SEC Division of Investment Management staff letter: Accounting Comment Letter

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON. D.C. 20549
ACT r eii - LlO
SETION l' 'i L..ISION OF RULE
VESTMENT MANAGEMENT PUBLIC , /! ~' ,
 V AILAILITY I if 9 ~
November 2, 1995
Dear Chief Fincial. Officer:
, The accounting staff of the Division of Investment Management (the "Division") has prepared ths letter to respond to questions raised by investment company registrnts and their independent public accountats with regard to certin accounting-related matters. These comments represeilt the views of the staff of the Division and are not necssanly those of the Securities and Exchange Commssion (the "Commssion"). The comments addressed in

letter apply to . fiings made by registered investment companes, including reports to ths shareholders. Ths lettr should be read in coItunction with similar letters previously and subsequently issued by the Division's accounting staff, Office of Disclosure and Review and Offce of Insance Products. '"

Transactions With Affiiates in a Master/Feeder Structure .:.~.,...
In a letter addressed to Chief Fincial Officers date November 1, 1994 (the "November 1 Lettr"), the Division expressed the position tht fuds that are compensate by affiliates for losses on certin of their investment holdings should account for such tranactions

as, contributions to capitaL. The staff has subsequently become aware of intances when the master fund in a "master/feeder" strcture received a capita contribution, but the effect of the tranaction was not disclosed at the feeder'level. Although a feeder fund includes thefincial

statements of its master fud in its anual and semi-annual report to shaeholders, the feeer fund's fincial statements should also reflect these capital contributions. .

If the master fud is organied as a parership, generally accepted accounting pnnciples

C'GAA") require the fmancial statements of the feeder to reflect its pro rata'portion of every master fud traction. Income recived by, the master fund parership is considered to be

recived, pro rata, by the feeder fud contemporaneously with the receipt by the master fud.

The distrbution policy of the master 'fund doe not dictate the feeer fund's accounting for income. The feeder fund's fincial statements should contain the same presentation and

disclosure suggeste by the November 1 Letter with respect to the feeder fud's pro rata benefit received from the master fud's receipt of a capital contrbution. If the master fund is organi as a corporation, classification of the masteF fud's

income in the feeder fud's fmancial statements depends upon the. distribution policies of the master fund. Until it is distrbuted, income recived by the master fund is recorded by a feeer fud as unrealizd. appreciation. When distrbutions are made by the master fund, it must

, 'differentiate distributions from capital gain and other sources from distributions of net investment income. The master fund's determtion of the source of its distrbutions dictates the accounting by the feeder. A capital contrbution to a master fund corporation wil not be automatically recorded by a feeder fund as such. Rather, as noted above, the feeder fund wil

account for it as it would any other increase in the master fund's overall net asset value. Notes

"J to the feeder fund's fmancial statements should refer to the circumstances surrounding the

capital contribution received by the master fund either specifically or by cross-reference to the corresponding note to the fmancial statements of the master fund and should indicate the feeder fund's benefit received. Accounting For Organization and Other Deferred Costs

In a letter dated May 9, 1995, the Division stated that the Investment Company Act of bearg certin 1940 (the "1940 Act") does not prohibit unt investment trsts ("UlTs") from 1 Since then, the Division has recived a number of organtional and offering expenses.

questions regarding the accminting for such expenses and the appropriate period of amortiztion. In accordance with GAA, costs' qualifying as organtion expenses should be amortizd over the period of benefit, not to exce sixty month. Organtion expenses generaly consist

of expenses incurred to establish a company and legally equip it to engage in business.2 Such

costs may be deferred and amortiZ by all registered investment companies. For accounting

purposes, offering cost, including the costs of registering securities with the Commsion and the states, do not qualif as organtion costs and, accordingly, require different accounting

treatment. Offerig costs are distinguishable from organtion expenses becuse they represent

costs associated with the sale of a fund's securities. Open-end funds may defer charging

offering costs to expense for a, period not to exceed one year. Closed-end funds and UlTs should charge offei:ing,costs to paid.,in-capital. In accordance with industr practice, closed￾end funds and UlTs may capitaiz offenng costs until the offerig period commences. For closed-end funds, the costs should then be charged to paid-in-capital imediately. For UlTs, such costs should be charged to paid-in capita no later than the close,of the period durig which unts' of the trst are first sold to the public, which generally does not exce th days. '

Since many UlTs have predetermed termintion dates, organtion expenses should

be amortized over the shorter of the life of the trust or sixty month from the date of commencement of operations. UlTs with trst indentures that contain provisions for mandatory termintion of the trst if assets fall below a specified level should acclerate the amortiztion of any remaing organtion costs when it appears probable that the trst wil termte before the sixty month or shorter period has elapsed. In such intaces,the reduction of the amortiztion period should be' considered a change in accounting 'estiate in accordace with

Accounting Principles Board Opinon No. 20 - Accounting Changes ("APB 20").3 1 Letter to Pierre de St. Phalle, Re: Unit Investment Trust Organtiona Expenses, publicly available May 9, 1995. Specifically, the letter addresses whether a UlT ca "bear the cost of preparg its registration statement, trst indenture and other documents, registerig its securties with the Commission and the states, and the intial audit of the trt." Although these expenses were referred to in the letter as

"organiational" expenses, the letter was not intended to address the accounting treatment of these types of expenses.

2 See paragraph 8.09 of the Audit and Accounting Guide - Audits of Investmnt Companies, issued by the America Institute of Certified Public Accountats, with conforming changes as of May 1, 1994. 3 Issued by the American Institute of Certified Public Accountats, July 1971. \ ¡

¡\ Financial Statements of Depositors Required by Forms N-8B-2 and 8-6

In many cases, the fmancial statements of the depositor may not be critical to evaluating and understading a UlT offering. As a result, the staff has not objected if, under certin

circumstances, a registrant omits the depositor fmacial statements required by Item 59 of Form

N-8B-2 and Instrction l(c) (as to the prospectus) of Form S-6.

Registrants have requeste clarification of the circumtaces under which the fmacial statements of the depositor may be omitt from Form N-8B-2 and Form S-6. In addition,

registrts that include fmacial statements have asked whether they are required to be audited.

Registrants using Form N-8B-2 orS-6 generally may omit depositor fmacial statements unless the depositor meets any of' the following conditions:

• The depositor has liabilties pursuant to Section 27 of the 1940 Act (associated with a periodic
  ,payment plan). Periodic payment plan certficates and some inurace products. arè subject to refund requirements under Section 27. The depositor's fmacial statements are importt in determg the abilty of the depositor to refund the required amounts.
• The depositor is considered the issuer of the securities whose reserves wil be relied upon to ensure payments. Insce companes issuing varable
  products charge fees for mortlity and expense risks which, in part, are credited to reserves required by state inurance statutes. The fmacial statements reflect the size of the reserves available to cover these and other risks.
• The depositor has a legal obligation to maintain a sec9ndary market for the
  securities. To prevent trsts from dimshig in siz during a specified period,

some depositors agree to maintain a seconda maket for the orderly tranfer of

ownership of trst units.4 ,The abilty of the depositor to continue to maintain that market is reflected in its fmacial statements.

• The depositor must continuously fuction as
  the issuer because of the nature of the offering. For example, equity ownership unts in some trsts have been .sold with the abilty to split the units into separate fmacial intrents. The separate intrments are separately traded' and have , differig market values attbutable to their unique economic chacteristics based on their diffenng demands on the assets of the issuer. Trading of the separate intrents usually req~ires the depositor's continuation in business. In addition, the depositor must remain continuously involved when additional equity ownership unts are issued or the separte intrments are reconstituted for the purose of a redemption. 4 More often, the depositor agrees only to attempt to maintain such a market but makes no legal commitment. This is not considered a legal obligation to maintain a secondary market.

If the depositor meets any of the above conditions so that fmancial statements are required, the following procedures should be noted:
Form N-8B-2, the 1940 Act registration form used by UlTs that are currently issuing securities, requires audited fmacial statements of the depositor. The fmacial statements must include a balance sheet, statement of income (profit and loss) and a statement of surplus for the depositor's most rècently completed fiscal year S as of the date of filing. Form S-6 is used to register under the Securties Act of 1933 securities of UlTs registered on Form N-8B-2 and also requires fmacial statements of the depositor. The form requires the fmacial statements' to contain a balance sheet as of a date with niety

days of the date of the filing. This requirement is modified by Rule 3-01(a) of S-X (17 CFR §21O.3-01(a)) which permits the balance sheet to be as of a date with 135 days of the date of fiing. The Commission, therefore, wil accpt balance sheets as ora date

withn 135 days of the date of fiing. If the balance sheet is unaudited, an audited balance sheet as of a date with one year of the date of the fiing must also be provided. The fmancial statements 'must also include an income (profit and loss) statement for the most

recently completed 'fiscayear and for any subsequent period up though the date of the latest balance sheet provided. The income statements must be audite though the date of the latest audited balance sheet. 6 " When fmancial statements are required in accordance with the policy set fort above, the Offce of the Chief A~ountat of the Division wil stil consider inormal written requests for omission or substitution of fmacialstatements pursuant to Rule 3-13 of S-X (17 CFR §210.3 13). ,,. Financial Statement Presentation of Fee Waivers :r~,)-.." There have been varing interpretations 'of the requirement to disclose fee waivers in a fund's statement of operations. The varing interpretations may result from current discrepancies between the Audit and Accounting Guide - Audits of Investmnt Companies 7 (which is considered to encompass GAA) and Rule 6-07 of S-X.8 Although the audit guide states that voluntary waivers need to be disclosed, it does not require volunta waivers to be stated separately in the statement of operations. Rule 6-07.2 of SoX requires fee reductions or reimbursements by any entity to be shown separately in the statement of operations as a negative amount or as a reduction of tota expenses. The rule makes no distinction between voluntary and involunta waivers and requires a note to the fmacial statements, to include the amounts and a brief description of, such arrgements. When there is an apparent confict, registrants should follow the requirements of S- X in fiings with the Commission. S The fmancial statements of the depositor are required to be prepared in accordance with Regulation S-X C'S-X"). Rule 3-02 of S-X (17 CFR §21O.3-02) requires a statement of cash flows to be fied as part of the financial statements.

6 Id. The statement of cash flows must also be audited though the date of the latest audited balance sheet. 7 Issued by the American Institute of Certified Public Accountants, with conforming changes as.of May 1, 1994. 8 17 CFR §21O.6-07

J .,
Compliance with Rule 18f-3.
Rule 18f-3 (17 CFR §270.18f-31 - Exemption for Open-End Management Investmnt Companies Issuing Multiple Clases of Shares,. Disclosure by Multiple Class and Master-Feeder Fund; Clas Voting on Distribution Plans was adopted on Februar 23, 1995.9 The rule, among other thgs, prescribes how income and expenses must be allocated among classes. The allocation methods selected by the fund, however, must be applied consistently from period to period. Pargrph (c)(2) of the rule allows income, realiz and unrealiz'capital gain and losses, and expenss not otherwise allocted to a particular class to be allocated on a settled share basis (as defmed in the rule) for companes operating under Rule 2a-7 of the 1940 Act and for companes declarg distrbutions of net investment income daily, provided those companes maintain the same

net asset value per share for each class.
Some registrnts have interpreted the rule to require funds electing to use the setted share method to apply consistently such method to all components of operations (including realiz and

unealizd gain and losses). We believe use of the same method to allocate all components of operations may result in a divergence of net asset value among classes when certin levels of subscriptions are recived by a fud.' The staff, therefore, wil not object if funds relying on Rule 18f-3 consistently use a dual allocatíonmethod where such method would reduce the likelihood of net asset values diverging among classes. The dual allocation method would permt the use of the relative net assets method, for allocating reaized and unrealiz gain and losses and the setted share method for allocat~g investment income and expenses.

Pro Forma Financial Information for Business Combin'tions Form N-14, the registration statement used to register securities to be issued in a business combintion, requires pro forma fmacial statements to be included if the,,,transaction meets the criteria set fort in Item 14(a)(2) of the form. Recently, the Division did not object to the

exclusion of certin fmancial inormation by registrants when the registration statements fied on Form N-14 solicited approval of the shareholders of two or more funds for proposals whereby the funds to be acquired (the "target fundstl) were to be combined with and into another fund (the "acquirg fund ").10 The tranactions typically are strctured so the combintion wil include any and al fuds that obtain shareholder approval; however, approval by every taget fund is not necessary for the merger to tae place. As a result, multiple pro forma presentation alterntives' are required, depending on the number of taget funds. 9 Investment Company Act Release No. 20915 (February 23, 1995) (60 FR 11876 (March 2, 1995)1.

10 E.g., Jaffray Funds, Inc., Form N-14 (File No. 33-58849). The pro forma combined
schedule of total return and expense ratios provided in ths filing contained information
for four years prior to the period covered by the pro forma combinng fmancial statements, which exceded the current requirement to provide the information, for the two prior years, as noted below.

Aricle 11 of S-X govern the form and content of pro forma fmancial statements. Rule 1l-02(b)(8) of S-X (17 CFR §210.11-02(b)(8)) states lIif the transaction is strctured in such a manner that significantly different results may occur, additional pro forma presentations shall be made which give effect to the rage of possible results. II A strct interpretation of ths requirement would produce full pro forma fmancial statements for each possible combintion. The staff believes that including full pro forma fmancial statements for each potential combination could be burdensome to the registrant and confing to shareholders. In situations where the acquiring fund wil combine with only target funds that receive shaeholder approval, the staff wil not object if, in lieu of providing pro forma fmancial statements for all possible

combintions of the eventu combined entity, registrants provide the following:
. pro forma combing fmacial statements reflecting the combintion of all funds that are involved in the proposed combintions, prepared in accordance with the requirements of Rule 11-02 (b) and (c) of S-X (17 CFR §21O.11-02(b) and (c)) based on the assumption that the shaeholders of all taget funds wil approve the tranaction; and . a schedule reflecting pro forma combined expense ratios and tota retu for every possible combintion involving the taget funds and the acquiring fund. The schedule should present tle inormation for all periods covered by the pro forma fmacial statements rc;ferred to above and for each of the two fisca years prior to the ealiest pro

forma fincial statements presented. Appropriate adjustments should, be made where

funds have different fiscal years, different dividend payout rates, or other relevant differences in order to provide a consistent presentation based on the actual results of the accounting surivor in each' scenaio. The expense ratio should be calculated in the maner set fort in Item 2 of Form N-1A, and total return should be calculated in the maner set fort in Item 22 of Form N-IA. In addition, a headnote to the schedule should explain the reason for presentation of the abbreviated pro forma inormation and briefly describe, if relevant, any assumptions that were made to conform the inormation of the various target fuds to that of the acquiring fund. .:,~~....~ Correction of Errors Certin funds are not imediately recording the correction of errors in their books and records. In cases where the correction would have an imediate effect on net asset value, some funds have capitalized the loss and, amorted it over some arbitrar period. APB 20 prescribes the accounting treatment'for adjustments resulting from the correction of errors. In pertinent par,

APB 20 requires the correction of errors to be recorded when identified. The staff believes that imediate recognition of the entire amount of the error should be reflected in the statement of operations and, if appropriate, the footnotes, regardless of the effect on net asset value.

Capitaliztion and subsequent amortiztion of error amounts are not accptable under GAA.

This letter contain inormation of importnce to the company's independent public

accountat; therefore, we encourage these items to be discussed with them. Any questions on the

contents of this letter or related matters can be' addressed to Anthony S. Evangelista, James F. Volk, Assistant Chief Accountats, or me at (202) 942-0590.

Very trly yours,

k~ ¿¿._~

Lawrence A. Friend
Chief Accountant