Mutual fund valuation and accounting notes @ bec doms

1. Executive Summary
Mutual fund is a trust that pools the savings, which are then invested in
capital market instruments such as shares, debentures and other securities.
It works in a different manner as compared to other savings organizations
such as banks, national savings, post office, non-banking financial
companies etc. as most, if not all capital market instruments, have an
element of risk, it is very essential that the investors have a clear
understanding of how mutual fund operates and what are the advantages as
well as limitations, how the net asset value (NAV) are calculated and what is
the impact of dividend on NAV etc. this understanding has to be created
among the investors by the distributors engaged in the marketing of mutual
fund products. The distributors should also be knowledgeable enough to
answer fundamental and basic questions raised by the investors. The
distributors need to understand accounting for the fund’s transactions with
the investors and how the fund accounts for its assets and liabilities which is
essential for them to perform basic role in explaining the mutual fund
performance to the investors. For example, unless the distributor knows how
the NAV is computed, he cannot use even simple measures such as NAV
change to assess the fund performance. He should also understand the
impact of dividends paid out by the fund or entry/exit loads paid by the
investor on the calculation of the NAV and therefore the fund performance.
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2. INTRODUCTION:
Meaning:
The mutual fund industry in India started in1963 with the formation of Unit
Trust of India, at the initiative of the Reserve Bank and the Government of
India. The objective then was to attract the small investors and introduce
them to market investments.
In a mutual fund, many investors contribute to form a common pool of
money. This pool of money is invested in accordance with a stated objective.
The ownership of the fund is thus joint or mutual; the fund belongs to all
investors. A single investor’s ownership of the fund is in the same proportion
as the amount of the contribution made by him bears to the total amount of
fund.
A mutual fund uses the money collected from investors to buy those assets
which are specifically permitted by its stated objective. Thus, a growth fund
would by mainly equity assets- ordinary shares, preference shares, warrants,
etc. An income fund would mainly buy debt instruments such as debentures
and bonds. The fund’s assets are owned by the investors in the same
proportion as their contribution bears to total contributions of all investors
put together.
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3. When an investor subscribes to mutual fund, he becomes part owner of fund’
s assets. In USA, mutual fund is considered as an investment company and
an investor “buys into the fund”, meaning he buys the shares of the fund. In
India, a mutual fund is constituted as a Trust and the investors subscribes to
the “units” of a scheme launched by the fund, which is where the term unit
Trust comes from. The term “unit-holder” is used to denote the mutual fund
investor which includes in both the open-end and close-end schemes.
In an open-end scheme, investors can buy and sell units from the fund
continuously. The stock exchange is not in picture. To ensure that there is
fairness, sale and purchase has to take place at fair value of the unit. Since
the units held by an investor evidence the ownership of the fund’s assets,
the value of the total assets of the fund when divided by the total number of
units issued by the mutual fund gives us the value of one unit. This is
generally called as Net Asset Value (NAV) of one unit or one share. The total
value of an investor’s part ownership is thus determined by multiplying the
NAV with the number of units held. As the fund’s investments are revalued
at their market prices, the net value of investments will change depending
upon the way prices of the investments move in the market. Therefore, the
NAV of the fund also fluctuates.
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4. Definitions:
Source Definition
Mutual Fund$ for “A mutual fund is a large pool of investment
Dummie$ 1997 money from lots and lots of people.”
FSOS Performance “A mutual fund is a collection of stocks,
Support New bonds, or other securities purchased by a
Employee Orientation group of investors and managed by a
2/1/97 professional investment company.”
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5. Quarterly Market “An investment company that pools the
Guide to Merrill Lynch money of many individuals and invests in a
Mutual Funds portfolio of stocks, bonds and/or cash
equivalents, actively managed by a portfolio
manager who buys and sells securities in an
attempt to take advantage of current or
expected market conditions.”
Business Week’s “A mutual fund is an investment company
Annual Guide to that pools the money of many individual
Mutual Funds 1991 investors. When the fund takes in money
from investors, it issues shares.”
Words of Wall Street “Popular name for the shares of open-end
1983 management investment companies. Such
shares represent ownership of a diversified
portfolio of securities, which are
professionally managed and which are
redeemable at their net asset value.”
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6. www.sec.gov/consum “A mutual fund is a company that brings
er/inwsmf.htm together money from many people and
invests it in stocks, bonds, or other
securities. (The combined holdings of
stocks, bonds, or other securities and assets
the fund owns are known as its portfolio.)
Each investor owns shares, which represent a
part of these holdings.”
Sage Online 1997 “A mutual fund is a savings/investment
account managed by money managers
employed by an investment company. Money
managers are professionals who select the
investments of the fund.
Introduction to Mutual “A mutual fund is a corporation with a state
Funds and MLAM charter to conduct business as an investment
1997 company. It invests in publicly traded stocks
and bonds, and issues its own shares to
investors, who become Mutual Fund
Shareholders.”
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7. Need for the project:
The selection of an existing mutual fund depends on its performance - past
as well as expected. How should an investor judge the performance of a
mutual fund? What criteria should be used to evaluate and rank a mutual
fund?
There are a number of mutual funds in the market. New schemes are hitting
the market almost daily, with new names and targets. So, it becomes difficult
for the small investor to judge the performance of the fund accurately.
The performance of a mutual fund scheme is reflected in its net asset value
(NAV) which is disclosed on a daily basis in case of open-ended schemes and
on weekly basis in case of close-ended schemes.
The Importance of Accounting Knowledge:
The balance sheet of mutual fund is different from the usual balance sheet of
other corporate entities such as Banks, Companies or Partnership firms. All
of the fund’s assets belong to investors and are held in fiduciary capacity for
them. Mutual fund employees need to be aware of the special requirements
concerning accounting for the fund’s assets, liabilities and transactions with
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8. investors and others like banks, custodians and registrar. This knowledge
will help them understand their place in the organization, by getting an
overview of the functioning of the firm.
Even the mutual fund distributors need to understand accounting for the
fund’s transactions with the investors and how the fund accounts for its
assets and liabilities, as the knowledge is essential for them to perform their
basic role in explaining the mutual fund performance to their investors. If
they don’t know how the NAV is computed, then they cannot use even
simple measures such as NAV change to assess the fund performance.
Scope of Project:
The project enables us to know that performance of mutual fund is reflected
in its net asset value (NAV). Hence, it is not that investor’s should invest in
those units which have highest NAV, but they should also consider what are
the risk and returns associated with the NAV. Also, the investor must
consider impact of dividend payout on the NAV. As far as accounting of
mutual fund is consider, SEBI lays down various guidelines and provisions in
which manner the AMC’s are required to maintain their accounts, what
should be the accounting effects and so on.
Methodology:
Data collection
Primary data-
Interviewed Fund manager Mr. Amankumar .Rajoria of Standard
Chartered Bank, Mutual Fund Dept., Fort.
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9. Secondary data-
Internet
Business magazines
Workbook
Characteristics of a mutual fund:
Mutual funds are not guaranteed by any bank or government agency.
Mutual funds provide a rate of return, in the form of dividends, capital
gains, and changes in share value.
There is always some investment risk.
Higher rates of return usually involve higher risk.
All mutual funds have costs which lower the shareholder’s rate of return.
Past performance is not a guarantee of future performance.
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10. Mutual funds can be purchased through brokers or directly from the fund
through its Transfer Agent
Advantages of Mutual Funds:
1) Portfolio diversification:
Mutual funds normally invest in a well-diversified portfolio of
securities. Each investor is a part owner of all the fund’s assets. This
enables him to hold a diversified investment portfolio even with a
small amount of investment.
2) Professional management:
The investment management skills along with the needed research
into available investment options ensure a much better return than
what an investor can manage on his own.
3) Reduction/Diversification of Risk:
Diversification reduces the risk of loss. When an investor invests
directly, all the risk potential loss is his own. While investing in a pool
of funds with other investors, any loss on one or two securities is also
shared with other investor.
4) Reduction of transaction costs:
A direct investor bears all the cost of investing such as brokerage or
custody of securities. When going through a fund, he has the benefit
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11. of economies of scale; the funds pay lesser costs because of larger
volumes, a benefit passed on to its investors.
5) Convenience and flexibility:
Investors can easily transfer their holdings from one scheme to
another. They can also invest or withdraw their money at regular
intervals. The mutual fund process is further made convenient with the
facility offered by funds for investors to buy or sell their units through
the internet or e-mail or using other communication means.
Disadvantages of Mutual funds:
1) No control over costs:
Investor pays investment management fees as long as he remains with
the fund, albeit in return for the professional management and
research. Fees are usually payable as a percentage of the value of his
investments, whether the fund value is rising or declining. He also
pays distribution costs, which he would not incur in direct investing.
2) No Tailor made portfolios:
Investors who invest on their own can build their own portfolios of
shares, bonds and other securities. Investing through funds means he
delegates this decision to the fund managers. High net-worth
individuals or large corporate investors may find this to be a constraint
in achieving their objectives.
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12. 3) Managing a portfolio of funds:
Availability of a large number of options from mutual funds may again
need advice on how to select a fund to achieve its objectives, quiet
similar to the situation when he has to select individual shares or
bonds to invest in.
MUTUAL FUND SCHEMES:
OPERATIONAL CLASSIFICATION:
1. OPEN-ENDED SCHEME:
When a fund is accepted and liquidated on a continuous basis by a
mutual fund manager, it is called ’open-ended scheme.’ The fund
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13. manager buys & sells units constantly on demand by the investors.
Under this scheme, the capitalization of the fund will constantly
change, since it is always open for the investors to sell or buy their
share units. The scheme provides an excellent liquidity facility to
investors. No intermediaries are required in this scheme.
MERITS:
1. It provides liquidity facility.
2. No intermediaries required.
3. Provide long term capital appreciation.
4. No maturity period.
DEMERITS:
1. Not traded on stock exchange.
2. Capitalization of fund is constantly changing.
2. CLOSE-ENDED SCHEME:
When units of a scheme are liquidated (repurchase) only after the
expiry of a specified period, it is known as a close-ended scheme.
Accordingly such funds have fixed capitalization & remain as a corpus
with the mutual fund manager. Units of close-ended are to be traded
on the floors of stock exchange in the secondary market. The price is
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14. determined on the basis of demand & supply. Therefore there will be,
two prices, one that is market determined & the other which is Net
Asset Value based. The market price may be either above or below
NAV. Managing a close-ended scheme is comparatively easy as it gives
fund managers ample opportunity to evolve & adopt long term
investment strategies depending on the life of the scheme. Need for
liquidity arises after a comparatively longer period i.e. normally at the
time of redemption.
MERITS:
1. The prices are determined on the basis of market price & NAV.
2. Gives fund manager ample opportunity to evolve & adopt long term
investment
strategies.
3. Invests in listed stock exchange & traded securities.
DEMERITS:
1. Open for subscription only for a limited period.
2. Exit is possible only at the end of specified period.
RETURN BASED CLASSIFICATION:
1. INCOME FUND SCHEME:
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15. The scheme that is tailored to suit the needs of investors who are particular
about regular returns is known as ‘income fund scheme.’ The scheme offers
the maximum current income, whereby the income earned by units is
distributed periodically. Such funds are offered in two forms, the first
scheme earns a target constant income at relatively low risk, while the
second scheme offers the maximum possible income.
2. GROWTH FUND SCHEME:
It is a mutual fund scheme that offers the advantage of capital appreciation
of the underlying investment. For such funds, investment is made in growth
oriented securities that are capable of appreciating in the long run. Growth
funds are also known as nest eggs or long haul investment. In proportion to
such capital appreciation, the amount of risk to be assumed would be much
greater.
INVESTMENT BASED CLASSIFICATION:
1. EQUITY FUND SCHEME:
A kind of mutual fund whose strength is derived from equity based
investments is called ‘equity fund scheme.’ They carry a high degree of
risk. Such funds do well in periods of favorable capital market trends.
A variation of the equity fund schemes is the ‘index fund’ or ‘never
beat market fund’ which are involved in transacting only those scripts
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16. which are included in any specific index e.g. the scripts which
constituted the BSE-30 Sensex or 100 shares National index. These
funds involve low transaction cost.
2. BOND FUND SCHEME:
It is a type of mutual fund whose strength is derived from bond
based investments. The portfolio of such funds comprises bonds,
debenture etc. this type of fund carries the advantage of secured &
steady income. However, such funds have little or no chance of capital
appreciation, & carry low risk. A variant of this type of fund is called
‘Liquid Funds.’ This specializes in investing in short term money
market instruments. This focus on liquidity delivers the twin features
of lower risks & low returns.
3. BALANCED FUND SCHEME:
A scheme of mutual fund that has a mix of debt & equity in the
portfolio of investment may be referred to as a ‘Balanced Fund
Scheme.’ The portfolio of such funds will be often shifted between
debt & equity, depending upon the prevailing market trends.
4. SECTORAL FUND SCHEMES:
When the managers of mutual fund invest the collected from a wide
variety of small investors directly in various specific sectors may
include gold & silver, real estate, specific industry such as oil & gas
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17. companies, offshore investments, etc.
5. FUND-OF-FUND SCHEME:
There can also be funds of funds, where funds of one mutual fund are
invested in the units of other mutual funds. There are a number of
funds that direct investment into a specified sector of the economy.
This makes diversified & yet intensive investment of funds possible.
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18. History of Mutual Funds in India and role of SEBI in
mutual funds industry:
Unit Trust of India was the first mutual fund set up in India in the year 1963.
In early 1990s, Government allowed public sector banks and institutions to
set up mutual funds. In the year 1992, Securities and exchange Board of
India (SEBI) Act was passed. The objectives of SEBI are – to protect the
interest of investors in securities and to promote the development to and to
regulate these securities market. As far as mutual funds are concerned, SEBI
formulates policies and regulates the mutual funds to protect the interest of
the investors. SEBI notified regulations for the mutual funds in 1993.
Thereafter, mutual funds sponsored by private sector entities were allowed
to enter the capital market. The regulations were fully revised in 1996 and
have been amended thereafter from time to time. SEBI has also issued
guidelines to the mutual funds from time to time to protect the interests of
investors. All mutual funds whether promoted by public sector or private
sector entities including those promoted by foreign entities are governed by
the same set of Regulations. There is no distinction in regulatory
requirements for these mutual funds and all are subject to monitoring and
inspections by SEBI. The risks associated with the schemes launched by the
mutual funds sponsored by these entities are of similar type. It may be
mentioned here that Unit Trust of India (UTI) is not registered with SEBI as a
mutual fund (as on January 15, 2002).
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19. Sponsor, Trustee, AMC and Other Constituents:
Mutual funds in India have a 3-tier structure of Sponsor-Trustee-AMC.
Sponsor is the promoter of the fund.
Sponsor creates the AMC and the trustee company and appoints the
boards of both these companies, with SEBI approval.
The mutual fund is formed as trust in India, and not as a company.
In the US mutual funds are formed as investment companies.
The AMC’s capital is contributed by the sponsor.
Investors’ money is held in the Trust (the mutual fund). The AMC gets
a fee for managing the funds, according to the mandate of the
investors.
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20. The trustees make sure that the funds are managed according to the
investors’ mandate.
Sponsor should have at least a 5-year track record in the financial
services business and should have made profit in at least 3 out of the
5 years.
Sponsor should contribute at least 40% of the capital of the AMC.
Trustees are appointed by the sponsor with SEBI approval.
At least 2/3 of trustees should be independent.
At least ½ of the AMC’s Board should be of independent members.
An AMC cannot engage in any business other than portfolio advisory
and management.
An AMC of one fund cannot be Trustee of another fund.
AMC should have a net worth of at least Rs. 10 crores at all times.
AMC should be registered with SEBI.
AMC signs an investment management agreement with the trustees.
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21. Trustee company and AMC are usually private limited companies.
Trustees are required to meet at least 4 times a year to review the AMC.
The investors’ funds and the investments are held by the custodian,
who is the guardian of the funds and assets of investors.
Sponsor and the custodian cannot be the same entity.
If the schemes of one fund are taken over by another fund, it is called
as scheme takeover. This requires SEBI and trustee approval.
If two AMCs merge, the stakes of sponsors changes and the schemes
of both funds come together. High court, SEBI and Trustee approval
needed.
If one AMC or sponsor buys out the entire stake of another sponsor in
an AMC, there is a takeover of AMC. The sponsor, who has sold out,
exits the AMC. This needs high court approval as well as SEBI and
Trustee approval.
Investors can choose to exit at NAV if they do not approve of the
transfer. They have a right to be informed. No approval is required, in
the case of open-ended funds.
For closed-end funds, investor approval is required for all cases of
merger and takeover (as per the curriculum).
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22. Closed end fund investors also do not have exit option.
Legal and Regulatory Framework:
Mutual funds are regulated by the SEBI (Mutual Fund) Regulations,
1996.
SEBI is the regulator of all funds, except offshore funds.
Bank-sponsored mutual funds are jointly regulated by SEBI and RBI.
If there is a bank-sponsored fund, it cannot provide a guarantee
without RBI
permission.
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23. RBI regulates money and government securities markets, in which
mutual funds invest.
Listed mutual funds are subject to the listing regulations of stock
exchanges.
Since the AMC and Trustee Company are companies, any complaints
against their board can be made to the CLB.
Investors cannot sue the trust, as they are the same as the trust and
cannot sue themselves.
UTI does not have a separate sponsor and AMC.
UTI is governed by the UTI Act, 1963 and is voluntarily under SEBI
Regulations.
SROs are the second tier in the regulatory structure.
SROs get their powers from the apex regulating agency, act on their
instructions and regulate their own members in a limited manner.
SROs cannot do any legislation on their own.
All stock exchanges are SROs.
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24. AMFI is an industry association of mutual funds. AMFI is not yet a SEBI
registered SRO.
AMFI is regulated by its own board made up of its members.
VALUATION OF SCHEME PORTFOLIOS:
The Need to Know Valuation Methods:
The value of investors’ holdings of units in a mutual fund is calculated on
the basis of Net Asset Value of investments by the fund. Distributors and
investors need to understand how mutual funds value the securities held by
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25. them in their portfolios, so they can understand how value of the investor’s
holdings in fund schemes is arrived at.
This knowledge will help them anticipate the fluctuations in the portfolio
values under different market scenarios and recommend or take their
decisions accordingly. This will also help them in comparing the
performance of different fund schemes by reviewing the valuation methods
followed by them.
The Regulation of Valuation Practices:
As the industry regulator, SEBI aims at protecting the investors by ensuring
that the valuation practices adopted by the AMC’s (Asset Management
Company) are
a. Based on the principles of “fair valuation” of portfolios securities.
b. Are uniform across the fund types and AMC’s to the extent possible.
The fair valuation ensures that realistic prices are used to compute the value
of portfolio securities and that there is no manipulation of the values of
portfolios. Uniform valuation practices ensure that everyone can compare the
performance of different schemes and AMC’s without worrying about
whether the fund valuation practices may be different from one scheme to
another.
AMC’s therefore adopt uniform portfolio valuation practices to the extent
possible.
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26. SEBI in turn regulates and
a. Prescribes detailed valuation methodologies in its Fund regulations
b. Mandates disclosure of valuation methods used for information of
investors.
Basic Valuation Principles:
Fair value-
It means value of security that is realistic and not based on any arbitrary
methodology. Fair value may be determined based either on purchase cost,
market price or on some accepted principles.
Fair value of Traded Securities-
Mutual funds invest essentially in marketable securities traded either on the
stock exchange or on to the money markets. The preference for traded
securities is given to ensure liquidity of the investments- ease with which the
securities can be sold. The second reason for the preference for ‘traded
securities” is to ensure that these securities receive ‘fair valuation at market
prices’ that are publicly available. This valuation process is known as “mark
to market”- bringing the value of the securities in the portfolio to reflect
their market value.
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27. Fair value of Illiquid Securities-
While fund managers always strive to include only traded or liquid securities
in their portfolios market conditions often result in some securities not being
traded in the market. Valuation of such non-traded securities poses a
problem of how to determine their ‘fair value’. Regulators prescribe methods
wherever possible or require the Trustees to determine the right
methodology and disclose to the extent possible.
Valuation date-
The date on which the fund calculates the value of its portfolio and the NAV
is known as the valuation date. Where funds value their investments on a
‘mark to market’ basis, the valuation date is the date on which the traded
price of a security is available. For non-traded security it means the date that
is selected and used for the valuation in accordance with some principles
and regulations.
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28. Valuation of Equity Securities:
The valuation principle to be used depends also upon whether a security is
traded in the market or not.
Traded Securities-
For traded securities the basis of valuation is ‘mark to market’. For this
purpose, on the valuation date, once the market price is obtained the fund
will multiply its current holdings in number of shares by the applicable
market price to get the “mark to market” value. The market price to be used
for valuation is determined as follows:
a. An equity security is valued at the last quoted closing price on the
stock exchange where it is “principally traded”.
b. If no trade is reported on principal stock exchange, the last quoted
price on any other recognized stock exchange may be used
c. If an equity security is not traded on ant stock exchange on a
particular valuation day, the value at which it was traded on the
selected/other stock exchange on the earliest previous day, may be
used, provided such date is not more than 30 days prior to the
valuation date.
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29. Thinly Traded Security-
For some securities market prices is not available easily. It becomes difficult
in such cases to apply the principle of ‘mark to market’. The reason for
non-availability of market price is the infrequency or small volume of trading
in a security. Such securities are then considered ‘thinly traded’ and SEBI give
some freedom to AMC’s to use their own methods of valuation in such cases.
SEBI defines thinly traded security as:
“An equity/convertible debenture/warrant is considered as a thinly traded
security if trading value in a month is less than Rs.5 lakhs and the total
volume is less than 50000 shares.”
Then market price or free valuation principle is used as follows:
a. In case trading I the security is suspended up to 30 days, then the last
traded price is used.
b. If trading in the scrip is suspended for more than 30 days, then the
AMC can decide the valuation norms to be followed and such norms
would be documented and recorded.
Non-Traded Securities:
When a security is not traded on any stock exchange for 30 days prior to the
valuation date, it becomes a ‘non-traded security’.
Valuation of Non-traded/Thinly traded securities:
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30. Both non-traded and thinly traded securities are to be valued “in good faith”
by the AMC on the basis of the valuation principles laid down below:-
a. Based on the latest available Balance sheet, Net worth per share is
calculated. [Net worth per share= (Share capital+ Reserves-
Miscellaneous expenditure and Debit balance of P&L A/c)/ No. of paid
up shares.]
b. Then value per share is calculated using the Capitalized Earnings
Method. The formula used is (Earnings per share *applicable P/E
multiple). For this purpose, average P/E ratio for the industry is to be
based upon BSE or NSE data. PER should be followed consistently. The
identified PER has to be discounted by 75% and only 25% of the
industry average P/E shall be taken as the applicable P/E multiple.
Earnings per share of the latest audited annual accounts are
considered for this purpose.
c. The value per share based on the net worth method and capitalized
earnings method, calculated as above, is averaged and further
discounted by 10% for illiquidity, to arrive at the value per share.
d. In case the EPS is negative, EPS value for that year is taken a zero for
arriving at capitalized earnings.
e. Where the latest balance sheet of the company is not available within
nine months from the close of the year, unless the accounting year is
changed, the shares of such companies shall be valued at zero.
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31. f. In case an individual security accounts for more than 5% of the total
assets of the scheme, an independent valuer has to be appointed for
the valuation.
Example:
1. Assume that we hold an engineering company’s share that is not
quoted on the market, but we know that the company makes Rs.2 EPS
and has a net worth of Rs.8 per paid up share.
2. We can use other traded engineering companies industry average for
basing the applicable P/E multiple say Rs.12.
3. With a 75% discount, the P/E multiple applicable to our untraded share
is 3 (12*25%).
4. We can use the multiple of 3 to obtain our untraded share’s price by
multiplying our company’s Rs.2 EPS with the applicable PER and get
the valuation price of Rs.6.
5. This is further averaged with the company’s net worth of 8 to give a
value of Rs. 7 per share [(6+8)/2].
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32. 6. Since our share is not liquid we must discount 7 by 10% to give a
valuation of Rs. 6.30 per share.
Equity dividends impact on NAV:
Income to be distributed as a dividend remains part of the fund’s NAV until
ex date. On ex date, the NAV is reduced by the amount of the dividend. The
table below illustrates the impact of an equity dividend payout on NAV.
Who When What
XYZ Biotech Initially began with $100,000 in
fund (January 1) assets
issued 10,000 shares
had an initial NAV of
$10.00 per share
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33. XYZ Biotech At the end of has had no expenses
fund the first quarter did not issue or redeem
of operation any shares
(April 5) earned $5,000 in interest
and dividends from the
assets in it’s portfolio
has an NAV of $10.50
per share
($105,000/10,000=$10.
50)
XYZ Biotech’s April 10 decides to distribute all
board of of the income earned by
directors the fund
declares a dividend with
record date set as April
15, ex date set as April
16, and payable date set
as April 25
XYZ Biotech April 15 still has an NAV of
fund (record date) $10.50
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34. XYZ Biotech’s April 16 (ex Removes the $5,000
board of date) from the fund’s assets
directors and puts it in a pending
dividend distribution
account (this will
decrease NAV by $0.50
per share)
XYZ Biotech April 16 (ex now has an NAV of
fund date) $10.00
XYZ Biotech April 25 pays a dividend of $0.50
fund (payable date) per share to all
shareholders of record as
of April 15
Note: The NAV is not
impacted by this payment
event.
Dividend entitlement relative to NAV paid/received:
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35. The table below illustrates which investors (buyers or sellers)
are entitled to the dividend in the previous example, and relates
their entitlement to the NAV they either paid for purchases or
received for liquidations.
An investor who is and who places the will...
a... trade...
buyer prior to ex date pay $10.50 per share,
(April 16) which includes the
$5,000 in income, and
will
be entitled to the
dividend when it pays.
buyer on or after ex date pay $10.00 per share,
(April 16 ) which does not include
the $5,000 in income,
and will
not be entitled to the
dividend.
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36. seller prior to ex date receive $10.50 per share
(April 16) for the liquidation, which
includes the $5,000 in
income, and will
not be entitled to the
dividend, as the income
was already reflected in
the $10.50 NAV.
seller on or after ex date receive $10.00 per share
(April 16 ) for the liquidation, which
does not include the
$5,000 income, and will
Be entitled to the
dividend when it pays.
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37. Valuation of Debt Securities:
Traded Securities-
A debt security may be traded on a stock exchange (corporate securities) or
in the interbank market (government security). If a security is traded on the
stock exchange then again publicly available and quoted market prices are
used for its valuation. If a debt security (other than govt. security) is not
traded on any stock exchange on a particular valuation day, the value at
which it was traded on the principal stock exchange on the earliest previous
day, may be used, provided such date is not more than 15 days prior to the
valuation date. If a debt security (other than govt. security) is purchased by
way of private placement, the price at which it was bought may be used for a
period of 15 days beginning from the date of purchase.
Thinly Traded Securities-
These needs to be identified and then valued especially. A debt security
(other than govt. security) is considered as a thinly traded security if on the
37

38. valuation date there is no individual trade on that security in marketable lots
on the principal stock exchange or any other stock exchange.
Valuation of Non-traded/Thinly traded security:
Valuation norms of such securities depend upon their maturity. Thus,
1. Money Market Securities and Debt Securities up to 182 days to
maturity-
Non-traded debt securities with residual maturity of up to 182 days
should be valued on the same basis as money market securities. These
securities are valued on the basis of amortization of purchase cost
plus accrued interest till the beginning of the purchase plus the
difference between the redemption value and the purchase cost that is
spread uniformly over the remaining maturity period of the
investments.
2. Non- traded, Non-Government, debt instruments over 182 days to
maturity- All non-traded debt securities including asset backed paper
with maturity of over 182 days are valued ‘in good faith’ by the AMC I
accordance with the detailed valuation principles laid by SEBI.
a. All Non-traded Debt Securities are classified into “Investment
grade” and “Non-Investment grade” securities based on their credit
rating. The non-investment grade securities are further classified
as “Performing” and “Non Performing” assets.
38

39. b. All Non-Government, investment grade debt securities, classified as
non-traded, are valued on yield to maturity (YTM) basis as
described later.
c. All Non-Government, non-investment grade, performing debt
securities are valued at a discount of 25% to the face value.
d. All Non-Government, non-investment grade, non- performing debt
securities would be valued based on the provisioning norms.
Computation Methodology for Yields used for
valuations of Debt Securities:
The approach to valuation of non-traded debt security is based on the
concept of “spreads” over the ‘benchmark rate’ to arrive at the yields for
pricing of non-traded security. The process is as follows-
Step A:
A Risk Free Benchmark Yield is calculated, using the government securities
as the base as they are traded regularly, free from credit risk and traded
39

40. across different maturity spectrums every week. All securities with minimum
traded value of Rs. 1 crore are grouped by maturities called “duration
buckets” – 0.5 to 1 year, 1 to2 year, 2/3 years, 3/4,4/5,5/4,5/6 and over 6
years. Then, volume weighted yields are calculated for each bucket. This is
done weekly or whenever the interest rates change.
Step B:
Expected yield on non-govt. securities is generally higher than the
corresponding maturity govt. security to reflect the higher credit risk on
non-govt. securities. The differences between the two yields are the “spread”
over the benchmark yield. “Spreads” are determined using the market prices
of non-govt. securities and comparing them with the yields on govt.
securities. The spreads are built only for investment grade corporate paper
which is grouped credit rating within each of the 7 duration buckets.
Step C:
Yields to be used for valuation are further adjusted to reflect the illiquidity
risk of a security. The yields have to be marked up/marked down to account
for the illiquidity risk, promoter background, finance company risk and the
issuer class risk. As illiquidity risk would be higher for non-rated securities,
higher expected yield would be used to value non-rated securities as
compared to rated securities. For securities rated by external agencies, SEBI
permits a discretionary discount up to 2 years and 0.75% for those of higher
40

41. duration. The AMC has to assign an internal credit rating to non rated
securities but with mandatory lower discounts or premiums.
Step D:
The yields so arrived for all categories of securities are used to price the
portfolio. If yields for any category of securities cannot be obtained using
any or all of the above steps, then a fund may use the credit spreads from
trades on appropriate stock exchange for the relevant rating category over
the AAA securities trades.
Valuation of securities with Call/Put Option:
a. Securities with Call option-
An issuer may call a debt security and repay before maturity. Such
securities with call option have to be valued at the lower of two
41

42. values- value obtained by valuing the security to final maturity and
that obtained valuing the security to call option date.
b. Securities with Put option-
Where investors have the option to redeem earlier than maturity.
Such securities with put option shall be valued at the higher of the
values obtained the security to final maturity and valuing the
security to the put option date.
Valuation and Disclosure of Illiquid Securities :
SEBI stipulates that-
a. Aggregate value of “illiquid securities” of a scheme, defined as
non-traded, thinly traded and unlisted equity shares shall not exceed
15% of the total assets of an open-end scheme and 20% of a
closed-end fund. Illiquid assets held in excess of the limits have to be
assigned zero value.
b. All mutual funds have to disclose s on March 31 and September 30 the
scheme-wise total illiquid securities in value and percentage of the net
assets while making disclosures of half yearly portfolios to the unit
holders.
c. Mutual funds are no allowed to transfer illiquid securities internally
among their schemes from October 1, 2000.
42

43. Risk, Return and Performance:
43

44. Rate of return is computed as: (Income earned/Amount
invested)*100.
This number can be annualized by multiplying the result by the factor 12/n,
where n is the number of months in the holding period. If the holding period
is in days, the above factor will be 365/n, where n is the number of days in
the holding period.
Change in NAV method of calculating return is applicable to growth
funds and funds with no income distribution.
Change in NAV method computes return as follows:
(NAV at the end of the holding period – NAV at the beginning of the
holding
period)/NAV at the beginning of the period. Return is then
multiplied by 100 and annualized)
E.g.) Annualizing the Rate of Return
If NAV on Jan 1, 2001 was Rs. 12.75 & June 30, 2001 was Rs. 14.35
% age change in NAV = (14.35 – 12.75)/12.75 x 100 = 12.55%
Annualized return = 12.55 x 12/6 = 25.10%
Percentage Change in NAV:
Assume that change in NAV is the only source of return.
Example:
NAV of a fund was Rs. 23.45 at the beginning of a year
44

45. Rs. 27.65 at the end of the year.
%age change in NAV = (27.65 – 23.45)/23.45 *100 = 17.91%
The total return with re-investment method or the ROI method is
superior to all these methods. It considers dividend and assumes that
dividend is re-invested at the ex-dividend NAV.
Total Return or ROI Method computes return as follows:
[(Value of holdings at the end of the period - value of holdings at the
beginning of the period)/ value of holdings at the beginning of the
period] x 100.
Value of holdings at the beginning of the period = number of units at
the beginning x begin NAV.
Value of holdings end of the period = (number of units held at the
beginning +
number of units re-invested) x end NAV.
Number of units re-invested = dividends/ex dividend NAV.
Expense ratio is an indicator of efficiency and very crucial in a bond
fund.
Income ratio is the ratio of net investment income by net assets. This
ratio is important for fund earning regular income, such as bond funds,
45

46. and not for funds with growth objective, investing for capital
appreciation.
Portfolio turnover rate refers to the ratio of amount of sales or
purchases (whichever is less) to the net assets of the fund.
Higher the turnover ratio, greater is the amount of churning of assets
done by the fund manager.
High turnover ratio can also mean higher transaction cost. This ratio is
relevant for actively managed equity portfolios.
If the turnover of a fund is 200%, on average every investment is held
for a period of 6 months.
Risk arises when actual returns are different from expected returns.
Standard deviation is an important measure of total risk.
Beta co-efficient is a measure of market risk. The quality of beta
depends on ex-marks.
If ex-marks are high beta is more reliable.
Ex-marks are an indication of extent of correlation with market index.
Index funds have ex-marks of 100%.
Comparable passive portfolio is used as benchmark.
46

47. Usually a market index is used as a benchmark.
Compare both risk and return, over the same period for the fund and
the benchmark.
Risk-adjusted return is the return per unit of risk.
Comparisons are usually done
With a market index
With funds from the same peer group
With other similar products in which investors invest their funds
When comparing fund performance with peer group funds, size
and composition of the portfolios should be comparable.
Treynor and Sharpe ratios are used for evaluating performance
of funds.
The quality of beta depends on ex-marks.
While fund managers are under pressure to increase their asset base, they
are confident of giving reasonable returns in the long term.
While that is a comforting thought for retail investors, fund managers agree
that it may be difficult to achieve the same levels of outperformance as in
the past. Prashant Jain, chief investment officer of HDFC Mutual Fund, notes
that in India, equities will continue to outperform all other asset classes
going forward. But there is a caveat. "The gap between performance of
equities and other asset classes will narrow," says Jain.
47

48. While fund managers are under pressure to increase their asset base, they
are confident of giving reasonable returns in the long term. However, they
warn against high expectations. "Investors should not expect equity funds to
give 90-100 per cent returns every year. Broad markets should give a CAGR
return in the range of 12-15 per cent over the next two-three years".
With opportunities in the broad market tapering out, funds are dependent on
the stock-picking abilities of fund managers. "I think it is becoming a stock
pickers' market. If we identify good companies which have the opportunity
and potential to grow, fund managers will continue to outperform the
markets”.
But fund managers are guarding against taking sectoral bets. Nilesh Shah,
chief investment officer of Prudential ICICI Mutual Fund, believes that the
days of sector-specific rallies are over. While they are bullish on sectors like
banking, infrastructure-related and consumer-dependent sectors, caution is
advised in taking big sectoral bets.
So what will drive equity returns this year? "I expect a re-rating of Indian
equities to happen soon. In many cases it has already started". Fund
managers also expect the mid-cap segment to do well, though they agree
that returns may not match that of last year. Jain is of the opinion that
mid-caps will continue to see good growth going forward. "Though there are
some stocks which have become overheated, the universe of mid-caps is still
pretty large, and it is possible to find 30-35 good stocks in the segment for
your portfolio," says he. "I would back them to do better than large-cap
stocks in the longer term".
48

49. Overall, fund managers continue to be bullish on equities, though they warn
against big return expectations. But rest, assured, if fund managers are to be
believed, they will continue to give better returns than other asset classes. "I
think at least for the next five-10 years, diversified funds will continue to
outperform the markets.”
ACCOUNTING:
Net Asset Valuation (NAV):
A mutual fund is a common investment vehicle where the assets of the
fund belong directly to the investors. Investor’s subscriptions are
accounted for by the fund not as liabilities or deposits but as “Unit
Capital”. The investments made on behalf of the investors are reflected
on the assets side and are main constitutes of fund’s scheme. Liabilities
of a mainly short term nature may be part of the balance sheet. The
fund’s total net assets are therefore defined as the assets minus the
49

50. liabilities. The following are the regulatory requirements and accounting
definitions laid down by SEBI.
NAV = Net Asset of the scheme/ Number of Units Outstanding
i.e.; (Market value of investments+ receivables+ other accrued
Income+ other assets- Accrued expenses- other payables –other
liabilities.)/ No. of units outstanding on the valuation date.
For the purpose of the NAV calculation, the day on which NAV is
calculated by the fund is known as the valuation date.
NAV for all schemes must be calculated and published at least
every Wednesday for closed end schemes and daily for the open
end schemes. The day’s NAV must be posted on AMFI’S website by
8.00 p.m. that day. Those close end schemes which are not listed
on the stock exchanges mat be publish NAV at monthly or
quarterly intervals as permitted by SEBI.
For valid applications received up to the cut off time, NAV
computed later that day would form the basis. For valid
applications after the cut off time, NAV computed the following
day would form the basis. For all schemes except liquid schemes,
the cut off time is 3 p.m. in respect of liquid schemes, a different
method is followed. Applications for fresh sales received till 1
p.m.’ NAV computed the previous day would form the basis for
50

51. that day and for applications received after 1 p.m., the same day
NAV shall be used. For repurchases, the corresponding cut off time
is 10 am.
A fund’s NAV is affected by 4 sets of factors i.e.; Purchase and sale
of investment securities, valuation of all investments securities,
other assets and liabilities and Units sold or redeemed.
“Other Assets” include any income due to the fund not received as
on the valuation date. “Other Liabilities” include expenses payable
by the fund. These income and expenses have to be accrued and to
be included in the computation of the NAV.
Additions and sales from the portfolio of securities, and changes in
the number of units outstanding will both affect the per unit asset
value. Such changes in securities and number of units must be
recorded by the next valuation date. If frequency of NAV declaration
does not permit this, recording may be done within 7 days of the
transaction, provided that the non-recording does not affect NAV
calculations by more than 1%. For example, if a fund declares NAV
every week, with the next declaration date being January 15, then
all sales/purchases/redemptions up to January 14 have to be
reflected in the NAV as of January 15, except for transactions
whose value does not affect the NAV by more than 1%.in case
non-recording of transactions leads to difference of more than 1%
between the declared NAV and final NAV, the AMC must pay the
51

52. investors at a price higher than NAV or repurchased from them at a
price lower than NAV. Similarly, the AMC/scheme must be recover
the difference from the investors where units are allotted to them at
a price lower than NAV or repurchased from them at a price higher
than NAV.
NAV are required to be rounded off up to four decimals places in
case of liquid/money market schemes and up to two decimals
places in case of all other schemes.
52

53. Pricing of Units:
Although NAV per unit defines the fair value of the investor’s holding in the
fund, the fund may not repurchase the investor’s units at the same price as
NAV. There can be entry and exit loads. The sale price is NAV plus entry load:
the repurchase price is NAV minus exit load. SEBI requires that the fund must
ensure that repurchase price is not lower than 93% of NAV (95% in case of
close end schemes) and that sale price is not more than 107% of NAV. The
difference between the repurchase and sale price should not exceed 7% of
the sale price.
SALE PRICE= Applicable NAV*(1+Entry load, if any)
REPURCHASE PRICE= Applicable NAV* (1-Exit load, if any)
For example, if the applicable NAV is Rs.10, the entry and exit load is 2%,
then sale price will be Rs. 10.20 and repurchase price will be Rs. 9.80. This
evident from the fact that difference between sale price and repurchase price
is Rs. 0.40, which is lower than 7% of sale price.
53

54. Fees and Expenses:
The AMC may charge the scheme with investment management and advisory
fees that are fully disclosed in the offer document subject to following limits:
@1.25% of the first Rs. 100 crores of weekly average net assets
outstanding in the accounting year, and @ 1% of weekly average net
assets in excess of Rs. 100 crores.
For no load schemes, the AMC may charge an additional management
fee up to 1% of weekly average net assets outstanding in the
accounting year.
In addition to fees mentioned above, the AMC may charge the scheme with
the following expenses:
A. Initial expenses of launching schemes ( not to exceed 6% of initial
resources raised under the scheme); and
B. Recurring expenses including:
Marketing and selling expenses including distributors
commission
54

55. Brokerage and transaction cost
Registrar service for transfer of units sold or redeemed
Fees and expenses of trustees
Audit fees
Custodian fees
Cost related to investor communication
Costs of fund transfer from location to location
Costs of providing account statements and dividend/
redemption cheques and warrants
Insurance premium paid by the fund or a scheme
Costs of statutory advertisements
Winding up costs for terminating a fund or a scheme.
The following expenses cannot be charged to the schemes:
Penalties and fines for infraction of laws
55

56. Interest on delayed payment to the unit holder
Legal, marketing, publication and other general expenses not
attributable to any schemes
Expenses on investment management/general management
Expenses on general administration, corporate advertising and
infrastructure costs
Depreciation on fixed assets and software development
expenses.
The total expenses charged by the AMC to a scheme, excluding issue or
redemption expenses but including investment management and advisory
fees are subject to the following limits:
On the first Rs. 100 crores of daily or average weekly net assets- 2.5%
On the next Rs. 300 crores of daily or average weekly net assets-
2.25%
On the next Rs. 300 crores of daily average weekly net assets- 2.0%
On the balance of daily or average weekly net assets- 1.75%
56

57. For bond funds, the above percentages are required to be lower by 0.25%.
Initial Issue Expenses:
SEBI has rationalized the Initial Issue Expenses as follows effective from April
4, 2006:
Initial Issue expenses will be permitted for closed ended schemes only
and such scheme will not charge entry load.
In closed ended schemes, the initial issue expenses shall be amortized
on weekly basis over the period of scheme. For example, a 5 year (260
weeks) closed ended scheme with initial expenses of Rs. 5 lakhs shall
charge Rs. 1923 (500000/260) every week.
In closed ended schemes where initial issues are amortized for an
investor exiting the scheme before amortization is completed, AMC
57

58. shall redeem the units only after recovering the balance proportionate
unamortized issue expenses.
Conversion of a closed ended scheme or interval scheme to open end
scheme/ or issuance of new units shall be done only after the balance
unamortized amount has been fully recovered from the scheme.
Open ended scheme should meet the sales, marketing and other such
expenses connected with sales and distribution of scheme from the
entry load and through initial issue expenses.
Unamortized portion of initial expenses shall be included for NAV
calculation, considered as “other asset”. The investment advisory fee
cannot be claimed on this asset. Hence, they have to be excluded while
determining the chargeable investment management/ advisory fees.
While calculating the maximum amount of chargeable expenses, the
unamortized portion of the initial issue expenses will not be included
as part of the average daily/weekly net assets figure.
58

59. Disclosures and Reporting Requirements:
MF/AMC shall prepare for each financial year, annual report and
annual statement of accounts for all the schemes.
MF shall have the annual statement of accounts audited by an auditor
who is independent of the auditor of the AMC.
Within 6 months of the closure of the relevant accounting year the
fund shall display the scheme wise annual report on their websites
59

60. which should be linked with AMFI website, mail the annual report/
arbitraged annual report to all unit holders.
Specific Disclosures in the Accounts:
Each item of expenditure accounting for more than 10% of total
expenditure should be disclosed in the accounts or the notes thereto
of the schemes.
The mutual fund shall make scrip wise disclosures of NPAs on the
yearly basis along with the half yearly portfolio disclosure. The total
amount of provisions against the NPAs shall be disclosed in addition
to the total quantum of NPAs and proportion of the assets of the
mutual fund scheme.
Large unit holdings (over 25% of net assets of a scheme) shall be
disclosed in annual and half yearly results by giving the number of
such investors and their total holdings in percentage terms.
It should be mentioned in the annual report of the Mutual fund that
unit holders may, if they so desire, request for the annual report of the
AMC.
Dissemination of Information:
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61. The fund shall furnish to SEBI once in a year, copies of audited annual
statements of accounts for each scheme and copy of six-monthly
unaudited accounts.
Within 30 days of the close of each of half year (March 31 and
September 30), the fund shall publish its unaudited financial results in
one national English newspaper and one newspaper in the language of
the region where the head office of the fund is situated. These results
are also required to be put on the websites of mutual fund with a link
provided to the AMFI website.
The trustees shall make such disclosures to the unit holders as are
essential to keep them informed about any information which may
have an adverse bearing on their investments
The annual report containing accounts of the asset management
companies should be displayed on the website of the mutual funds.
Accounting Policies:
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62. Investments are required to be marked to market using market prices.
Any unrealized appreciation cannot be distributed and provision must
be made for the same.
Dividend received by the fund on a share should be recognized, not on
the date of declaration, but on the date the share is quoted on
ex-dividend basis. For example, if a fund owns shares on which
dividend is declared on April 5, and the shares are quoted on
ex-dividend basis on April 20, the dividend income will be included by
the fund for distribution/NAV computation only on April 20.
In determining the holding cost of investments and the gain or loss on
sale of investments, the average cost method must be followed.
Example, a fund acquires 100 shares in company A for Rs. 5000 on
April 1. It buys another 150 shares in the same company for Rs. 7000
on April 15. It sells shares of company A for Rs. 3500 on April 30. The
gain on sale is Rs. Rs. 1100 calculated as- Average cost of holding per
share in company A= (5000+7000)/ (100+150) = 48. Total holding
cost of shares sold= 48*50=2400. Gain on sale= 3500-2400=1100.
Purchase/sale of investments should be recognized on the trade date
and not settlement date.
Bonus/rights shares should be recognized only when the original
shares are traded on the stock exchange on an ex-bonus/ex-rights
basis.
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63. Nonperforming assets and income thereon shall be treated in
accordance with SEBI’s guideline issued on this subject.
Investments owned by mutual funds are marked to market. Therefore,
the value of investments appreciates or depreciates based on market
fluctuations, which is reflected in the balance sheet. However, this
change in value constitutes unrealized gain/loss. When any
investments are actually sold, the proportion of the unrealized
gain/loss that pertains to such investments becomes realized
gain/loss, therefore, at any time, the NAV includes realized and
unrealized gain/loss on investments. While SEBI prohibits the
distribution of unrealized appreciation on investments, realized gain is
available for distribution.
Equalization: An open end scheme sells and repurchases units on the
basis of NAV. SEBI therefore prescribes the use of an equalization
account, to ensure that creation/redemption of units does not change
the percentage of income distributed. This involves following steps:
Computation of distributable reserves:
Income + Realized gain on investments – Expenses – Unrealized
Losses (Unrealized gains are excluded). Practically, many funds
make the adjustment for unrealized losses in computation of
equalization only at the time of dividend distribution. This is to
avoid variation in per unit equalization balance on a day to day
basis.
63

64. The following percentage is then computed:
Distributable Reserves/Units outstanding
The above percentage is multiplied with the number of new
units sold, and the equalization account is credited by this
amount, if units are sold above par: if the units are sold below
par, the equalization account is debited by this amount. The
same percentage is multiplied with the number of units
repurchased, and the equalization account is debited by this
amount if the units are repurchased above par: if the units are
repurchased below par, the equalization account is credited.
The net balance in the equalization account is transferred to the profit
and loss account. It is only adjusted to the distributable surplus and
does not affect the net income for the period.
Illustration of accounting of important mutual fund
transactions:
Day 1:
An open end fund issues 1000 units at its face value of Rs. 10 per unit.
Unit capital will appear in the balance sheet at Rs. 10,000
(1000*10)
64

65. (If units were issued at a price above par i.e. at a price higher
than Rs.10 per unit, the difference will appear as premium in the
balance sheet)
Rs. 10,000 received is invested in various securities.
Investments will also appear at Rs. 10,000 in the balance sheet.
Effect of accounting entries
Investments: Debit of Rs.10,000
Unit capital: Credit of Rs. 10,000
NAV per unit= Rs.10
(Net assets are the total assets at market value less current liabilities
and provisions. In this example, we have assumed current liabilities,
other income and expenses to be zero. Hence, investments= net
assets. Units outstanding are 1000. Thus, NAV= 10000/1000=Rs.10)
Day 2:
Market value of investments rises to Rs. 11,000
Unrealized appreciation= Rs. 1000 (market value of investments
11,000 less cost 10,000).
Investments will be marked to market i.e. they will appear in the
balance sheet at Rs. 11,000
65

66. Effect of accounting entries:
Investments: Further Debit of Rs.1000
Profit and Loss Account: Credit of Rs.1000.
NAV per unit= 11,000/1000= Rs. 11.
Day 3:
Market value of investments rises to Rs. 12,000.
10% of the original portfolio is sold i.e. investments with an original
cost of Rs. 1000 are sold for 1200.
Investments will now appear in the balance sheet at Rs. 10,800
Realized gain on sale of investments= Rs.200 (Sale price-cost i.e.
1200-1000)
Unrealized appreciation now stands at Rs. 1800 (market value of
investments in hand 10800 less cost 9000)
Effect of accounting entries:
Investments: Credit of Rs.1200
Cash/Bank: Debit of Rs.1200
NAV per unit= Rs.12
Face value of unit: Rs.10
Realized gain: Rs.0.20 (200/1000)
66

67. Unrealized gain: Rs.1.80 (1800/1000)
Day 4:
Investments continue at a market value of Rs. 10,800 (original cost
Rs.9000)
The fund sells 100 additional units and repurchases 75 units, both
transactions taking place at Rs.12 per unit.
Effect of transaction involving sale of units:
Units outstanding will increase to Rs.1100
Sale consideration will be Rs.1200, accounted as:
Increase in unit capital (Credit)= Rs.1000 (Thus, unit
capital will appear in the balance sheet at Rs.11,000)
Credit to equalization account=Rs. 20 (realized gain in
NAV: Rs. 0.20per unit * units sold:100)
Credit to unit premium reserve= Rs.180 (unrealized
appreciation in the NAV:Rs.1.80 per unit * units sold:100)
Effect of transaction involving repurchase of units:
Units outstanding will decrease by 75 to 1027
Cash outlay on repurchase will be Rs. 900 (75*12) accounted as:
67

68. Decrease in unit capital= Rs. 750 (75*10). (Thus, unit
capital will appear in the balance sheet at Rs.10,250)
Debit to equalization account= Rs.15 (unrealized gain in
NAV:Rs. 0.20per unit * units repurchased:75)
Debit to unit premium reserve: Rs.135 (unrealized
appreciation in NAV:Rs.1.80 per unit* units
repurchased:75)
Transfer to revenue account= Net balance in the equalization account.
Guidelines for Identification and Provisioning for
Non-Performing Assets (Debt Securities) for Mutual
funds:
Non- performing assets in a fund’s portfolio have a significant bearing on
fund’s NAV. Hence, SEBI has become out with guidelines for the
identification and treatment of non-performing assets by mutual funds.
A. Definition of Non-Performing Assets (NPA):
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69. An asset shall be classified as non-performing, if the interest and/or
principal amount have not been received or remained outstanding for
one quarter from the day such income/installment has fallen due.
B. Effective date for classification and provisioning of NPA’s:
The definition of NPA may be applied after the lapse of a quarter after
the due date of the interest. For example, if the due date for interest is
30.06.2000, it will be classified as NPA from 01.10.2000, if the
interest was still unpaid as of 1.10.2000.
C. Treatment of income accrued on the NPA and further accruals:
After the expiry of the 1st quarter from the date income has fallen due,
there will be no further interest accrual on the asset, i.e. if the due
date for interest falls on 30.06.2000 and if the interest is not received,
accrual will continue till 30.09.2000 after which there will be no
further accrual of income. In short, taking the above example, from
the beginning of the 2nd quarter there will be no further accrual of
income.
On classification of the asset as NPA from a quarter past due date of
interest, all interest accrued and recognized in the books of accounts
of the fund till the due date should be provided for. For example, if
interest income falls due on 30.06.2000, accrued will continue till
30.09.2000 even if the income as on 30.06.2000 has not been
received. Further, no accrual will be done from 01.10.2000 onwards.
69

70. Full provision will also be made for interest accrued and outstanding
as on 30.09.2000.
D. Provision for NPAs- Debt Securities:
Both secured and unsecured investments, once they are recognized as
NPAs, call for provisioning in the same manner. Where these
investments are part of a close end scheme, the phasing would be
such as to ensure full provisioning prior to the closure of the scheme,
unless the schedule phasing is earlier.
The value of the asset must be provided as per the following
timeframes or earlier, at the discretion of the fund. A Mutual fund will
not have any discretion to extend the period of provisioning. The
provisioning against the principal amount or installments should be
made at the following rates, irrespective of whether the principal is
due for repayment or not.
a) 10% of the book value of the asset should be provided for after 6
months past due sate of interest i.e. 3 months from the date of
classification of the asset as NPA.
b) 20% of the book value of the asset should be provided for after 9
months past due sate of interest i.e. 6 months from the date of
classification of the asset as NPA.
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71. c) Another 20% of the book value of the asset should be provided
for after 12 months past due sate of interest i.e. 9 months from
the date of classification of the asset as NPA.
d) Another 25% of the book value of the asset should be provided
for after 15 months past due sate of interest i.e. 12 months
from the date of classification of the asset as NPA.
e) The balance 25% of the book value of the asset should be
provided for after 18 months past due sate of interest i.e. 15
months from the date of classification of the asset as NPA.
In other words, a mutual fund is allowed to phase out the provisioning
over a one-half-year period from the date interest becomes overdue.
Book value for the purpose of provisioning for NPAs has to be taken as
value determined a sper the prescribed valuation method.
Illustration:
10% provision of book value as determined above
01.01.2001
6 months past due date of interest i.e. 3 months from the date of
classification of asset as NPA
(01.10.2000)
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72. 20% provision
01.04.2001
20% provision
01.07.2001
25% provision
01.10.2001
25% provision
01.01.2002
Thus, 1 ½ years past due date of income or 1 ¼ year from the date of
classification of the asset as an NPA, the asset will be fully provided for.
If any installment is fallen due, during the period of interest default, the
amount of provision should be installment amount or above provision
amount, whichever is higher.
E. Reclassification of assets:
An asset earlier classified as non-performing can become performing
again if the borrower starts paying the interest or principal amount
that were overdue. Upon reclassification of assets as performing assets:
1. In case a company has fully cleared all the arrears of interest,
the interest arrears provisions can be written back in full.
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73. 2. The asset will be reclassified as performing on clearance of all
interest arrears and if the debt is regularly serviced over the
next two quarters.
3. In case the company has fully cleared all the arrears of interest,
the interest not credited on accrual basis would be credited at
the time of receipt.
4. The provision made for the principal amount can be written back
in the following manner:
100% of the asset provided for in the books will be written
back at the 2nd quarter where the provision of principal
was made due to the interest defaults only.
50% of the asset provided for in the books will be written
back at the 2nd quarter and 25% after every subsequent
quarter where both installments and interest were in
default earlier.
5. An asset is reclassified as a standard asset only when both
overdue interest and overdue installments are paid in full and
there is satisfactory performance for a subsequent period of 6
months.
F. Receipt of past dues:
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74. When fund has received income/principal amount after their
classifications as NPAs:
1. For the next 2 quarters, income should be recognized on cash
basis and thereafter on accrual basis.
2. The asset will be continued to be classified as NPA for these two
quarters.
3. During this period, of two quarters, although the asset is
classified as NPA, no provision needs to be made for the
principal if the same is not due and outstanding.
4. If part payment is received towards principal, the asset
continues to be classified a NPA and provisions are continued as
per the norms set at (D) above. Any excess provision will be
written back.
G. Classification of Deep Discount Bonds as NPAs:
Investments in Deep Discount Bonds can be classified as NPAs, if any
two of the following conditions are satisfied:
1. If the rating of the bond comes down to grade “BB” or below.
2. If the company is defaulting in their commitments in respect of
other assets, if available.
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75. 3. In case of full Net worth erosion.
Provision should be made as per norms of set at (D) above as soon as
the asset is classified a NPA. Full provision will be made if the rating
comes down to grade ‘D’.
H. Reschedulement of an overdue asset:
In case any company defaults on either interest or principal amount
and the fund has accepted a reschedulement of the schedule of
payments then the following practice may be adhered to:
i. In case it is a first reschedulement and only interest is in default,
the status of the asset, namely NPA may be continued and
existing provisions should not be written back. This practice
should be continued for two quarters of regular servicing of the
debt. Thereafter, this may be classified as performing assets and
the interest provided nay be written back.
ii. If reschedulement is done due to default in interest and principal
amount, the asset should be continued as non-performing for a
period of 4 quarters, even though the asset is continued to be
serviced during these 4 quarters regularly. Thereafter, this can
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76. be classified as performing asset an d all the interest provided
till such date should be written back.
iii. If the reschedulement is done for a second/third time or
thereafter, the classification of NPA should be continued for
eight quarters of regular servicing of the debt. The provision
should be written back only after it is reclassified as performing
asset.
Treatment of derivatives:
In India, SEBI has permitted mutual funds to use derivative trading subject to
certain conditions. From the perspective of accounting, such instruments
need to be marked to market, with consequent impact on NAV. That means
the open positions are valued at the last quoted price at the exchange where
the instrument is traded, while non traded contracts are valued at fair price
as per procedures determined by the AMC and approved by the Trustees.
The unrealized value appreciation/depreciation on all open positions is
considered for determining net asset value.
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77. Case Study:
Funds and Liability Reconciliation.
The Client:
State Bank of India Mutual Fund (SBIMF) is one of the leading Mutual Fund
having 29 Investor Service Centres (ISCs) across the country. It has a corpus
of about Rs 50 billion ($125 million) from approximately 50 different
schemes having more than a million investors.
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78. The inflow of funds is from their ISC's. The funds collected are subsequently
transferred to their main account at SBIMF corporate office. Similarly, they
issue cheques for dividend, interest, brokerage and redemption on regular
intervals.
The Challenge:
SBIMF wanted their investor applications to be processed, and the statement
of account to be dispatched on the same day. This was possible only on
getting credit confirmation from the bank i.e. the investor's cheques getting
cleared and deposited.
Fund Reconciliation:
The funds were collected under various schemes through ISC's and the same
was deposited in various banks across the country. Depending on deposited
amount the investor was allotted units calculated on the prevailing NAV (Net
Asset Value) of that day. To reach the final corpus for the days transaction,
for a particular scheme one had to reconcile all the cleared and uncleared
cheques.
Liability Reconciliation:
Similar to fund reconciliation, all cheques issued to investors and brokers
had to be reconciled. Before issuing the cheques one had to make sure that
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79. the required funds were available in the scheme account.
The Solution:
Computronics followed up with SBIMF ISC's to get clearance of wrong credits
and pending applications. Close vigilance of bank accounts of all schemes
led to faster reconciliation. During peak periods we managed more than a
1000 cheques a day.
The Benefits:
Due to Computronics close monitoring of the reconciliation process SBIMF
was able to mobilize and invest their fund in different securities depending
on the scheme features. This also led to High Net Investors being able to
invest and redeem faster.
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80. Conclusion:
The value of investors’ holdings of units in a mutual fund is calculated on
the basis of Net Asset Value of investments by the fund. Distributors and
investors need to understand how mutual funds value the securities held by
them in their portfolios, so they can understand how value of the investor’s
holdings in fund schemes is arrived at.
This knowledge will help them anticipate the fluctuations in the portfolio
values under different market scenarios and recommend or take their
decisions accordingly. This will also help them in comparing the
performance of different fund schemes by reviewing the valuation methods
followed by them.
Mutual fund employees need to be aware of the special requirements
concerning accounting for the fund’s assets, liabilities and transactions with
investors and others like banks, custodians and registrar. This knowledge
will help them understand their place in the organization, by getting an
overview of the functioning of the firm.
Even the mutual fund distributors need to understand accounting for the
fund’s transactions with the investors and how the fund accounts for its
assets and liabilities, as the knowledge is essential for them to perform their
basic role in explaining the mutual fund performance to their investors. If
they don’t know how the NAV is computed, then they cannot use even
simple measures such as NAV change to assess the fund performance.
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81. 81