From the Chief Accountant
of the Division of Investment Mangement:
Annual Industry Comment Letter
February 14, 2001
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 and investment advisers.
Audit Guide Implementation
On November 21, 2000, the American Institute of Certified Public Accountants revised its Audit and Accounting Guide, Audits of Investment Companies. The revised Guide codifies new accounting standards on several issues, including amortization of premium or discount on bonds, accounting for offering costs, and the accounting for excess expense plans. Registrants and their auditors are reminded that Staff Accounting Bulletin No. 74 requires disclosure of the impact of new accounting standards that have been promulgated, but are not yet effective, in the footnotes to the financial statements.1 This disclosure should include a brief description of the new standard, a discussion of the methods of adoption allowed by the standard, a discussion of the impact that adoption of the standard is likely to have on the financial statements, and disclosure of the potential impact of other significant matters that the registrant believes might result from the adoption of the standard.2
Senior Securities Table Disclosure
Item 4 of Form N-2 requires the registration statement of closed-end funds to disclose debt coverage information in a senior securities table.3 This information is required to be audited.4 Several registrants and their auditors have asked questions about compliance with the audit requirement. In meeting the form's requirements to include financial statements, financial highlights and an audit opinion covering the financial statements and financial highlights, registrants typically incorporate by reference the annual report.5 The senior securities table information, however, is usually not contained in the annual report because this information is only required in the registration statement. As a result, the audit opinion does not cover the senior securities table information. Registrants, therefore, have asked whether the senior securities table information can be deemed audited because it is derived from information contained in the audited financial statements, even though it is not covered by the auditors' opinion on the financial statements and financial highlights.
We do not believe the requirement that the senior securities table be audited is met merely because the information in the table is derived from audited financial statements. To meet the audit requirement, the independent accountant must express an opinion on the senior securities table itself or on a financial statement or financial highlights that include the senior securities table. Registrants must include, or incorporate by reference, this opinion in the registration statement. One way to meet the senior securities audit requirement is for the registrants to include the senior securities table information with the per share and ratio information in the financial highlights. Since the financial highlights are specifically covered by the audit opinion, the senior securities table information also would be covered. If registrants, however, include the senior securities table information elsewhere in the annual report, the audit opinion must expressly cover the senior securities table. Alternatively, if a registrant includes the senior securities table only in the registration statement, the registrant should file a separate opinion in the registration statement covering the senior securities table information.
AIMR Performance Verification and Auditor Consents
An increasing number of registrants include certain private account performance information of investment advisers in their registration statements and disclose that this information is presented in accordance with the Association for Investment Management & Research Performance Presentation Standards ("AIMR-PPS"). We have noted that a number of these presentations do not fully comply with the requirements of AIMR-PPS. For example, many presentations do not include the standard compliance statement required by AIMR-PPS.6 If registrants choose to disclose that performance information is prepared and presented in accordance with AIMR-PPS, then we remind registrants that it may be misleading to not comply with all of the performance and presentation standards required by the AIMR standards.7 Additionally, when a third party, such as an independent public accountant, is named in a registration statement as having performed a verification in accordance with AIMR-PPS, the written consent of that third party is required to be filed as an exhibit to the registration statement.8
Discounting Market Quotations for Large Holdings (Block Discounts)
We recently received a question about whether it is appropriate for a registered investment company to value an unrestricted security at a discount or premium from a readily available market quotation based solely on the size of the investment company's holding. The 1940 Act requires a registered investment company to value securities using market quotations when they are readily available9 Therefore, we do not believe it is appropriate to discount or mark-up a readily available market price for an unrestricted security solely because an investment company holds a large quantity of the outstanding shares of an issuer or holds an amount that is a significant portion of the security's average daily trading volume.
Updating Requirements for Financial Highlights Included in a Registration Statement Subsequent to a Stock Split
Several registrants have asked whether retroactive adjustment to the financial highlights and financial statements is required after an investment company issues a stock split.10 Staff Accounting Bulletin Topic 4C requires that a change in capital structure be presented retroactively if such change occurs before the release of the financial statements or the effective date of the registration statement, whichever is later.11 When a stock split occurs after the effective date of the registration statement, some registrants make a supplemental filing pursuant to Rule 497 ("sticker") to provide investors with information about the transaction, including an updated financial highlights table showing the effect of the stock split on a per share basis. Since the supplemental filing under Rule 497 does not update the registration statement, this information does not need to be audited. When a registrant files its annual update or any other post-effective amendment to the regis-tration statement, however, the registrant is required to include an audited retroactively adjusted financial highlights table.
Pro Forma Financial Statements and Filings Pursuant to Rule 488 of the Securities Act of 1933
Typically, management investment companies file a registration statement on Form N-14 when merging investment companies and may elect to file pursuant to Rule 488 under the 1933 Act requesting automatic effectiveness.12 As a condition to Rule 488, the filing must be materially complete. We have seen a growing number of registration statements filed pursuant to Rule 488 that do not include the required pro forma, audited annual, or unaudited semi-annual financial statements. When an open-end investment company files pursuant to Rule 488 and excludes this information, the staff considers the filing materially incomplete, and will suspend the automatic effectiveness by notifying the registrant in writing.13
Financial Highlights and Financial Statements During Reorganizations When Performance is being Carried Over
The staff receives numerous inquiries each year on the financial statements and financial highlights requirement for "shell" investments companies who utilize the historical performance of a predecessor entity subsequent to reorganization. In August, the Division granted no-action relief to Janus Adviser Series, permitting the Adviser Series to use the historical performance information of the predecessor entities (in this case several classes) in their initial registration statement provided that, among other things, Adviser Series represented it would carry forward the financial statements and financial highlights of the predecessor entities and report their historical financial information as their own.14 When investment companies reorganize existing funds or classes into new "shell" entities and carry over past performance information, the new "shell" entities should also carryover the prior financial highlights and financial statements.
Auditor Independence Issues
In last year's "Dear CFO Letter," we reminded registrants of the requirements of Independence Standards Board, Independence Standard No. 1, Independence Discussions with Audit Committees (ISB No.1).15 ISB No.1 requires auditors to discuss, 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 and affirm, in writing, that in their professional judgment they are independent of the company.16 During our examination of registrants, we have found several instances where the auditor did not deliver the required written correspondence to the audit committee or board of directors. We remind registrants and auditors for both investment companies and investment advisers that auditors of any financial statements filed with the Commission must comply with the provisions of ISB No.1.17
ISB No.1 also requires auditors to discuss their independence with management. In this discussion we encourage the board of directors or their audit committee to consider the Commission's recently adopted rule amendments concerning auditor independence.18 Those amendments identify certain relationships that render an accountant not independent of an audit client. The relationships addressed include, among others, financial, employment, and business relationships between auditors and audit clients, and relationships between auditors and audit clients where the auditors provide certain non-audit services to their audit clients. As applied to investment companies and investment advisers, we encourage a robust discussion of services provided by auditors to related entities within the mutual fund complex, including affiliated broker/dealers and other funds in the complex and the potential independence issues that may arise.
Ratification of Independent Accountants
The Commission has adopted amendments to the rules under the 1940 Act effective February 15, 2001, which pertain to the role of independent directors of investment companies.19 Included in the amendments is Rule 32a-4, a new rule that exempts investment companies from the Act's requirement that shareholders vote on the selection of the fund's independent public accountant if the investment company has an audit committee composed wholly of independent directors.20 While the rule is optional, we encourage investment company registrants to consider adopting an audit committee consisting solely of independent directors.
This letter contains information of importance to your 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, Kenneth B. Robins, Assistant Chief Accountants, or me, at (202) 942-0590.
Very truly yours,
John S. Capone
|| See Disclosures by Registrant When an Accounting Standard Has Been Issued But Not Yet Adopted, SEC Staff Accounting Bulletin No. 74, 53 Fed. Reg. 110 (1987) (Adding Topic 11-M "Disclosure of the Impact that Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant When Adopted in a Future Period" to the Staff Accounting Bulletin Series). SAB 74 states:
The staff believes that this disclosure guidance applies to all accounting standards which have been issued but not yet adopted by the registrant unless the impact on its financial position and results of operations is not expected to be material. In those instances where a recently issued standard will impact the preparation of, but not materially affect, the financial statements, the registrant is encouraged to disclose that a standard has been issued and that its adoption will not have a material effect on its financial position or results of operations. When adoption of new accounting standards have a material impact on a registrant's financial position and results of operations, disclosure should be made in the footnotes to the company's financial statements.
||Under Item 77L of Form N-SAR, registrants are required to indicate any change in accounting principle that will materially affect the registrant's financial statements filed, or to be filed, for the current fiscal year with the Commission. Item 77L also requires the registrant's accountants to prepare a letter discussing the preferability of the accounting change to accompany this disclosure. We will not, however, require this letter if an accounting change results solely from a standard promulgated by a new Audit and Accounting Guide.
||Item 4.3 of Form N-2, (captioned Senior Securities (hereinafter "Senior Securities Table")) states:
Furnish the following information as of the end of the last ten fiscal years for each class of senior securities (including bank loans) of Registrant. If consolidated statements were prepared as of any of the dates specified, furnish the information on a consolidated basis: (1) Year; (2) Total Amount Outstanding Exclusive of Treasury Securities; (3) Asset Coverage Per Unit; (4) Involuntary Liquidating Preference Per Unit; and (5) Average Market Value Per Unit (Exclude Bank Loans).
||Item 4.3 instructs registrants preparing the senior securities table to follow Instruction 8 to Item 4.1, which requires the senior securities table to be audited.
||Item 23 of Form N-2, (captioned Financial Statements), prescribes the contents of annual reports to shareholders required by Section 30(d) of the Investment Company Act of 1940 ("1940 Act"). The annual report must include the financial statements prescribed under Articles 3 and 6 of Regulation S-X (17 C.F.R. §§ 210.3-01 to -20, 210.6-01 to -10 (2000)) and the financial highlights table under Item 4.1 of the Form. Item 23 of Form N-2 does not specifically require the senior securities table to be included in annual reports to shareholders.
||For current AIMR standards, see Association of Investment Management and Research, AIMR Performance Presentation Standards Handbook (2d Ed. 1996). In addition to a number of other presentation requirements required by AIMR, investment advisers seeking to comply with the AIMR-PPS must include a compliance statement to accompany all performance presentations: "[insert firm name] has prepared and presented this report in compliance with the Performance Presentation Standards of the Association for Investment Management and Research (AIMR-PPS). AIMR has not been involved with the preparation or review of this report."
||As part of its inspections program, the Office of Compliance Inspection and Examinations routinely reviews the disclosure and compliance practices of registrants that claim compliance with AIMR-PPS.
||Section 7 of the 1933 Act states:
If any accountant, engineer, or appraiser, or any person whose profession gives authority to a statement made by him, is named as having prepared or certified any part of the registration statement, or is named as having prepared or certified a report or valuation for use in connection with the registration statement, the written consent of such person shall be filed with the registration statement.
15 U.S.C. § 77g(a) (2000).
|| See 15 U.S.C. § 80a-2(a)(41) (2000) (Section 2(a)(41) of the 1940 Act); 17 C.F.R. § 270.2a-4 (2000) (Rule 2a-4 under the 1940 Act).
||A fund must provide its financial highlights pursuant to either Item 9 of Form N-1A, or Item 4 of Form N-2.
|| See Topic 4-C of the Staff Accounting Bulletin Series ("Change in Capital Structure").
||Rule 488(a) under the 1933 Act states: "A registration statement filed on Form N-14 by a registered open-end management investment company . . . shall become effective on the thirtieth day after the date upon which it is filed with the Commission . . .." 17 C.F.R. § 230.488(a) (2000).
||Rule 488(b) under the 1933 Act states: "No registration statement shall become effective pursuant to paragraph (a) of this section if, prior to the effective date of the registration statement, it should appear to the Commission that the registration statement may be incomplete or inaccurate in any material respect and the Commission furnishes to the registrant written notice that the effective date is to be suspended." 17 C.F.R. § 230.488(b) (2000).
|| See Janus Adviser Series (pub. avail. Aug. 28, 2000).
|| See Independence Standards Board, Independence Standard No. 1, "Independence Discussions with Audit Committees" (Jan., 1999). ISB No.1 became effective for audits of companies with fiscal years ending after July 15, 1999.
|| See Letter from John S. Capone, Chief Accountant, Division of Investment Management to Chief Financial Officer (pub. avail. Dec. 30, 1999).
||Audited financial statements filed with the Commission in compliance with forms under the Investment Company Act of 1940 and the Investment Advisers Act of 1940 must follow Regulation S-X, including those filed pursuant to Schedule G of Form ADV. See, e.g., 17 C.F.R. § 210.1-01(a)(4) (2000). Rule 2-01 of Regulation S-X requires an auditor to be independent. 17 C.F.R. § 210.2-01 (2000). For those advisors that are sole proprietors, or who do not have a board of directors, or an audit committee or their equivalents, correspondence should be addressed to the person, or group of persons, who is responsible for selecting and ratifying the independent auditor.
|| See Revisions of the Commission's Auditor Independence Requirements, Securities Act Release No. 7919, 65 Fed. Reg. 76008, (Nov. 21, 2000).
||See Role of Independent Directors of Investment Companies, Investment Company Act Release No. IC-24816, 66 Fed Reg. 3,734 (2001).
||This rule is effective February 15, 2001. See Id. at 3,745. Under the provisions of this rule, a registered management investment company, or a registered face-amount certificate company, is exempt from the provision of section 32(a)(2) of the Act (codified at 15 U.S.C. § 80a-32(a)(2) (2000)) that requires the selection of the company's independent public accountant be submitted for ratification or rejection at the next succeeding annual meeting of shareholders, if: (a) The company's board of directors has established a committee, composed solely of directors who are not interested persons of the company, that has responsibility for overseeing the fund's accounting and auditing processes ("audit committee"); (b) The company's board of directors has adopted a charter for the audit committee setting forth the committee's structure, duties, powers, and methods of operation or set forth such provisions in the fund's charter or bylaws; and (c) The company maintains and preserves permanently in an easily accessible place a copy of the audit committee's charter and any modification to the charter.