees.14 The standard requires auditors to discuss their independence with either the company's audit committee or board of directors. Auditors must disclose, in writing, all relationships between the auditor and its related entities and the company and its related entities that may impact an auditor's independence. Auditors also must affirm, in writing, that in their judgment they are independent of the company. We remind registrants that this correspondence is subject to inspection during periodic and other reviews.15
Issuance of AICPA Audit and Accounting Guide
On September 14, 1999, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants approved the AICPA Audit and Accounting Guide for Investment Companies. The audit guide outlines changes to existing practice that, in certain areas, differs from the requirements of Regulation S-X under the federal securities laws. For example, the audit guide permits the presentation of a condensed schedule of investments containing only a fund's 50 largest holdings. In contrast, Rule 12-12 of Regulation S-X requires all securities held by a fund to be separately listed in the schedule. We remind registrants that notwithstanding the audit guide, the financial statements of registered investment companies must be prepared in accordance with the requirements of Regulation S-X.
Financial Statements Submitted via EDGAR
We would like to remind registrants that all semi-annual and annual reports must be filed with the Commission within 10 days of distribution to shareholders.16 Semi-annual and annual reports must be submitted electronically via EDGAR under submission type "N-30D" and other interim or periodic reports should be submitted under type "N-30B-2". We also remind registrants that financial statements can be incorporated into a registration statement, post-effective amendment or other document by reference, but only if the requirements of Rule 303 of Regulation S-T have been met.
* * *
This letter contains information of importance to the company's independent public accountants; therefore, we encourage you to discuss these items with them. Address any questions about the contents of this letter or related matters to Brian D. Bullard, Assistant Chief Accountant, or me, at (202) 942-0590.
Very truly yours,
John S. Capone
N-17f-1, N-17f-2, and ADV-E are the filings required by Rules 17f-1 and
17f-2 under the Investment Company Act and Rule 206(4)-2 under the Investment
Advisers Act, respectively.
believe that if an adviser redeems its shares in a fund, the redemption
proceeds should be reduced by any outstanding receivables due from that
adviser at the time of the redemption. See Section 17(a)(3) of the
Investment Company Act.
receivables from an adviser or third party are outstanding and possibly
uncollectible, a number of other issues arise, including whether the
adviser or another affiliated person has violated Section 17(a)(3) of the
Investment Company Act, and whether the financial condition of the adviser
or other service provider should be disclosed in the fund's prospectus. See,
e.g., In the Matter of Vector Index Advisors, Inc., Investment Company
Act Release No.
22055 (July 8, 1996).
Instruction 4 to Item 9 of Form N-1A; Instruction 16 to Item 4 of Form
Rule 6-07.2(g) of Regulation
Letter from Lawrence A. Friend, Chief Accountant, Division of Investment
Management, to Chief Financial Officers (Nov. 7, 1997) (section concerning
closed-end fund expense ratios).
Item 3 of Form N-1A; Item 3 of Form N-2.
Letter from Barry D. Miller, Associate Director, Division of Investment
Management, to Craig S. Tyle, Esq., General Counsel, Investment Company
Institute (Oct. 2, 1998).
American Institute of Certified Public Accountants, Statement of Position
98-5, "Reporting on the Costs of Start-Up Activities" (Apr. 3,
14(a) has been interpreted to mean that a new investment company cannot
make a public offering of its securities unless the company has a bona
fide net worth of $100,000, and that such amount cannot be loaned or
redeemed as a temporary accommodation by those persons who make the
investment, nor can there be any intention, when the investment is made,
to redeem or dispose of such investment. See, e.g., Automation Shares,
Inc., 37 S.E.C. 771 (1957); Champion Fund, Inc. (pub. avail. Mar. 9,
1972 and June 26, 1972).
EITF Topic No. D-76, "Accounting by Advisors for Offering Costs Paid
on Behalf of Funds, When the Advisor Does Not Receive Both 12b-1 Fees and
Contingent Deferred Sales Charges" (July 23, 1998; Sept. 23-24,
EITF Issue No. 85-24, "Distribution Fees by Distributors of Mutual
Funds That Do Not Have a Front-End Sales Charge" (June 27, 1985 and
Feb. 6, 1986).
e.g., Cypresstree Asset Management Corporation, et al.,
Investment Company Act Release Nos. 23312 (July 10, 1998) (notice) and
23378 (Aug. 5, 1998) (order).
Independence Standards Board, Independence Standard No. 1,
"Independence Discussions with Audit Committees" (January,
1999). This Standard is effective for companies with fiscal years ending
after July 15, 1999.
Rule 31a-1(a) under the Investment Company Act. ("Every registered
investment company . . . shall maintain and keep current the accounts,
books, and other documents relating to its business which constitute the
record forming the basis for financial statements required to be filed
pursuant to Section 30 of the Investment Company Act of 1940 and of the
auditor's certificates relating thereto"). Under Rule 2-01(b) of Regulation
S-X, an auditor is required to be independent. The new Standard
requires the independent accountants to confirm in writing that they are
in fact independent. This required communication supports the auditor's
certificate that they were independent in performing their duties.
Rule 30b2-1 under the Investment Company Act.